Monday, June 27, 2011

Monetary policy is growth-friendly, but we are suffering from a surfeit of stimulus

This chart is very much worth a periodic review, since it illustrates the strong link between monetary policy and the health of the economy.

Note that prior to every recession since 1960, the real Fed funds rate (using the PCE Core deflator, the Fed's preferred measure of inflation) has risen substantially. In all but one case, the real funds rate exceeded 4% prior to every recession. The last recession was the only exception to that rule, since the real funds rate only rose to 3%. The level of the real funds rate is a good measure of how tight the Fed is; the higher the tighter. When real interest rates become very high, it is a sign that the Fed is restricting the flow of liquidity to the economy, and money becomes scarce and therefore very expensive to borrow. (They usually do this in response to a rise in inflation.) High real borrowing costs begin to snuff out risky initiatives, and increase the demand for money. People begin to prefer letting cash sit in money market funds rather than putting money at risk. Speculative activities become very expensive; it's more rewarding to own a bond than it is to be long gold or commodities. When enough of that happens, economic activity begins to weaken, and those with high debt burdens get crushed.

Also note that prior to every recession, the slope of the yield curve from 1 to 10 years was either flat or negative. A flat or inverted yield curve is a classic sign of tight money, because it is the bond market's way of saying that the Fed is so tight that it will almost certainly have to lower rates in the future. The combination of a high real funds rate and an inverted curve is thus an excellent sign that the Fed has put a big squeeze on the economy and a recession is thus very likely.

Today the situation is the exact opposite of a monetary squeeze. The real funds rate is almost as low as it's ever been, and it has been negative for more than 3 years now. This is typical of the early stages of a recovery. Recessions are provoked by a severe tightening of monetary policy, and once the economy has stalled the Fed reverses course and steps on the monetary gas. Their aim is to make money very cheap to borrow, and to weaken the demand for money. As the demand for money weakens, the velocity of money increases—people start spending the money they hoarded going into the recession, and this helps pull the economy out of its slump. We're now on the upslope of the monetary policy roller-coaster.

This recovery has been unusually slow to gain traction, and one reason is that the demand for money remains very high. M2 velocity has been very low (because money demand—the inverse of money velocity—has been very strong) since late 2008. Money demand has been so strong, in fact, that banks have been unwilling to use their mountain of reserves to make new loans, and the economy has been unwilling—in aggregate—to borrow more money, preferring instead to deleverage. Banks prefer to hold on to their reserve "cash" instead of spending it on new loans.

But this is not to say that the economy will be spinning its wheels forever. One thing we know almost for sure is that the economy is not suffering from a lack of liquidity right now, and liquidity shortages are what have precipitated every recession in the past. It would be highly unusual and surprising to see a double-dip recession any time soon.

What is more likely is that the economy will continue to grow, albeit slowly.

Why slowly? I have been arguing since early 2009 that we are suffering from a surfeit of stimulus. Fiscal policy is supposedly very stimulative, with federal spending having increased by fully 25% relative to the rest of the economy, generating gigantic deficits that have never been seen in postwar U.S. But excessive government spending coupled with increased regulatory burdens (e.g., Dodd-Frank) and huge deficits actually act to depress the economy in several ways. To begin with, when the government appropriates a big new chunk of economic activity by increasing its spending (and transfer payments), this wastes the economy's scarce resources and creates perverse incentives (e.g., by rewarding the idle and punishing the ones working hard). Second, new regulatory burdens dampen animal spirits by raising the cost of doing business. Third, huge deficits create the very rational expectation of huge new tax burdens, further increasing the cost of business. When you make businesses more costly to run, you should expect to see fewer new businesses. And when you increase tax rates on the margin, this reduces the reward to risk-taking and work, so you should expect to see fewer new businesses and fewer people offering their services to the labor market.

Furthermore, the hugely expansive position of the Federal Reserve—with its absolutely unprecedented and off-the-charts purchase of $1.6 trillion of government and agency debt—has most likely weakened the dollar and helped push up commodity prices. There remains great uncertainty about how and whether the Fed will be able to tighten policy in time to avoid an unpleasant rise in inflation—which is already on the rise. Monetary policy fears go a long way to explaining the strong speculative urges that have driven gold and commodity prices to new highs in recent years. And monetary uncertainty has undoubtedly contributed to dampen investor confidence in the future.

So to summarize: the chart at the top says we have every reason to expect the economy to continue to grow, but a surfeit of monetary and fiscal stimulus amounts to a significant headwind to growth. Memo to Washington: please stop the stimulus, it's really hurting!


Benjamin said...

The PCE deflator, minus food and energy, for 12 months ended 5/11 is 1.3 percent.

I hardly think that suggests we are in an inflationary environment. Unit labor costs are going down. Real estate values are dead. The S&P 500 is below 1999 levels. Signs of inflation are feeble, fleeting.

Commodities are set on global markets, and China is the biggest buyer for many. There are some structural oddities--like the USA corn ethanol program. Should we really monetarily suffocate our economy because our corn ethanol program has boosted corn prices? Or because OPEC has colluded on crude prices, Chavez is an idiot, and Russia is run by thugs? Libya had a meltdown? Indeed, this suggests the problems in commodities are caused by political structural problems, not too much money.

I guess this is how you do a Japan. You find some asset, some commodity that is rising in price, and say you need tight money. Even when the PCE core deflator is running at 1.3 percent.

I agree federal outlays should be cut back to 18 or even 16 percent of GDP, and the federal budget brought back into rough balance (although there is no shortage of capital anywhere). I do wonder about one thing--due to past excesses, the US government pays hundreds of billions of interest back into the private sector every year.

If we run a a balanced budget, we will essentially be adding hundreds of billions of interest back into already glutted capital markets.

You think interest rates are low now?

Wait till the federal government runs a balanced budget.

scharfy said...

Surfeit of stimulus?....

I dunno. More like a dearth of demand.

The 'crowding out' argument is a difficult one to make with the 10 year @ 2.95%.

Credit bubble still unwinding. Thoughtful post.

Balanced budgets right now might satisfy my inner Calvinist, but it won't do much for GDP, IMO.

Public Library said...
This comment has been removed by the author.
Public Library said...

Financial repression...

Jeff said...

Scott, you nailed it again. Capital investment and expansion are risk/return propositions. With the cost of doing business rising (regulation) and the returns being less (high taxes and potential higher taxes), the present value of some future potential stream from that investment shrinks. It’s no more complicated than that.

Decision makers are still uncertain which way this whole thing is going to break: 1) higher taxes, higher debt, more regulation; or 2) lower taxes, lower spending, less regulation. They look at Greece and say ‘we are not that far behind’.

Who wants to invest here when they can invest in say Canada, Ireland, South Korea or most other countries that have lower tax rates. (Canada past the US on the Economic Freedom Index!!) Heck, I’d rather invest in Australia right now than the US…and am.

But let me ask this again, what happens when the banks loosen and all those excess reserves enter the monetary system…with a multiplier effect?

PS Benjamin, how in the world can a balanced budget and low rates and a stable dollar be bad? My goodness man. We basically ran balanced budgets and had a currency based on silver/gold for 200 years.

Jeff said...

Here is one small business guy who gets it...

William said...

"Suffering from a surfeit of stimulus" seems counter intuitive to me.

What I think makes more sense is that the credit bubble artificially stimulated the US economy and GDP. Easy credit enabled more of everything to be sold from houses to automobiles to motorcycles to mobile homes to furniture and granite counters to home and corporate electronic equipment - computers, cell phones, flat panel TVs - everything! Just think of how home equity loans were used for example.

The net effect of the credit bubble was to over expand all these industries: to many shops, too many shopping malls, too many construction workers and sales staff and too many employed in "finance".

The ease of credit brought forward a lot of purchases in all these areas. Thus spending is not so necessary right now - saving to pay down credit is a more urgent priority.

Until the deleveraging is complete and until there is a real need for more houses, etc. the economy will bump along. To estimated a US productive capacity gap of 10% is overstating it because a lot of previous GDP strength was artificially generated. Maybe the gap is really only 5%.


Benjamin said...


I am for smaller federal government, and a roughly balanced budget. I think interest rates will stay for generations due to high savings rates. As the world gets wealthier, more people have income they can save. We are generating huge pools of capital.

As for exchange rates, a lower rate for the dollar boosts exports, and brings tourists here (and real estate buyers). I never understood the bleats for a strong dollar--I think people conflate the word "strong" with actual US strength.

We are strong when we don't borrow money to pay for imports.

I suspect also the braying for a strong dollar represented the interests of US multinationals, who wanted a strong dollar to cheaply set up overseas plants, and then import back to the US.

The dollar actually did most of its decline under Bush. It could go lower, and that would help our economy.

Buddy R Pacifico said...

Yes to Scott's comments AND yes to William's comments.

TradingStrategyLetter - Weekly Summary said...

Soft patch. Only depression is amoungst the fearless elected officials who might not have as much to spent as they want.