The Fed is right to intervene to ward off recession
Sunday, 17 February 2008
Ethan Harris
AS the US economy and markets weaken, perennial pessimists have moved to centre stage, arguing for the inevitability of a serious recession. Tax rebates will not help, they argue, because heavily indebted consumers will simply save the rebate. And the Federal Reserve is "pushing on a string". Moreover, even if policymakers could rescue the economy it would be a mistake to stop a necessary adjustment in imbalances. Easing policy would only encourage excessive consumption, a big trade and budget deficit and dependence on rising asset prices - and it would extend the "serial asset bubbles". A good example of the "purge the imbalances" argument was Steve Roach's piece in FT (January 7).
Are things this bad? It now appears almost certain that about $100bn in tax rebate cheques will be distributed in June, July and August. Clearly a big chunk will be saved, but it is not clear why the consumer will respond differently than in the last rebate of 2001. In our forecast, we assume 50 per cent is spent. If correct, the rebate will boost growth in the second half by 2.0 percentage points, followed by withdrawal symptoms in the first half of 2009.
Aggressively easy monetary policy is helping the economy avoid an even worse outcome. Disruptions to the credit market have made monetary policy more difficult, but they have not made policy impotent. Fed easing has contributed to a sharp weakening of the dollar, causing spending to shift from foreign to domestic goods. Fed rate cuts, combined with aggressive efforts to open the money market, have caused a sharp drop in short-term interest rates and a surge in mortgage refinancing. The Fed can even help the morbid subprime sector: as the Fed cuts the funds rate below 3.0 per cent it begins to mitigate the reset of adjustable rate mortgages. If it cut the funds rate to 1.0 per cent, this would in effect stop the resets. By creating a steep yield curve the Fed is accelerating the healing process in the banking sector.
While the "pushing on a string" argument is partly correct, the "purge the imbalances" argument is dangerously wrong. Slow growth and a weak dollar are already reducing the trade deficit, the housing bubble is correcting without a recession and, as home prices fall, this should push up the saving rate. Allowing a deep recession will not cure the saving-investment imbalances. Fixing imbalances requires shifting the composition of aggregate demand - out of consumption and housing and into investment and exports - not lowering aggregate demand. If the Fed allows a serious recession, some imbalances will improve and others will worsen. The saving rate will fall as the unemployed struggle to pay their bills. The budget deficit will rise as tax revenues dry up. Only the trade balance will improve, because of a sharp decline in imports.
But there is a deeper problem with the "purge the imbalances" approach: it implies an unsustainable path for the economy. At about 5.0 per cent, unemployment is near its inflation-neutral rate -- at which core inflation should be relatively stable. But if the US goes into recession, joblessness will rise sharply. Holding unemployment above its inflation-neutral rate will over time create spiralling deflation. Thus, unless the US wants a replay of Japanese deflation, the economy will have to experience a period of above-trend growth, pushing unemployment back below the inflation-neutral rate. All of the improvement in the trade balance will be reversed. You cannot fix a saving-investment imbalance by creating unsustainably high economic slack.
The "serial bubble" argument is also seriously flawed. The Fed's aggressive easing early this decade did not create the housing and credit bubble. The Fed's mistake was being too slow to restore interest rates to normal levels. Alan Greenspan, former Fed chairman, stuck to the "measured pace" of tightening policy in spite of an accelerating boom across asset markets. Bubbles are hard to identify ex ante, but by late 2004 the evidence was compelling: not only were home prices rising much faster than incomes, there was a dramatic increase in the use of exotic mortgages and investors piled into "high return" markets.
The lesson for policymakers is not to step aside and let the economy collapse. Even with aggressive easing, the economy will probably only narrowly avoid a recession and growth in 2009 is likely to be weak as well. Economies do not morph directly from near-recessions into asset bubbles; there is a transition and the Fed can take advantage to restore policy quickly to normal.
The writer is chief US economist at Lehman Brothers.
FT Syndication Service
AS the US economy and markets weaken, perennial pessimists have moved to centre stage, arguing for the inevitability of a serious recession. Tax rebates will not help, they argue, because heavily indebted consumers will simply save the rebate. And the Federal Reserve is "pushing on a string". Moreover, even if policymakers could rescue the economy it would be a mistake to stop a necessary adjustment in imbalances. Easing policy would only encourage excessive consumption, a big trade and budget deficit and dependence on rising asset prices - and it would extend the "serial asset bubbles". A good example of the "purge the imbalances" argument was Steve Roach's piece in FT (January 7).
Are things this bad? It now appears almost certain that about $100bn in tax rebate cheques will be distributed in June, July and August. Clearly a big chunk will be saved, but it is not clear why the consumer will respond differently than in the last rebate of 2001. In our forecast, we assume 50 per cent is spent. If correct, the rebate will boost growth in the second half by 2.0 percentage points, followed by withdrawal symptoms in the first half of 2009.
Aggressively easy monetary policy is helping the economy avoid an even worse outcome. Disruptions to the credit market have made monetary policy more difficult, but they have not made policy impotent. Fed easing has contributed to a sharp weakening of the dollar, causing spending to shift from foreign to domestic goods. Fed rate cuts, combined with aggressive efforts to open the money market, have caused a sharp drop in short-term interest rates and a surge in mortgage refinancing. The Fed can even help the morbid subprime sector: as the Fed cuts the funds rate below 3.0 per cent it begins to mitigate the reset of adjustable rate mortgages. If it cut the funds rate to 1.0 per cent, this would in effect stop the resets. By creating a steep yield curve the Fed is accelerating the healing process in the banking sector.
While the "pushing on a string" argument is partly correct, the "purge the imbalances" argument is dangerously wrong. Slow growth and a weak dollar are already reducing the trade deficit, the housing bubble is correcting without a recession and, as home prices fall, this should push up the saving rate. Allowing a deep recession will not cure the saving-investment imbalances. Fixing imbalances requires shifting the composition of aggregate demand - out of consumption and housing and into investment and exports - not lowering aggregate demand. If the Fed allows a serious recession, some imbalances will improve and others will worsen. The saving rate will fall as the unemployed struggle to pay their bills. The budget deficit will rise as tax revenues dry up. Only the trade balance will improve, because of a sharp decline in imports.
But there is a deeper problem with the "purge the imbalances" approach: it implies an unsustainable path for the economy. At about 5.0 per cent, unemployment is near its inflation-neutral rate -- at which core inflation should be relatively stable. But if the US goes into recession, joblessness will rise sharply. Holding unemployment above its inflation-neutral rate will over time create spiralling deflation. Thus, unless the US wants a replay of Japanese deflation, the economy will have to experience a period of above-trend growth, pushing unemployment back below the inflation-neutral rate. All of the improvement in the trade balance will be reversed. You cannot fix a saving-investment imbalance by creating unsustainably high economic slack.
The "serial bubble" argument is also seriously flawed. The Fed's aggressive easing early this decade did not create the housing and credit bubble. The Fed's mistake was being too slow to restore interest rates to normal levels. Alan Greenspan, former Fed chairman, stuck to the "measured pace" of tightening policy in spite of an accelerating boom across asset markets. Bubbles are hard to identify ex ante, but by late 2004 the evidence was compelling: not only were home prices rising much faster than incomes, there was a dramatic increase in the use of exotic mortgages and investors piled into "high return" markets.
The lesson for policymakers is not to step aside and let the economy collapse. Even with aggressive easing, the economy will probably only narrowly avoid a recession and growth in 2009 is likely to be weak as well. Economies do not morph directly from near-recessions into asset bubbles; there is a transition and the Fed can take advantage to restore policy quickly to normal.
The writer is chief US economist at Lehman Brothers.
FT Syndication Service