Wednesday, June 16, 2010

A strengthening economy calls for tighter Fed policy


I've been intrigued by this chart for a long time. What I think it shows is that the Fed has typically been very responsive to the state of the economy's health. The capacity utilization rate, shown in the blue line, is a pretty good proxy for how strong or weak the economy is. The real Fed funds rate (using the core PCE deflator) is a good proxy, in my view, for how easy or tight Fed policy is. In the view of those like the Fed that believe in the Phillips Curve theory of inflation, capacity utilization is also a decent proxy for the amount of "resource slack" in the economy, and thus an important input to monetary policy decisions. The logic goes like this: the lower the rate of cap utilization, the more idle resources there are, and the more idle resources, the greater the deflationary pressures on prices, so the more the Fed ought to ease. With cap utilization rates now rising rather rapidly, it would follow that monetary policy ought to begin to tighten.

The Fed doesn't always follow this model, however, as well as it probably should. As this chart shows, there are times when the Fed is proactive (tightening in advance of increases in capacity utilization with the aim of slowing the economy and thus preventing inflation from rising), and there are times when the Fed is reactive (responding with a significant delay to changes in capacity utilization). These different policy responses generally lead to inflation consequences. For example, the Fed was reactive throughout most of the 1970s, and inflation rose substantially. The Fed was proactive from the early 1980s through 1987, and that was a period of significant disinflation (falling inflation). The Fed was then reactive from the early 1990s through 1998, but inflation was relatively low and stable during that period, perhaps because the Fed had been so tight for so long in the decade prior. Since the early 2000s the Fed has generally been reactive, tightening policy with a significant delay in the wake of the strong economic pickup that started in mid-2003. Not surprisingly, inflation accelerated from 2003 through 2008.

The past year or two stand out as unusual in two respects: 1) the economy weakened sharply and to an unprecedented degree, but 2) the Fed took only limited action to ease. The latter can be explained away by noting that although the Fed could not deliver the negative interest rates, as their model (akin to the Taylor Rule) would have called for, it did engage in massive quantitative easing by expanding bank reserves by more than $1 trillion. In any event, we observe that for the past 18 months or so, inflation has been generally tame—does that not mean the Fed has done exactly the right thing?

I'm not ready to say that I have more respect for the Fed or their model of inflation, but I also don't want to ignore the facts. Of course, even the best model can have problems if political considerations overrule the model's policy prescriptions. In any event, going forward this model is saying that the Fed should begin raising rates sooner rather than later, otherwise it will end up committing the sin of reactivity that plagued monetary policy in the 1970s. It's something to think about.

13 comments:

Benjamin said...

Well, we are still a full 10 percentage points away from capacity utilization rates of the 1990s, when there was little inflation.

We are swamped in empty office, retail and industrial property space.

We have 10 percent unemployment, and I know of no 50+ unemployed white-collar guy who ever expects to get a job again.

I would say the Fed can run the printing presses until the plates melt.

We have had a recession, and a depression in real estate.

Paul said...

"I would say the Fed can run the printing presses until the plates melt."

Only Benji is allowed to commit heresies against Milton Friedman's holy writ.

Benjamin said...

Paul-

Actually, MF said tight money supply policies extended the Great Depression.

I am speakingly a bit jocularly, but now is no time to tighten up.

Scott Grannis said...

The worst time to tighten monetary policy is when it becomes obvious that a tightening is needed. That was the big mistake the fed made in the 1970s. Also, I find very pernicious the notion that easy money can goose the economy. Easy money can never create growth. If it comes in response to strong money demand, as we had in late 2008 and early 2009, then it is ok. But otherwise it is just inflationary. I note the continued rise in gold prices, which tells me that there is too much money in the world.

Paul said...

"Actually, MF said tight money supply policies extended the Great Depression."

And he said the post-war inflation was the result of excessive easing. His k-percent rule is at odds with your melt-the-plates advice.

Benjamin said...

Paul-

I like the k-percent rule. There may be extreme times, such as full-blown wars and deep recessions, that the k-percent rule needs to be loosened.

As to gold, the Chinese are buying. They have rising disposable incomes. China's currency is tied to the dollar and vice-versa, effectively. And due to global tensions, wars, and few sovereign meltdowns, there is flight to gold.

Even the USA is extending itself too far, entering decades-long wars in Iraqistan financed by debt, at trillions of dollars.

As much as I dislike gold as an investment, I understand some investors. After all, if you cannot buy GM debt, if you cannot trust BP, if AIG was a fraud, and if even sovereign nations default on their debt, then maybe gold looks alright.

As disposable income rise in China, then Satan's Shiny may have a long run. But so might diamonds, silver, platinum and palladium.

Or, gold may bust as it did in the late 1980s, leaving investors down for decades.

Paul said...

Benji,

The point is you constantly accuse the rest of us of being Friedman heretics. Only Benji The True Economic Conservative stands up to be counted when the going gets tough.

Except when he doesnt.

Donny Baseball said...

Scott-
You may or may not have focused on this item before, but it is something I watch closely: RV sales. Check out WGO's announcement today. The RV market is rebounding nicely, and RV sales to me are quite indicative of economic health.
Cheers,
DB

Donny Baseball said...

Scott-
Here'e another - container shipping is rebounding so fast that the world's largest container line is plagued by a shortage of shipping containers:
http://www.tradewinds.no/liner/article561526.ece
Cheers,
DB

Benjamin said...

Scott-

CPI out today (6/17) and it is down.
Really, if prices are going down, not up, don't you think the Fed has some elbow room here?

Paul-

I agree with MF 99 percent of the time. I will hold out my conservative bona fides to anybody, and especially anybody in the Republican Party, now nothing more than confederation of feckless poltroons.

septizoniom said...

donnybaseball has cork in his bat.

Paul said...

"I agree with MF 99 percent of the time."

And, by your past statements, you apparently position yourself as the arbiter of when that 1% deviation is acceptable.

"I will hold out my conservative bona fides to anybody, and especially anybody"

says the guy who likes Obamacare, mercantilism, and voted for The Messiah.


"..in the Republican Party, now nothing more than confederation of feckless poltroons."

Again, it is to laugh. Your boyfriend is absolutely burying us , but your wrath is targetted at those trying to stop him.

You're a fraud, Benji.

Scott Grannis said...

Donny: thanks for those contributions, they definitely help round out the macro picture of growth that I see.