inflation

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Fed Funds Rate: Minus 5%?

Buried in this weekend’s news was a report on the internal analysis being undertaken by the Federal Reserve Board with respect to its ongoing efforts to stimulate the economy. One of the more interesting nuggets is the calculation that, given the state of the economy right now, especially the balance between inflation and unemployment, the Fed should be setting its benchmark overnight interest rate, the Fed Funds rate, at -5%. Yes that’s minus 5%.

Since interest rates cannot go below zero that presents quite a difficulty!

But, ever the innovative crowd, the Fed has come up with all sorts of tricks to provide monetary stimulus even though its primary weaponry has been rendered useless.

They have undertaken a slew of actions, such as buying Treasury bonds and holding them in a portfolio, that are collectively called ‘quantitative easing’ or unconventional monetary policy.

The net objective of lowering interest rates is, of course, to stimulate the economy by making borrowing more attractive and simultaneously easing the cost of debt burdens. An increase in lending that results from lower interest rates causes a flood of money, i.e. the lent cash, to enter the economy. This additional money then greases the economic wheels, and activity rises. or so the notion goes.

When interest rates are so low that they cannot be lowered to generate this stimulus effect the Fed has to resort to its irregular bag of tricks. Its acquisition of Treasury bonds also is a way of pushing money into the economy since the cash its uses to buy the bonds is now in the hands of the former bondholders who can now use it for something else.

So we should all applaud the Fed for being willing to undertake all these unusual actions: its aggression is helping offset the timidity of the politicians who passed a relatively small fiscal stimulus. Small that is relative to the size of the problem.

So overall I give the Fed a high grade for its efforts.

But that -5% should grab our attention. If that is the ideal interest rate for the moment we can immediately sense the depth of our continuing crisis. Given that a target Fed funds rate in ‘normal times’ might be 3% to 4%, the Fed would have to raise rates by 8% to 9% to get back to ‘normal’. Such a run up in rates would be unbelievably restrictive: it would kill any chance of recovery and then some. So we can infer from the -5% that interest rates are going to be low, maybe even zero, for quite some time. I would guess that, barring some dramatic event, we will not see Fed funds much above zero for the next two years at least.

Naturally there are huge risks associated with all this unconventional policy and the extent of the monetary stimulus. In particular we have to be careful not to prime a surge in inflation. I don’t see this as a problem right now since the economy is operating so far from capacity: all that cash will be put too use closing the gap between where we are now and our capacity limitations.

One last thing: since no one really knows just when this monetary easing will show up as inflation, it is good to see the Fed is already planning its ‘exit strategy’.

Still: minus 5%. That seems a little ridiculous doesn’t it?

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Europe, Deflation Fears, and Us

This morning’s New York Times carries a very disturbing report on the Spanish economy. In particular it highlights what appears to be the onset of a bout of deflation. Apparently retailers throughout the country are now having to cut prices in order to encourage any kind of spending, and the rate in the reduction in price levels is now reaching an alarming pace. The most disturbing aspect of the Spanish situation is that their unemployment rate is now up at 15.5% and is heading higher: it might easily reach 20%. The combination of unemployment at those levels and falling prices is exactly the combustible mix that characterized the Great Depression so events in Spain bear considerable attention.

And Spain is not alone: other European countries are facing disastrous economic declines as well, not least Ireland which is arguably worse off than even Spain.

So the obvious question becomes: could we also fall into this deflationary and high unemployment trap?

A quick answer would be no.

The reason is that the US has taken some extraordinary measures that the Europeans have not. For instance, the Federal Reserve Board has pursued a very aggressive monetary policy from the beginning of the crisis. It started by reducing interest rates quickly and when that failed to produce the normal or expected response it adopted a series of highly unusual, some might say unorthodox, policy steps such as beefing up its own balance sheet by buying securities from private investors. Such purchases have the effect of putting more cash into private hands and therefore increasing the nation’s money supply,i.e. the total amount of cash and cash equivalent money in circulation. In theory this should boost economic activity, or more likely prevent further contraction.

In conjunction with the Fed’s creative activities, the US has also gone on a binge of deficit spending, which is the classic ‘Keynesian’ response to a fall in demand in the private sector – recall that ‘recession’ is simply a term used to describe an economy that is shrinking, and that the shrinkage is, in turn, usually caused by a drop in demand for goods or services by private consumers.

Traditional economic theory teaches that the Fed’s ‘normal’ monetary policy, cutting interest rates, should be sufficient to return a shrinking economy to growth. This is because lower interest rates encourage a new bout of borrowing, which means that cash is freshly available for boosting spending.

A moment’s thought of that traditional policy will immediately lead you to see the reason the current crisis is so difficult to deal with.

It relies on lending.

Without healthy banks the drop in interest rates will have little effect due to the fact that there are no banks prepared to lend. So the recovery effort stalls at the first hurdle.

Plus, this time consumers are so snake bitten by declining home values and collapsing stock prices, both of which are wiping our household savings, that the amount of effort needed to get people out borrowing and spending again is beyond the reach of normal policy.

This is particularly true because we went into the crisis with interest rates already fairly low: so there was not much leeway for aggressive interest rate cuts before we reached zero. And interest rates cannot go below zero.

All this is familiar on both sides of the Atlantic.

What is different in Europe is their resistance to running a Keynesian style fiscal policy, i.e. going into deficit spending to stimulate demand; and this is coupled with a level of denial, until quite recently, about the true situation in the larger European countries like France and Germany. Since the European Union acts as a single entity for monetary policy purposes, through the European Central Bank, countries like Spain are left to fend for themselves. They have to comply with the central monetary policy and so have to rely heavily on fiscal policy at their local levels.

It is easy to get a little haughty at this point and criticize the centralization that seems to have caught Spain in a terrible vice. But we should all recall that the US also has huge regional differences in its economic performance: just look at the damage being wrought in Michigan by the auto industry collapse; or in Nevada, California and Florida by the real estate collapse and our air of superiority should evaporate quickly.

In fact much of the beneficial effect of the Federal stimulus package is being entirely offset by highly restrictive policies being enacted at the state level. Just as cash is pumped into the economy by the Feds local jurisdictions are cutting back on spending and therefore negating the Fed stimulus.

In this regard, the only reason that California is not being touted as an economic disaster of Spanish proportions is that no one sees it as an independent country! Its budgetary crisis, which is of epic proportions, gets treated as a local disturbance rather than a national implosion.

With home and stock prices still falling [or at least remaining weak]; with lower demand reducing commodity prices – things like oil are costing less because consumption has fallen faster than output; and with unemployment likely to rise well into next year the scene is set for deflation here too.

And that fear has been sufficient for some, myself included, to urge the Fed to induce a bout of inflation. Some of you may have noticed that Ben Bernanke actually went on record as saying the Fed was targeting a 2% inflation rate over the medium term. This was his way of letting the credit markets know that he was prepared to stoke inflation rather than allow deflation set in.

How would he do that?

By pumping tons of cash into the economy. If the money supply grows faster than the potential growth rate of the economy we normally get inflation. As of now the economy is running well below its potential, so all the cash being injected will simply lift activity towards that potential rather than result in inflation. The tough part comes when the economy starts growing again and the money supply remains higher than needed – as it would given all the Fed’s extraordinary efforts of late. The ‘neat trick’ the Fed is trying to pull off is to signal its intention to produce modest inflation, and hence calm deflationary fears, while at the same time attempt to judge the right moment to rein in money supply to prevent inflation exploding.

Rather them than me.

Unfortunately for Spain they are tethered to the less expansionary policies of the European Central Bank and the highly conservative fiscal policies of its largest trading partners. It is in awful trap. And deflation is an almost inevitable result of it having to contract its economy severely to achieve a rebalancing rather employing the kinds of tools we have here.

So, coming back to the question of whether we can expect a Spanish style crisis here, the long answer is also no.

But there is no room for complacency: our political willpower to pursue the necessary bailouts and stimulus has been wafer thin at times. Raging on about the future costs of ballooning Federal deficits, or about the cost of saving the banks, and debating the efficacy of government spending at times like these are corrosive to that willpower.

In other words, we could easily become like Spain.

We dodged the big one because we did the ‘right thing’. Let’s hope we have the sense to keep on doing it.

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What Kind of Recovery

Perhaps it’s simply Spring, but there has been some mildly encouraging data over the past two or three weeks. So the discussion has turned towards the nature of the upcoming recovery. In particular will it be a sharp upturn? Or will it be a long slow slog?

Before we get to that let me first say that the economy remains deeply mired in this recession and that in my opinion all the so-called early signs of our having reached the bottom are just as likely to be false omens.

Having said that, the housing market has shown a little life lately, but much of that activity is in the form of sales of foreclosed homes. These still count as home sales in the aggregate data, but they are hardly an early sign of strength. Quite the contrary. Foreclosures tend to press down on other homes in the same areas, so as sales of foreclosed homes gather pace the effect is to lower home values. Besides, home prices have still not fallen back to a level where affordability gets back to its historic norms. For that to happen we need another 10% – 15% drop.

With unemployment hanging ominously across the nation, and home prices still falling it is hard to paint an aggressive recovery picture.

Nonetheless some analysts are now predicting a very sharp upturn later this year and early next. I don’t agree with this outlook. Or at least I fail to see anything to support such a prediction yet.

The main premise upon which the optimists rest their case is the historic data since World War II. Every steep recession since then has been followed by an equally steep recovery. Conversely, slow or shallow downturns have been followed by slow or shallow upturns. It is tempting to suggest that this trend will repeat itself now.

I don’t agree.

My reasoning is as follows: most post 1945 recessions have been characterized by very sharp increases in manufacturing unemployment, particularly in the auto industry. Plant closings and layoffs typically accompany the first signs of a drop in demand and contribute to the gathering recession by eliminating wage earning jobs and hence potential consumption. This rapid snowballing of job losses and consequent cuts in consumption produce a sharp “V” shaped recession because consumption postponed by fearful consumers gathers pace anew as soon as the fear of job losses abates. Which it does once industry has closed sufficient plants and people realize ‘the worst is over’. The reappearance of consumers creates demand that manufacturers cannot meet from their diminished operations so they start re-hiring. Quickly this creation of new jobs, which is really the reinstatement of the old jobs, further quells fears and increases consumer purchasing power from the new wages being earned.

So a typical post war recession ends as sharply as it began, leaving the economy back where it was and following its historic growth pattern of about 3% to 4% GDP increase a year – right in line with population growth plus productivity improvements.

This time the downturn is far more widespread across the economy – job losses are not concentrated in manufacturing – and the banking crisis goes on unabated. This last factor alone suggests to me that getting a recovery well established will be difficult. Past post 1945 recoveries have not been as hindered by bank failures as this one will be. Without sufficient credit to fund expansion of factories and other operations businesses will be much more cautious about re-hiring than normal.

As long as we have weak banks, who are either unable or unwilling to lend, we will suffer through a long period of slow GDP increase. There will be growth, but it may well be insufficient to offset population growth, so per capita GDP may fall.

If, as I expect, inflation picks up during the recovery then we could be set for a few years of sluggish growth accompanied by rising prices. This is far from the pleasant picture being painted by the optimists, most of whom are connected with Wall Street so it is their job to paint scenarios in which investing in stocks can be encouraged. By and large these are the same people who said there was no bubble, so I feel comfortable disagreeing with them!

Overall I think the bottom of this decline will be reached in early summer – after further home price declines and all the large lay-offs have taken place. After that we will start the slow climb back. I just cannot see a healthy economy re-emerging until late 2010 or even early 2011. There are too many impediments and too much debris to clear away.

And I am not too sure that we are going to be successful cleaning up the banks any time soon. That’s still the issue to follow most closely.

Addendum:

I mentioned above that I expected inflation to pick up. Here’s why: All that money being pumped into the economy by way of bailouts and stimulus will eventually fuel an increase in prices – inflation. Any time the government increases the money supply at a rate above the general growth rate of the economy it runs the risk of stoking inflation because the increased amount of money is not matched by an increased amount of stuff to spend it on. To bring the amount of money into line with the amount of goods the price per item of goods goes up. Hence inflation.

The only time this doesn’t happen is when the money supply is pumped up while the economy is operating well below its ‘potential’. Under those circumstances the increased money supply goes towards getting the economy back to capacity: it is absorbed by the creation of more goods and services, rather than by increasing the prices of existing goods and services.

To the extent the economy arrives back at its potential, or at least is growing again, any excess money created during the stimulus or through bailouts runs the risk of fueling inflation later on.

Under our current conditions all the extra money being forced into the economy is not likely to create inflation immediately – we are simply too far under potential growth – but is likely to show up as inflation in the medium term after growth has re-emerged.

Hence my prediction of an uptick in inflation sometime next year or early 2011.

By the way: as a government policy I would argue that stoking inflation would be ‘good thing’. It eliminates deflationary fears; it alleviates debt burdens – future debt repayments are in inflated currency; and it pumps up bank profits because it raises interest rates. While it may sound odd to advocate a good dose of inflation, I think it would be sensible public policy right now … as long as we can rein it back in in the future.

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