August 19, 2002
Strange News From the Federal Reserve

At current levels of unemployment, there is downward pressure on the rate of inflation. Unless the unemployment rate falls sometime in the next two years, it is more likely than not that the U.S. will be in deflation--and in that case the Federal Reserve's ability to stimulate the economy will be very small.

I would have thought that a desire to stay far away from the edge of deflation would have provoked more interest rate reductions by now. It continues to puzzle me... Bonds: Federal Reserve policymakers made no change in their target for overnight interest rates when they met last week, and the wording of their statement indicated they won't cut rates unless it seems clear the pace of economic growth is not going to pick up again. Nevertheless, the minutes of the previous policymaking session in late June, which were released last week, showed that the sudden slowing in growth caught the officials by surprise. Strong retail sales figures for July, particularly for motor vehicles, got the current quarter off to a solid statistical start, and initial claims for unemployment benefits so far have remained below the 400,000 mark, suggesting that payrolls are continuing to expand, albeit slowly. At this point, the economic evidence weighs against a rate cut at the next policymaking session on Sept. 24...

-- John M. Berry

Posted by DeLong at August 19, 2002 01:19 PM | Trackback

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There is considerable criticism of FRS monetary expansion from "monetarists." Though monetarists seem to still regret that Hooverism was not given a proper chance in the 30's, their arguments are sounded in the Wall Street Journal and elsewhere and may be prompting excessive caution by the FRS.


Posted by: on August 19, 2002 02:44 PM

That is very unfair to monetarists. Milton Friedman made his reputation on criticising the Fed's behaviour during 1930-33. Monetarism did not even exist as a theory before the 1960s. On Japan's current deflation, Friedman has proposed a very similar solution to Paul Krugman - unsterilised, unlimited purchases of government bonds.

Posted by: peter vm on August 19, 2002 03:55 PM

At current levels of unemployment, there is downward pressure on the rate of inflation.

A one-factor model of economy-wide prices?

Posted by: George Zachar on August 19, 2002 06:10 PM

One can criticise the Fed for many things, and yes, for a good reason, the financial markets wanted Greenspan to cut rates last week. At the same time interest rate futures, and better the whole curve had rallied so much in anticipation of a move, that there was not much to be gained by delivering the move. What have we seen now following the decision: Equities up, bonds, Eurodollars down, but the latter two after an enormous rally in the period before. In the meantime the Fed's senior loan officers' survey shows that lending standards have only tightended modestly again compared to the previous quarter. Was it that wrong then, to keep the powder dry for maybe one more meeting, with the added benefit of looking at more data with rates already at 1.75%?

Posted by: Michiel Remers on August 19, 2002 11:12 PM

Michiel Remers comments:

At the same time interest rate futures, and better the whole curve had rallied so much in anticipation of a move, that there was not much to be gained by delivering the move.

I know I'm behind the curve on theory (IANNE), but this is wonderful - the endgame of rational expectations. If something is rationally expected, it dosen't actually need to be done. How generally does this apply?

Posted by: Jonathan Goldberg on August 20, 2002 07:00 AM

If something is rationally expected, it dosen't actually need to be done. How generally does this apply?

Greenspan has talked at length publicly about this.

Specifically, he's characterized zero inflation not as a hard data point, but as an environment where businesses don't expect it.

He's also referred to trust within business as "capitalized reputation", where folks expect counterparties to be trustworthy, lowering varous friction costs.

Posted by: George Zachar on August 20, 2002 07:37 AM

August 19, 2002
PBS Economic News

ALICE RIVLIN, COMMENTARY: Equity investors are hoping the Federal Reserve will soon cut interest rates and give the market a bounce. Back in the booming '90s these same folks insisted that the Fed had no business raising rates to deflate stock prices. The Fed, they argued, should not concern itself with asset prices, it should maximize sustainable growth and raise rates only to ward off general inflation. Indeed, that view prevailed inside the Fed, which did not raise rates until mid '99. By then, the extreme tightness of labor markets plus unsustainable consumer spending prompted serious worry about the whole economy overheating. The view that monetary policy should focus on sustaining growth, not asset prices, would not lead the Fed to ease anytime soon unless recovery shows clear signs of reversing. The economy will likely grow slowly until it catches up with the excess capacity created in the boom years and capital spending picks up. The interest rate sensitive sectors of the economy, especially housing and automobiles, are already strong and should not be further stimulated. The Fed does not have much more room to ease and had better hoard its ammunition. Besides, earnings prospects and corporate scandals make it tough to argue that stock prices are too low. Fed action to give the market a temporary bounce is a bad idea. I'm Alice Rivlin. [Former Fed Governor]

Posted by: on August 20, 2002 09:10 AM

Jonah: you have unwittingly stumbled on a question which I strongly suggest you un-ask, because the answer to it will cause you vast amounts of needless mathematical pain. There is something called a "saddle-path" dynamic equilibrium, which can be defined (via an oversimplification which is absolutely excruciating to the cognoscenti) as the set of paths of policy actions over time which is consistent with a set of expectations about policy actions in the future. So long as the market remains "on the saddle-path" in this sense, because it believes that the choice is cuts now or cuts pretty soon, the argument would be that there is potential an advantage from waiting to gain some information, since the actual actions of economic actors are the same. Obviously, if the Fed were to continue to not cut (or even to raise), then we'd be "off the saddle-path", but within limits, the rational expectations argument that you're having fun with is not actually as ridiculous as it appears.

Either the above makes sense or it doesn't. If it doesn't, I earnestly entreat you to forget you ever read it; I reiterate that nothing but pure pain has ever come to anyone who went through the experience of learning the mathematics of saddle-paths.

Posted by: Daniel Davies on August 20, 2002 09:31 AM

I think some of these arguments miss the point, as the late lamented Rudi Dornbusch indicated if the Fed fires two early and too often there's a danger of leaving no ammo in the magazine. There'll be time enough later in the year to get what little traction might be left from another drop in rates if things go on getting worse instead of better - remember what's been done up to now hasn't exactly revolutionised things, and the damage to confidence from another drop could be important (ie it might just push us over the edge). Don't forget the dollar is being allowed to fall, and this in the immediate term could do more to ward off the threat of deflation in the US, by exporting it to Europe. The real threat lies on the other side of the Atlantic, and especially in Germany, where of course the methods of measuring inflation are so antiquated that we don't really know what the actual rate is (if indeed we know this anywhere), and where interest rates are being maintained at excessive rates due to an apparent obsession with inflation. Ever heard of asymmetric risk anyone?

Posted by: Edward Hugh on August 25, 2002 12:47 PM
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