July 22, 2003
Panic in the Bond Market?

Morgan Stanley's Stephen Roach sees a bond-market panic driven by depressed "animal spirits" on the part of bond traders. The Federal Reserve needs to keep long-term interest rates low to spur investment and recovery. How it can do this if it is indeed the case that long-term bond interest rates are now being set by panicked traders rather than forward-looking economists is a mystery: Morgan Stanley: ...There are a number of alternative explanations to this dramatic sell-off in the bond market.  There are those, of course, who claim that signs of incipient economic recovery have turned the bond market inside out.  While I'm hardly objective on that point, even the diehard growth optimists concede that the evidence remains mixed at this point and that the vigorous recovery call is still a forecast (see Dick Berner’s July 18 dispatch, "Recovery Signs").  Others have argued that the rapidly deteriorating federal budget deficit is the culprit, sparked by the administration’s midyear confession that the budget shortfall is likely to hit $455 billion in the current fiscal year.  While I would be the last to minimize the significance of this development, it hardly qualifies as the singular surprise that can explain the bond market’s...

Posted by DeLong at 12:53 PM

June 30, 2003
A Correspondent Asks...

"Why do you say that it is so foolish for Lawrence Kudlow to compare May-June to March-April rates of growth of the monetary base and to conclude that monetary policy is becoming more restrictive?" The answer is that month-to-month monetary base growth rates are very, very noisy. Banks' demands for reserves and public demand for currency fluctuates a lot on a month-to-month basis, especially if you express changes as annual growth rates (which Kudlow does). For example, take a look at the month-to-month changes in the monetary base since the start of 2000: But does this bounciness mean that monetary policy is extraordinarily restrictive one month and extraordinary expansionary another? No. It just means that the demand for high-powered money is noisy, and thus that a central bank that wants to stabilize short-term interest rates (or any of the broader measures of the money stock) will find that it has to make the monetary base bounce around considerably from month to month. Why, then, does Kudlow think that comparing March-April to May-June growth rates is an interesting number? I have no idea. I've never met any monetary economist who understands why either....

Posted by DeLong at 05:58 PM

June 27, 2003
Out of Gas

Stephen Roach meditates on the gap between what the Federal Reserve wants the American economy to do--grow at 4 percent per year for a couple of years or so--and the tools at the Federal Reserve's disposal: Morgan Stanley: ...Since the equity bubble popped in early 2000, the US economy has been on an anemic 1.7% annualized growth path. That includes a mild recession in the first three quarters of 2001 and an unusually subpar recovery in the subsequent seven quarters. Significantly, the post-bubble growth pace has been well below America?s productivity-driven potential growth rate that most put in the 3.25% to 3.75% zone. The result is the emergence of a wide margin of slack between aggregate supply and demand. For a US economy that entered this post-bubble business cycle at a 2.25% inflation rate, this slack has been sufficient to push the US dangerously close to the deflation threshold; in the first five months of 2003, annualized core CPI inflation has averaged just 1.2%. Little wonder the most common complaint heard from US businesses pertains to the lack of pricing leverage. In this context, the Fed?s goal is simple -- to get the economic growth rate back above its long...

Posted by DeLong at 06:17 AM

June 21, 2003
Forthcoming Federal Reserve Rate Cut

The Washington Post's John Berry puts his ear to the ground and guesses that the Federal Reserve will cut interest rates next week by 0.50 percentage points (a 60% chance) or by 0.25 percentage points (a 40% chance). That seems about right to me--but his sources are much, much better than mine. One bone to pick, however. John Berry says that economists were "surprise[d]" by the fact that "recovery has been halting and 'jobless' despite huge doses of monetary and fiscal stimulus." This economist hasn't been surprised. Simply look at the late-1990s boom and the structural sources of the acceleration in productivity growth, and a "jobless recovery" looked like a definite possibility. Rate Cut Looking Like a Sure Thing (washingtonpost.com): ...Federal Reserve officials, concerned there is still no sign of the solid pickup in U.S. economic growth needed to foreclose the possibility of deflation, appear certain to cut their target for overnight interest rates next week. There is broad agreement among investors and analysts that a rate cut is coming, but there is disagreement about whether policymakers will lower their 1.25 percent target by a quarter-percentage point or by a half-point. The latter seems to be more likely as a...

Posted by DeLong at 06:48 AM

June 08, 2003
Fighting Deflation as Job #1

Alan Greenspan says that fighting deflation is job #1 now: Greenspan No 'Major Evidence' of Growth (washingtonpost.com): ...Federal Reserve Chairman Alan Greenspan said today there is no "major evidence" that U.S. economic growth is accelerating and hinted again that the central bank may soon cut interest rates to boost growth and guard against a dangerous period of deflation. Speaking via satellite to a meeting in Berlin of the world's leading private bankers, Greenspan said the Fed has no concerns that a pickup in growth would cause inflation to get worse. Instead, "we would be far more inclined, as we have been over the last couple of years, to be taking out insurance against economic weakness" that could cause what he termed a "corrosive deflation." The Fed is concerned not about "the issue of deflation in the sense of falling prices per se, but the issue of corrosive deflation, that is, a deflation that essentially feeds on itself, creates falling asset prices, which in turn brings down levels of economic activity," the Fed chairman said......

Posted by DeLong at 08:49 AM

September 12, 2002
More People Worry About Deflation

The Economist steps up to the "let's worry about deflation" plate. I agree with them. The Federal Reserve, however, does not seem to: the Federal Reserve appears to believe that the NAIRU--the unemployment rate at which inflation is constant--is somewhere near 5.5 percent (rather than the 4.5 to 5.5 percent I would estimate), and that the rate of growth of potential output--which is the rate at which real GDP has to grow to keep the unemployment rate constant--is only a shade above 2 percent per year (rather than the 3.5 percent per year that I would estimate). Economist.com: ...As a result, there is a risk that, before the end of 2003, the rich world's three biggest economies—America's, Japan's and Germany's—could all have negative inflation rates. A sharp jump in oil prices as a result of America invading Iraq could, of course, push up headline inflation. But the longer-term impact of higher oil prices would be deflationary, not inflationary. Higher oil prices operate like a tax that depresses growth, so their medium-term impact would be to heighten the deflation risk. DeAnne Julius, a former member of the Bank of England's monetary policy committee, argued in a recent speech that there is...

Posted by DeLong at 04:45 PM

September 09, 2002
Stephen Roach on "The Great Failure of Central Banking"

I don't agree with Stephen Roach that the Federal Reserve should have made interest rates higher and tried to make unemployment higher in the late 1990s in order to diminish investment spending and collapse the stock market bubble. In my view, the time to deal with any problems created by the bubble's collapse is when the bubble collapses--not before. Relative to a lower-stock prices, lower-investment, one-percentage-point-of-unemployment-higher bubble-popping path for the U.S. economy in the late 1990s, the actual path that we took gave us an extra $1 trillion of real production. You can complain about how that $1 trillion was distributed. You can regret that a large chunk of it--$200 billion?--was spent on investments that have much lower social value looking forward than their social cost. You can fear the damaging consequences of banruptcy and fraud on the economy. But you have to argue that these drawbacks from the fallout are quantitatively very large for the cost-benefit analysis to go Stephen Roach's way. Nevertheless, he makes his case more strongly than anybody else does: Morgan Stanley: ... Yet out of this glorious disinflation a new inflation was borne -- asset inflation. And central bankers didn’t have a clue how to...

Posted by DeLong at 09:58 AM

September 06, 2002
Think Analytically!

Think Analytically! I remember one day during the first Clinton Administration when Joe Stiglitz came into the room to chair a meeting, looked around, noticed that--so far--only economists had shown up, and announced that nobody who did not have a Ph.D. in economics would be allowed to speak at the meeting. (Do I need to point out that that Joe was making a joke?) He was. All of us got it. All of us cheered and applauded. We did so not because we Clinton-era economists all agreed on all the issues--anybody with half an ear to the ground would know that we did not. We did so because we had found that it was possible to make intellectual and policy progress in discussions with economists because we had all been trained to think analytically: to break the issue down into background assumptions about the world, beliefs about the principal causal mechanisms, and claims about the likely effects of different policies on those chains of cause-and-effect. When we disagreed--as we often did--we could quickly ascertain where and why, and then agree on how to go hunting for pieces of information that would help resolve the disagreement. This was in striking contrast...

Posted by DeLong at 05:58 PM

The Economist Joins the Pile on Alan Greenspan

This week's "Economics Focus" in the Economist joins the pack piling on to Alan Greenspan for not deflating America's stock market bubble earlier: Economist.com: ...There may be no painless way to deflate bubbles. Yet the correct test is not whether a bubble can be deflated without some loss of output. Rather, it is whether the early pricking of a bubble causes less pain than letting it grow only to burst later. The longer a bubble is allowed to inflate, the more it encourages the build-up of other imbalances, such as too much borrowing and investment, which have the power to turn a mild downturn into something nastier. If the Fed had let some air out of the bubble earlier, America's economy might now be better placed for future growth... Admittedly, for the Fed to justify an increase in interest rates when inflation was low would have been hard—but not impossible. It could, for instance, have argued that raising rates and so containing financial imbalances would avoid future economic instability and hence a large undershoot in future inflation. Central bankers do not have a political mandate to respond to asset prices. Even so, Mr Greenspan could still have done more to...

Posted by DeLong at 03:10 PM

September 03, 2002
In the Shadow of the Grand Tetons

Richard Berner from Morgan Stanley gives his take on the conversation at last weekend's Federal Reserve Jackson Hole symposium (sponsored by the Federal Reserve Bank of Kansas City). From my perspective, the strangest and most worrisome thing about his report of the conversation is the "European" belief that interest rates have to stay high to promote the "liquidation" of potentially bankrupt enterprises. This is not a strong current of thought in America (save, perhaps, for the pages of the New Republic): ...Few U.S. monetary policymakers fret that low interest rates will forestall corporate downsizing, because they believe that U.S. financial markets are appropriately denying capital to those sectors where gluts are biggest, or giving it to new management who will clean house. On the contrary, some officials worry that Corporate America is hesitant to hire. So while they are guardedly optimistic, they seemed more open-minded about the need for additional stimulus than recent press commentary had suggested. All agreed that the U.S. economy's resilience in the face of financial shocks was comforting, but no guarantee that it would persist.... With oil prices meaningfully higher than we forecast, I share their concern that fourth-quarter growth could zigzag back toward 2%. Such...

Posted by DeLong at 12:39 PM

August 28, 2002
Defending the Economy by Attacking Asset Prices?

I have always been of the school that central banks should watch asset price bubbles with alarm, but should not raise interest rates in order to try to prick them. My guiding principal has thus been: "Sufficient unto the day is the evil thereof." I suppose I have been most affected by the memory of the Great Depression, where the Fed's desire to restrain asset prices generated interest rate increases that played a role (how big a role is still in dispute) in starting the snowball that became the avalanche of the Great Depression. Here Samuel Brittan cautiously, judiciously makes the case for a more aggressive policy toward asset price bubbles. I'm unconvinced, but it is certainly worth thinking about. Samuel Brittan: Taking asset prices seriously: ...a regime of inflation targets alone has now come under criticism for a different reason. The fear now is not that real output has been neglected but that asset prices have been. There is a vigorous if rarefied debate about whether asset prices as well as consumer price inflation should be specifically targeted. The riposte of central bankers is that asset prices are in fact taken into account insofar as they are expected to...

Posted by DeLong at 09:17 PM

August 24, 2002
Louis Uchitelle of the New York Times Also Worries About Deflation

Louis Uchitelle writes about the danger of deflation--and wonders why more people aren't worrying about it. I think the answer is that people are worrying about it. However, it's not yet a crisis, or even a clear and present danger. But it does seem to me that it could become a clear and present danger in a year, if things do not break favorably. Cost-Cutting Can Start a Ruinous Circle: ...Why isn't that danger uppermost in everyone's mind? Why are forecasters like James Glassman, a senior economist at J. P. Morgan Chase, so optimistic? In a nutshell, they expect an infusion of demand from somewhere that will reverse the cost-cutting and persuade companies to expand investment, production and hiring. Their main hopes are more tax cuts, more growth in federal spending and more interest rate cuts by the Federal Reserve. They also count on people to finance consumption by continuing to extract equity from their homes, which are still rising in value. Mainly, though, it is stimulus from Washington that for Mr. Glassman will save the day. "If Washington cannot get us moving toward full employment within a year," he said, "then there will be more federal stimulus. We have...

Posted by DeLong at 09:28 PM

June 28, 2002
Macroeconomic Effects of WorldCom

Richard Berner of Morgan Stanley thinks that WorldCom's accounting fraud will have little effect on financial markets--raise risk premia by 5 basis points (that is, 0.05%), but not have much of an additional effect on confidence or capital supply. If he is right, than the net effect will be stimulative, for the fear that WorldCom's accounting fraud will have bigger effects will cause the Federal Reserve to wait-and-see: to delay any raising of interest rates until the reliability-of-accounts situation becomes clearer. Morgan Stanley Investors fear that WorldCom's alleged fraud and presumed other lurking corporate blowups threaten the economy and financial markets. By escalating capital-market risk premiums, this and other shocks might further depress stock prices and trigger a broader-based credit crunch. In my view, that's unlikely. But the threat is likely to postpone Fed action to adjust monetary policy until late this year. Dave Greenlaw and I now expect that the Fed will remain on hold until November, and that officials will raise rates by just 50 basis points by year-end......

Posted by DeLong at 10:16 PM

June 24, 2002
Is Now Really the Time to Fight Inflation?

Curbing inflation? What inflation? Don't they look at their own graphs? Everyone else seems to have started focusing on the fact that demand appears likely to grow more slowly than potential output. Economist.com | Looking both ways | Jun 24th 2002 | From The Economist Global Agenda America's Federal Reserve meets this week to decide whether to leave interest rates on hold or raise them. Most economists think a rate rise is now a question of when, not if. But the central bank has to steer a difficult path between curbing inflation and helping recovery......

Posted by DeLong at 08:11 PM

June 20, 2002
The Federal Reserve Says Its Keeping Its Foot on the Gas

At the moment short-term real interest rates are negative: the 1.75% per year interest rate that the Federal Reserve has set on overnight federal funds is less than the rate at which consumer prices are rising. This is a very stimulative posture--it tells businesses that they should undertake investments that (in the short term at least) promise any profits at all, no matter how low. Now the Federal Reserve is telling us that there are no interest rate hikes on offer for the next few months. The Federal Reserve does not have confidence that the recovery is strong and steady enough to risk disrupting it by raising interest rates and making the incentive to invest less. The Federal Reserve does not fear rising inflation enough to want to raise interest rates to put downward pressure on price increases. | washingtonpost.com: Fed May Not Raise Rates At Least Until September | John Berry | June 20, 2002 | The Federal Reserve now appears unlikely to raise interest rates until the fall, at the earliest, because inflation remains extremely low and the U.S. economy is not growing fast enough to create many new jobs. At the beginning of the year, some investors...

Posted by DeLong at 09:10 PM

The Economist's Fears for the Strength of the U.S. Recovery

It is a strange business cycle conjuncture that the U.S. is in now. Stock prices appear overvalued, and likely to fall--an extremely unusual thing to happen at the start of the recovery. Business investment seems likely to weaken further. Yet productivity growth appears extraordinarily strong. The most likely forecast thus seems to involve (a) relatively slow growth--less than the growth rate of potential output (which is about 3.5% per year, or perhaps a touch more), coupled with (b) rising unemployment for the rest of this year at least. The Economist's gloomy take: Economist.com: ...there are good reasons for the markets' current angst. Doubts about the pace of economic recovery lie behind much of it. Wall Street is still, by any historical measure, extremely highly valued.... In so far as they ever made sense, such valuations assumed a speedy return to the extraordinarily high profit claims of the late 1990s. That assumption seems increasingly far-fetched. Mr O'Neill may not have noticed any " substantive information" recently, but others have. In particular, they fret about signals that the American consumer may be running out of steam. May's retail sales fell by an unexpectedly large 0.9%. With no evidence of a rebound in...

Posted by DeLong at 11:32 AM

June 03, 2002
European Monetary Policy

The Economist reports that "...there is a real risk that the European Central Bank will feel it has to raise interest rates" this summer, and blames it on two factors: (i) the European Central Bank's statutory obligation to keep inflation below two percent per year, and (ii) the failure of European governments to undertake steps that would reduce the unemployment rate at which inflation begins to creep upward.

Posted by DeLong at 02:02 PM

May 23, 2002
Strong American Relative Growth

During the 1990s, U.S. economic growth by far outstripped that of the other major industrial economies.

Posted by DeLong at 02:27 PM