The Wall Street Journal's Greg Ip outlines the three schools of thought within the Fed about when and how to start raising interest rates:
WSJ.com - Fed Looks at Several Approaches It Can Take When Raising Rates: 'Baby Steps' Fed governor Martha Seger once referred to Mr. Greenspan's preference for many quarter-percentage-point interest-rate moves over long stretches as "baby steps." Of the 36 rate changes in his first seven years as chairman, all but six were less than half a percentage point. "Gradualism," as Fed officials label this, dates back at least to 1967, when Yale University economist William Brainard argued that when a central bank isn't sure about the economy, it should take small steps so that it can change course if its assumptions prove wrong. Mr. Brainard's work is referenced in many Fed staff studies with names such as "Is the Fed too timid?"... Smaller moves would require the Fed to start raising rates sooner, because it would take longer to get the federal funds interest rate back to neutral. That means the Fed would begin tightening before the economy has used up its slack, consistent with the Fed's traditional aim of "pre-empting" any increase in inflation.... The risk with an early increase in rates is that it could short-circuit the recovery before it starts to bring down unemployment....
'Backloading' After seven years on the job, Mr. Greenspan got more aggressive.... The Fed tries to gauge where the greatest risks for the economy lie and then errs on the side of setting rates too high or too low in order to minimize that risk. Some Fed officials suggest this approach should lead the Fed to wait a long time before raising rates, then move rates quickly up to neutral. They would much rather minimize the odds of the economy stumbling and the deflation danger reappearing than the odds of the economy, and inflation, taking off.... Once the Fed was convinced that the expansion wouldn't be derailed, it might have to move quickly to avoid leaving rates too low when the economy had used up its slack. Some officials worry that putting off tightening increases the odds that the Fed will have to move so fast that it invites unpredictable market repercussions, as in 1994. But others note that in spite of the turmoil, the 1994 tightening was notably successful....
'Late and Leisurely'.... "Inflation has been trending down for the last three years and it has now reached levels that I feel are actually too low for the health of the economy," Fed Governor Ben Bernanke, a Princeton University economist who joined the Fed two years ago, said in a recent speech. This gives the Fed a third option for raising rates that it didn't have in the past: Wait and move so leisurely that inflation rises, creating a cushion against deflation, or generally falling prices. Mr. Bernanke prefers that the Fed hold inflation between 1% and 2%, using the Fed's preferred inflation measure, the personal consumption price index excluding food and energy. In the 12 months ended in January, that measure increased 0.8%.... Some Fed officials caution that once inflation starts to rise, it might be hard to stop. Inflation of 2% wouldn't be a big deal, Mr. Stern says. "But how confident can I be that 2% is where we settle, as opposed to going higher from there?"...
Mark me down for "late and leisurely." I'm uncomfortable with an inflation rate below 2%. (And I'd be even happier with an inflation target of 3%.)
Posted by DeLong at March 18, 2004 11:12 AM | TrackBack
I think the move will be very late and very slow. Partly it depends on the job picture. 2% inflation w/ 4% unemployment (less leisure) is different than 2% inflation with 5.5% unemployment (more leisure). Do today's factors prescribe a "leisure suit"?
I think Greenspan will let inflation rise above 2%. I suspect he misses the power to pull on a lever and have an effect.
A key not mentioned is productivity. AG will target high productivity over other variables.
Posted by: bakho on March 18, 2004 11:36 AMA higher inflation rate is preferable why? Is it because it would allow us to get real wages down, and employment up, in a more timely fashion? If so, I see nothing wrong with that -- provided we as a society are prepared to supplement lower market wages with government subsidies (an expanded EITC) and other benefits (national health insurance being at the top of the list). But is this the reasoning behind Delong's preference? I wish he would clarify.
Posted by: Luke Lea on March 18, 2004 11:58 AMThe 1994 tightening was successful at what?
It was sold as a premptive move to dampen the economy and thus keep inflation from accelerating. It seemed to work in this way.
But what is the relevant lesson for today?
The stock market reaction was muted because earnings growth was so strong. The drop in the S&P 500 P/E was about what should have been
expected from the 1994 tightening.
Moreover, the 1994 tightening was about twice as big as a Taylor rule would have suggested.
Unitl there are signs of genuine domestic inflation, and significant hjob growth and wage improvements, I would expect Greenie to go very slow.
The only thing keeping this economy muddling along is the ultra low rates; If that goes, ya got real trouble.
Hence, why he is waiting for signs of sustainable growth -- i.e., job creation.
Posted by: Barry Ritholtz on March 18, 2004 12:51 PMThe Federal Reserve tightening beginning in February 1994 was successful in slowing the economy gently, limiting any inflation pressures and having a mild effect on corporate earning and the stock market. There was no question by September-November 1993 that the Fed would soon be raising the funds rate from 3%. The problem was that brokerage houses were intent on selling bond derivatives to institutions even as it was evident rates would soon be rising. When rates began to rise there were derivative shocks in the bond markets, but the shocks were brought on by poor or worse advice. All in all, by 1995 the economy was gaining speed, the stock and bond markets were gaining rapidly, and investors who had been patient were better than fine, and the Fed had been successful.
Posted by: anne on March 18, 2004 12:54 PMWhy is higher inflation desireable? Read Krugman:
http://web.mit.edu/krugman/www/japtrap.html
Basically, the Fed can control unemployment by changing the interest rate. Move interest rates down, unemployment goes down. The Fed will also move the interest rate up as a brake on inflation. When interest rates are around 4%, the Fed has a lot of leeway to move interest rates up if inflation is too high or down if unemployment is too high. The problem is when there is deflation and high unemployment, the Fed cannot move the interest rate below zero (actually about 1%). That is where we are today. The Fed cannot stimulate the economy and employment by dropping interest rates because they are as low as they go. Raising interest rates would increase unemployment and perhaps lead to deflation and recession. Right now the Fed is powerless as a force to stimulate the economy. Only fiscal policy will work right now and we have an administration that does not understand how to use that fiscal policy effectively. If inflation were around 4%, deflation is not a concern.
Posted by: bakho on March 18, 2004 12:56 PMNotice that the Euro-zone annual inflation rate has fallen to 1.6% in February. Japan is in deflation. There is selective price pressure in the developed countries for energy and several other commodities, but general inflation is remarkably little.
Posted by: anne on March 18, 2004 01:03 PMThe FOMC minutes from January 28 show that Board members thought inflation was likely to hold fairly steady this year. Even so, the FOMC statement then and at the March meeting continued to report that inflationary risks were "almost" balanced. Why "almost" if inflation is steady? Maybe because it is steady at to low a rate. In that case, then a non-aggressive approach to neutral rates would be just the ticket.
Posted by: K Harris on March 18, 2004 01:40 PMhttp://quote.bloomberg.com/apps/news?pid=10000039&refer=columnist_berry&sid=aDBAczWLBr3w
Remember also that the Bureau of Labor Statistics employment cost index increased only 2.9% last year, and average hourly earnings rose 1.7% for the year through February.
Posted by: anne on March 18, 2004 01:54 PMAnne,
Isn't it common for inflation to start in selected places? I'm not convinced yet, but it won't take many more months of .2% core inflation to convince me that the commodity inflation has leaked into the core. Despite the number of unemployed, the economy might have some trouble adjusting to these price changes and start registering that difficulty as generalized inflation. If that has happened, it will take a 1% hike just to avoid an even more stimulative policy, and then another 1 or 2% just to get back closer to neutral. I don't think it makes such a huge difference, but the Fed might as well act quickly if the data is screaming. Usually the data is murky enough to justify small moves though.
Posted by: snsterling on March 18, 2004 02:19 PMThere was recently a similar increase in commodity prices. When? In 1965. Commodity prices actually ran up quite a bit after the Federal Reserve had finished the tightening sequence in 1964. We found there was no general inflation effect from the commodity price increases even though the labor market was more robust than now. Labor costs are the prime costs for business, and there is sadly no pressure there.
I do not worry about an inflation push from commodity price increases, though I would surely like to have an Administration fostering better energy efficiency and conservation and stimulating more refining capability and gas supply improvment.
Posted by: anne on March 18, 2004 02:32 PMCorrection: The commodity price surge I recalled came 1993 and 1994....
March 10, 2004
John M. Berry - Bloomberg
"As for the analysts worried that the surge in commodity prices foretells a surge in overall inflation, they too might want to look back at the early '90s.
Prices of many commodities rose strongly in 1993 while the Fed held its overnight rate target steady at 3 percent, and they continued to rise in 1994 after the Fed began to lift the target.
None of the commodity price surge showed up in core consumer prices. The year-over-year change in the CPI less food and energy prices, which was 3.2 percent in December 1993, had dropped to 2.6 percent by the end of 1994."
"Mark me down for "late and leisurely." I'm uncomfortable with an inflation rate below 2%."
I'd say you should be pretty comfortable thru November at least. The probability of AG doing anything that would risk choking off the stock market gains or this month's latest refinancing boom is slim and none.
Posted by: flory on March 18, 2004 03:03 PMCynic's view
Mark me for the cynic's view of why the choice will be "late and leisurely." Mr. Greenspan will bend over backwards to help the Bush administration if he can. His concern for the political implications of a tightening move as a greeting to an incoming Kerry administration will be minimal
With globalization, many jobs can be done anywhere. With hundreds of millions of Chinese and Indian workers moving from agriculture to mfg and service jobs there will be low wage inflation for a long time. There is an interesting passage in the beginning of The Price of Loyalty where AG and Mr Paul are going through the business reports and looking at jobless economic expansion. Under those conditions, why would any central bank raise interest rates?
Posted by: bakho on March 18, 2004 05:27 PMThe other factor keeping wages low is modernization and using robots in mfg. We just had a whoopTdo announcement from one company that will expand now that they have wrung out wage and health benefits from the UAW down to $11. That's about $22K/yr. They will be closing operations elsewhere and modernizing here to produce more with fewer workers.
Posted by: bakho on March 18, 2004 05:35 PMAre not the europeans aiming for 2% inflation,as this is the optimum, for employment and revenue. At 1% the economy is almost deflationary. Taxes on higher incomes should be increased and the revenue pushed down into the lowest wage earners, and perhaps into public works until the economy starts to run properly.
Posted by: big al on March 18, 2004 06:01 PMWould our host be so kind as to put his mind to inflation in Iraq, or point me towards someone who is doing so? It strikes me that since the CPA has arrived (what an unfortunate acronym that is, given Andersen) and wages for all these teachers and doctors have gone sky-high relative to what their wages used to be, inflation should be a worry there. Or am I nuts?
Posted by: Linkmeister on March 18, 2004 10:56 PMIp is back today (March 19), with a review of the January 28 Fed minutes. He raises the possibility that some Board members will want to hike rates because they think financial and housing markets have gotten complacent about Fed policy. Of course, since that meeting, stock prices are down. So, however, are Treasury prices. Housing cooling? Given the extremes we have been looking at and the magnitude of seasonal adjustment to late autumn and winter housing starts and sales data, I couldn't say.
Posted by: K Harris on March 19, 2004 05:27 AMIf we assume that interest rates should rise,
and that AG will not raise them on aWol's watch,
then they will be raised on Kerry's. And so,
just as aWol blamed Clinton for his recession,
Kerry will be similarly plagued by having to
withstand rising interest rates. If Kerry is
to scale back any of the tax cuts, it is
difficult to envision a jobs recovery. Is there
ANY hope?
bakho wrote, " The Fed cannot stimulate the economy and employment by dropping interest rates because they are as low as they go."
O yea? Dumb some money into the system and watch what happens. Remember, we are talking about real interest rates here, not nominal ones.
Posted by: Luke Lea on March 19, 2004 07:27 AMMake that "dump" not "dumb" in the above post.
Posted by: Luke Lea on March 19, 2004 07:36 AMWhen I look at price changes in urban real estate over the past 30 years, I find they have moderately out paced the period increase in the S&P index. I simply do not think there is evidence of a real estate bubble as opposed to a sharp increase in recent years as interest rates have come down.
Posted by: anne on March 19, 2004 11:22 AMPlease anne.
"I simply do not think there is evidence of a real estate bubble as opposed to a sharp increase in recent years as interest rates have come down."
What would count as evidence for you? Or are you recommending a change in language --not "bubble" but "sharp increase"?
Something tells me that this is not just a semantic debate for you.
Do you know what a heroic stand this is? ( I assume you are not a real estate agent.)
In every way this is like the stock market bubble. Not just a "sharp increase" but one that is not sustainable and hence the term/warning "bubble".
Luke --real as opposed to nominal interest rates:
Please clarify.
Are you adjusting for inflation? Are you adjusting for dollar depreciation? 1% is the posted rate --is that "nominal" for you? In any case, "dump some money into the system and watch what happens" happens every day by way of debt issuance. See, for example, the indefatigable ( and at times painfully so) Noland
http://www.prudentbear.com/creditbubblebulletin.asp
So we are watching what happens.
Should Japan exit the fx market, I expect to see interest rates increase to cushion the fall in the dollar. Do you see any takers for Japan's position?