Edmund Andrews writes about the Federal Reserve's current policy dilemma:
Posted by DeLong at June 28, 2004 09:10 PM | TrackBack | | Other weblogs commenting on this postThe New York Times > Business > Your Money > Up, Yes. But How Much, How Fast?: ...Having cut interest rates to their lowest level in more than 40 years, the Federal Reserve is expected to start raising them again at its policy meeting on Tuesday and Wednesday... a final exam for Alan Greenspan, who, at 78, has been the Fed chairman for 17 years. Mr. Greenspan, who is expected to retire when his term as a Fed governor ends on Jan. 31, 2006, has already steered the economy through two recessions, three wars, a stock market crash, a bubble and a bust, and the terrorist attacks of Sept. 11, 2001. He must now wean the nation from a historic borrowing binge that he consciously fostered....
The big question is not whether rates will rise, but how much and how fast. Mr. Greenspan, acutely aware that abrupt rate increases in 1994 led to considerable economic pain, has made it clear that he wants to move more slowly this time.... Even though Mr. Greenspan's political standing has never been higher - Democrats and Republicans overwhelmingly supported his appointment to a fifth term as chairman - he has come in for continuous second-guessing and criticism among bond traders and investors who contend that he has fallen "behind the curve" on inflation.... Consumers, able to borrow more money without higher monthly payments, have responded in force. Mortgage debt has soared at double-digit percentage rates for the last two years, climbing $1 trillion in the last year alone. Americans borrowed to buy new houses or to improve their old ones. By refinancing at lower rates, they extracted cash to buy furniture and appliances. Using either their home-equity loans or zero-interest loans from car companies, they bought record numbers of cars, pickups and sport utility vehicles. By all accounts, consumer spending propped up the economy at a time when businesses felt too shell-shocked to invest in new equipment or to hire more workers....
So far, the strategy has worked. Business investment revived last summer. The economy, which lost more than two million jobs in the first three years of President Bush's term, has created nearly a million since January. There are also preliminary indications that wages, stagnant for some time, are about to rise as companies hire more aggressively.... Much has changed since the Fed moved to pre-empt a rise in consumer prices 10 years ago.... Perhaps most important, the Fed has labored mightily to take the surprise out of any policy change. More than six months ago, in speeches and policy statements, Fed officials began telegraphing the possibility of rate increases. The idea, of course, is to keep financial markets from being spooked....
Fed officials contend that the high level of household debt is not an economic concern. Because housing prices have climbed at double-digit annual rates in many markets, they say, household assets have climbed even faster than debt, and net worth has rebounded to record levels.... What worries top Fed officials much more is the specter of rising consumer prices. Senior officials admit that they were surprised by unexpectedly big jumps in consumer prices in February and March....
J. Bradford DeLong, a professor of economics at the University of California at Berkeley, said he thought inflation would remain low for some time because there were still large numbers of unemployed workers. The nation has one million fewer jobs today, he said, than it did when employment peaked four years ago. In addition, he said, the adult population in the United States has expanded by about 1.4 million a year over the last four years. "We are still five to six million jobs below where we should be," Mr. DeLong said, even if one assumes that many adults will choose not to work. "We are still very short of reaching potential output." That is clearly the view of Mr. Greenspan and other Fed governors, all of whom have argued at length that the economy still has considerable "slack" and that recent jumps in consumer prices are based on passing events rather than long-term inflationary pressures. But many economists disagree....
"
Doesn't the possibility of stagflation worry you ? We financed a guns and butter deficit by printing money before, and wound up a decade later with high unemployment AND inflation.
Moreover, one would think that the weaker dollar would eventually show up in the price level (Dixit did a paper that showed that exporters take some time to raise their prices in the face of revaluation of their currency).
I am just curious about your views on this.
How much slack the economy has is debatable.
Especially when you start looking at the excess capacity by sector. Yes, there is massive excess capacity in the communication sector, for example. But on the other hand the basic industry sectors of the economy are operating at about 90% of capacity.
Moreover, inflation expectations plays a major role in the wage setting process and it looks like inflation expectations are bottoming.
Moreover, productivity has been great for the last couple of years but the evidence is very strong that productivity growth is now slowing sharply. In the 4th Q it was 2.9%. With the revision of 1st Q real GDP productivity will also be revised down to about 3% and 2nd Q productivity will be even slower.
In the first half of the year core inflation has been some 2.5% to 3%, at the top of the band
of acceptable inflation to the Fed. If the fed allows the higher oil prices to be monetized it will be making the same error it made in the early 1970s.
The 1970s inflation was born in the LBJ guns & butter economic policy and his fellow Texan is now following the same policy receipe.
Posted by: spencer on June 29, 2004 05:08 AMLast week I was making a client presentation and showed how import prices for consumer goods excluding autos and energy was now rising and the deflator for GAFO merchandise --department store type goods-- was bottoming. I went on to explain how this would be a major negative for the relative performance for retail stocks.
A portfolio manager in the meeting replied that this was exactly what Walmart was saying.
Posted by: Spencer on June 29, 2004 05:13 AMWhere would the "stag" in stagflation come from? I am not expecting the Blue Chip's 4.4% GDP growth forecast for Q2 to come true (consumption spending growth seems well off the Q1 pace so far in Q2), but why should we expect stagnation? On the other side, how much "flation" do we need before we begin to think that inflation is a problem for anybody but the Fed? Don't most studies of the impact on inflation on real side performance find that many multiples of today's inflation rate would be needed to slow growth? I know the Fed is being really generous, but do we really think the Fed is being stupid, that the Fed will throw away two decades of progress on inflation? The core inflation rate is still below 2%, after all.
Posted by: kharris on June 29, 2004 05:15 AMThe economy as whole is at a greater risk with the dollar in a relatively weakened state. Most of the core inflation is a result of higher oil and other imported goods prices. The Iraq war right or wrong is winding down, OPEC is increasing output reducing pricing pressures on oil. Raising interest rates slowly will increase the value of the dollar and we will have a two fold reduction in oil prices.
I am sure that Professor DeLong can tell me the actual percentages, but current defense spending as a percentage of GDP is not as high as it was during the early 1970s or as high it was under Reagan in the mid 1980s. Going forward the war on terror may require the increase of the defense budget as a percentage of GDP, but that today remains to be seen.
If we were going to have 'stagflation' I would guess that it would not be a guns and butter situation but rather a butter and drugs issue. As the population ages and congress continues to offer more and more health benefits to increasingly healthy seniors without means testing, then perhaps it is possible that from a tax burden and health cost burden that working individuals in all tax brackets could experience a significant drag on increased wages and employment in the economy as a whole.
A weak dollar trends toward inflation. I believe that if the Fed is to continue its drive to maintain stable prices it has no choice but to strengthen the dollar through the Fed Funds rate. As we consider the employment picture two things come to mind. First, 10 years a go we didn’t even believe that we could maintain the current level of employment without the employment level itself being inflationary. Secondly, if the Federal government was not the largest single payer of medical claims and if our health care was subject to greater price shopping employees would not see their increased earnings continually siphoned into heath care premiums. Health care is the real inflation in the economy.
Posted by: Gray on June 29, 2004 05:36 AMSpencer,
Your comment on performance in the retail sector, I think, is smack in the middle of the inflation debate. The beloved Chairman has suggested that, while pay for workers will rise, that rise need not translate into inflation because generous profit margins are likely to be pared in response to higher input costs. It obviously could be a bit of both - narrower margins and higher retail prices - but that was not Greenspan's story. The level of demand, and its impact on pricing power, seems the key.
Posted by: kharris on June 29, 2004 05:57 AMhttp://pep.typepad.com/public_enquiry_project/2004/06/prof_delong_is__2.html
Posted by: Adrian Spidle on June 29, 2004 07:43 AMI think we are going to see something much more interesting than mere stagflation.
For more than 20 years, Japan has been subsidizing its exports by buying dollars to suppress the yen exchange rate. Over the last decade, most of the rest of Asia has joined in. Asian foreign currency reserves now total over $2 trillion, and the cumulative US current account deficit appears to be nearly $4 trillion, rising $500 billion per year.
Some characterize this as foreigners "investing in America." To me, it looks exactly like the bubble-era "vendor financing" of the telecomms business. Asians send us useful goods, and we send them dollars. In a rational world, they would send the dollars back and demand that we send them useful things in return. Instead, their governments buy up the dollars and loan them back to us at absurdly low rates.
Does anyone really think that there is no limit to the amount of debt we can accumulate? Perhaps there isn't; back in the '90s I wouldn't have believed we could ever reach the current levels. But perhaps there is. Though the Bank of Japan bought about $350 billion from January of '03 through March of '04, and has authorization to buy about $1 trillion more, they stopped at the end of March, and the Japanese public is beginning to wake up to what is going on; in May the popular journal Chuô Kôrôn ran two articles describing and questioning the policies. What would the American people be thinking if the US government had sold $700 billion in bonds to buy yen or yuan, and had a budget to do $2 trillion more? Because our GDP is about twice Japan's, that's the scale of those currency interventions.
One way in which our trade could be balanced would be to have a $250 billion fall in imports together with a $250 billion rise in exports. The implications of such changes are daunting.
Posted by: jm on June 29, 2004 07:49 AMReagan's peak defense spending was 6.2% in 1986. Bush is at 3.7% and that does not even count HS or most of the Iraq costs. This is up from the Clinton low of 3.0%
John Kerry does not believe the defense budget can be easily cut because
1. stabilizing Iraq is going to require continued troop commitment,
2. the Iraq commitment Mr Bush made will require more troops by about 5% of current force,
3. the US is losing a lot of equipment and needs overhaul because of the harsh sandy environment of Iraq,
4. not to mention replacing armaments and equipment.
Some equipment will be left there (less expensive than shipping it back). Kerry proposes getting some savings by not deploying star wars and keeping only the research. Entitlements are up compared to Reagan in 1986. Medicare has about doubled and Medicaid costs have tripled. We really need to contain our health care costs because it is a drag on the economy.
Kerry interview on what defense will cost:
http://www.armytimes.com/story.php?f=1-292925-3043564.php
Posted by: bakho on June 29, 2004 07:55 AMThose are % GDP (From CBO)
Posted by: bakho on June 29, 2004 07:57 AMQuestions for anyone -- if the 15 year Japanese depression is over will Japanese bonds quickly go back to 4%-5%-- they are already starting to rise sharply. If they do will it generate significant upward pressure on US & world rates?
Posted by: Spencer on June 29, 2004 09:00 AMKharris asks:
"Where would the "stag" in stagflation come from? ...why should we expect stagnation?"
Maybe stagnation would come from a deep-recession or depression triggered by the inability of overly indebted American consumer's to carry on their recently traditional role of "world consumer of last resort" thus triggering global financial and economic collapse. This would prove particularly true if we didn't really get stagflation, but the worse alternative of Fisherian debt deflation. It all seems now to depend on whether or not we can grow our way out of the mess we've created, overcoming problems as we grow. I can't see how we do it, but maybe others have clearer vision.
Kharris then asks:
"On the other side, how much 'flation; do we need before we begin to think that inflation is a problem for anybody but the Fed?"
Good question. Maybe inflation is not really a problem going forward, given other weaknesses. Instead maybe we just view inflation (beyond some low level which Keynesians view a a necessary good) as a tax, as Wassily Leontief and others have done.
Or maybe some of the Austrians are more correct, and we'll see massive worldwide (or at least American) inflation that proves to be a problem for we who have thought it a good idea to be "savers" rather than "debtors." And after all the bubbles burst, and savers who haven't hedged well lose their holdings along with many debtors, then we can all wait a decade or two to see who is willing to lend what to whom, as we rekindle confidence in something in the wake of chaos and depression.
Posted by: Dabbler Dave on June 29, 2004 09:40 AMOther economists disagree? Disagree with what? The comments from DeKaser do not seem to take issue with the premise that there is still excess supply. He does not that the non-wage components of employee compensation are rising faster than prices are but then real wages are falling even as productivity continues to rise.
Posted by: Harold McClure on June 29, 2004 09:58 AMSpencer:
Interesting comments about sector specific levels of capacity. My little tirade about other economists disagreeing was directed at what was in the NYTimes article specifically and preceded reading your comments.
Posted by: Harold McClure on June 29, 2004 10:02 AMMajor question -- is the recent weakness in commodity prices a correction or a trend reversal? Looks like a correction to me -- copper and aluminum prices already appear to have bottomed. Historically industrial raw material prices have been a great leading indicator of oil prices and world growth.
Could the recent commodity price weakness just have been part of the undwinding of the carry trade -- a significant number of investors are adding commodities to portfolios that never held them before.
Posted by: spencer on June 29, 2004 10:11 AMBakho - interesting comments on the defense budget. A CNN People-in-the-News story on Don Rumsfeld noted his original mission in early 2001 was to find ways to reduce DoD spending. I'm glad to here that in one way - maybe Bush43 was serious about downsizing the government when he first became President, but this goal seems to have been abandoned on several fronts.
Posted by: Harold McClure on June 29, 2004 10:11 AMDespite the high level of comments here, i agree with Richard Green's original point: that i think there is a real risk of stagflation here, and have been saying (as my friends will tell you, with wearying regularity) since summer '03 that i expected early signs of stagflation by late '04.
I do not believe that we will see '70s style stagflation, but i believe that the combination of modestly increasing prices and lack of real wage growth and higher interest rates will put a crimp in buying power (which is the "stag" component); i believe, as several have noted, that the odds of a declining dollar will increase the risk of the "flation" part.
My actual guess is that we will see rather low growth going forward, lack of improvement in the jobs-to-population ratio, increasing (to modest but still worrisome levels) inflation, and i call the net of that "stagflation."
Posted by: howard on June 29, 2004 11:15 AMFor the record, despite my "gloom and doom" comment earlier, my guess is that somehow we will muddle through this thing rather than crash the system. "Muddle through" equates in my mind to the type "stagflation" that Howard refers to just above.
Posted by: dabbler dave on June 29, 2004 12:22 PMA lot of the 70s "stagflation" was due to an economic dislocation due to soaring energy prices. It wasn't until energy conservation measures of the 1970s had dropped the price of energy by the early 80s that the economy came out of its funk.
Recent data shows consumer spending up, but Walmart and Target spending are down. Could it be that people paying much more for gasoline can afford much less at Walmart and reduce the number of drives to the stores to compensate?
The real risk is that we are spending so much money on the military and Iraq and collecting so little revenue that we will ignore our infrastructure and workforce training to the point of diminishing our competitiveness.
Posted by: bakho on June 29, 2004 12:28 PMThe commentary on this topic has been very high-level. I think the stag will come from lower growth and the effects of falling asset prices, flation from increased costs of things we need and in commodity costs. The wave of inflation is already starting.
Our markets are manipulated by the central planners, and I think, barring a six-sigma kind of event, an exogenous shock, they'll manage a muddle through scenario.
Posted by: phil on June 29, 2004 08:45 PMHoward re: stagflation worries
I think your view is plausible but have some quibbles. When you say
"...lack of real wage growth and higher interest rates will put a crimp in buying power (which is the "stag" component)",
I note that we haven't had growth in wages for awhile and yet buying power runs unabated with HELs. No crimp there or for the short term unless house values drop, no?
Interest rates should exert downward pressure on housing prices --starting tomorrow if the pundits are right.
Moreover since AG has been incessant about the hike for what seems like an eternity, many have already made their move. So I expect less sales in July and Aug. This should also exert downward pressure on house prices.
Those sales within the market should be moving to smaller/cheaper and we should see an increase in the foreclosure rate for those who couldn't move.
In this scenario the consumer gets a chance to go shopping just as soon as the house prices recover to enable the HELs.
In the meanwhile, higher interest rates will make the imports he's been buying more expensive, exerting downward pressure on the demand for these goods, no? And if there was any pricing power before, there should be less under these tighter conditions.
Increasing the rates should support the dollar but only in the sense that it slows the descent (given the deficits).
Is this stagflation? The label is not too important to me --it does not look swell.
calmo, the times had a fascinating chart yesterday, which i'm going to cite from memory. In 1980, there was something in the neighborhood of $50B of credit card debt (north of $100B in today's dollars); today, there's something like $800B. That's what has sustained consumer purchasing power.
And that's why i combined the lack of real wage growth and rising interest rates; it's going to become harder and harder for people to use credit cards to sustain consumption.
In conjunction with the end of the refinancing boom that you point to (goodness, did you see what washington mutual reported about earnings?), i don't see where consumption-sustaining legs are for the 80% of households with under $80K of annual income.
As it happens, i don't much care if it's "stagflation" or merely weak growth (although it was fun, 12 months ago, to project something that not another soul saw on the horizon) either: the macroeconomic situation definitely does not look swell, as you say....
Posted by: howard on June 29, 2004 10:39 PMhoward (unique projector)
The credit card debt is drained by the HELs no? The information I have is that the default rate is kept as low as it is, only because most of the folks have access to this financial instrument. (The stats on how much of the monthly credit card bill is paid, how many of the card holders are paying off only the minimum, etc are astounding.)
Is there a "crimp" in purchasing power? A glance at the auto market informs me (better than say Walmart sales but that's useful too).
My favourite source on this issue is NT's Kasriel who usually supplies graphs which not only support his arguments but provide an historical snapshot as well.
I said earlier that I thought that somehow we'd "Muddle Through." In other, earlier DeLong forums I've asked what rabbits might be pulled from hats to help us muddle a while longer. No one offered up any, in the wake of the Refi rabbit that helped inflate the credit bubble, housing bubbles, etc.
On reflection, I should have said that I "hope" we somehow find a way to muddle through. I still harbor deep fears that we will not, and will crash-land the system and hurt many people in the process.
I still believe that the FED should have incorporated bubbles into its sights earlier, say 1995, and stopped the party earlier. Now we may have reflated some of the equities bubble, pumped up housing bubbles, and added to the credit bubble.
If raising rates now triggers events that lead to bubble popping, that in turn lead to debt deflation, then what? Is anyone other than fringe Austrian economists worrying about Hyperinflation that might accompany asset deflation?
Let's let Stephen King have a last word, talking about where we go from here with regard to both policy solutions (interest rate hikes and exchange rate depreciation) and market solutions.
"Ultimately there has been too much borrowing, and asset prices are inflated, it is quite difficult to escape from the conclusion that there has been excessive spending, a process of 'borrowing from the future.' ...
"So, either policy will have to do its work, deflating expectation in the vague hope of delivering a soft landing for the general economy, or the markets will impose their own solution. Sadly, any market solution is likely to be rather unpleasant -- currency turbulence, falling house prices and declining share prices. Yet these are the prices that we might eventually have to pay for our collective refusal to allow the bubbles of recent years fully to deflate. It might have been an impressive recovery so far, but the marshlands of debt upon which it is built may eventually bring the whole structure crashing down."
"Marshlands of Debt May Sink Global Recovery," Stephen King, Managing Director of Economics at HSBC,Independent News, 28 June 2004
http://news.independent.co.uk/low_res/story.jsp?story=535677&host=3&dir=272
See also, "Inflated Expectations," The Economist, 1 July 2004
http://www.economist.com/finance/displayStory.cfm?story_id=2877003
Great site fatty lose weight with reductil and reductil uk
Posted by: reductil on July 6, 2004 02:06 PMGreat site fatty lose weight with reductil and reductil uk
Posted by: reductil on July 6, 2004 10:39 PMGreat site fatty lose weight with reductil and reductil uk
Posted by: reductil on July 8, 2004 02:48 PMGet it up mate, it's fun!
Posted by: Viagra on July 8, 2004 08:27 PMIt gets yours up to the top dude! The girl will enjoy it!
Posted by: cialis on July 13, 2004 02:40 PMMuppets love Viagra!
Posted by: Viagra UK on July 14, 2004 03:36 AMI don't really think your thoughts are right. Maybe you need a loan?
Posted by: payday loans on July 15, 2004 12:40 PMThanks for your blog!
Posted by: Kontaktanzeigen on July 16, 2004 06:12 AMHire a car to feel higher!
Posted by: Car hire UK on July 20, 2004 05:07 PMHire a car to feel higher!
Posted by: Car hire on July 20, 2004 11:59 PMGreat site fatty lose weight with reductil and reductil uk
Posted by: reductil uk on July 23, 2004 07:51 PM