Monday, March 15, 2010

The Fed can't resist allowing the economy to dictate policy

This chart compares the rate of capacity utilization in manufacturing, mining, and electric and gas utility industries, as calculated by the Federal Reserve, with the inflation-adjusted Federal funds rate. The capacity utilization number is not a literal measure of industrial capacity, but it does serve as a decent proxy for the amount of "slack" present in the economy, which in turn is a proxy for how weak or strong the economy is. The real funds rate is a decent proxy for how tight or loose monetary policy is.

As the chart illustrates, these two variables have been highly correlated for the past 15 years, and they have tended to move together most of the time since 1970. What this means is that the Fed almost always pays a lot of attention to the state of the economy when it makes decisions regarding whether to tighten or to ease monetary conditions. That's because in the Fed's model of inflation, economic slack plays a very important role: the model assumes that idle capacity which results from economic weakness exerts strong downward pressure on prices, and this in turn calls for—and permits—very accommodative monetary policy. The Fed today feels comfortable predicting that interest rates will be unusually low for a long time, because it believes that a lot of idle capacity effectively negates the inflationary risk of easy money.

There are two problems with this approach. One, because inflation does not necessarily move in the same direction as economic growth; it's very possible for high inflation to lead to very weak growth and lots of economic slack—you only have to study the hyperinflationary economies of Brazil and Argentina to see plenty of evidence to support this claim. Inflation is a monetary phenomenon, as Milton Friedman taught us.  Two, because it imparts a reactionary bias to monetary policy: the Fed tends to end up chasing the economy as it strengthens or weakens. For example, when the economy became very strong in the 1996-2000 period, the Fed over-reacted and tightened too much, thus setting the stage for the 2001 recession and the deflationary pressures that became evident in 2000-2003. This in turn set the Fed up for a massive easing campaign, which led to rising inflation pressures (e.g., the housing market bubble) in 2004-2008. The Fed insists it is proactive, but its model of inflation makes it behave in a reactive fashion, and that tends to amplify the gyrations of the business cycle.

As most supply-siders would argue, it would be far better for the Fed to pay attention to market prices, such as the value of the dollar, the price of gold, the prices of commodities, the shape of the yield curve, the level of real interest rates, the breakeven spreads on TIPS, and credit and swap spreads. Right now, for instance, these market-based indicators of inflationary pressures and economic health are saying that there is no reason for the Fed to be as easy as it is, and that in fact the Fed should have begun raising interest rates some time last year. The economy is clearly coming back to life, and inflationary pressures are clearly rising. There are no signs of impending economic distress in these indicators that would warrant today's super-easy monetary policy stance.

What's the message for investors? For one, I think there is a very strong likelihood that the market is over-estimating the risk of deflation, and consequently that the market is overly-pessimistic about the future prospects for the US economy.

Two, I don't think that easy money has resulted in unwarranted optimism about the economy's future, just as I don't believe that the faux-stimulus fiscal policies we have in place are the only reason the economy is growing. When fiscal policy and monetary policy are appropriately calibrated, they can contribute to the economy's health and potential growth, but they can't create growth out of thin air.

I don't see any sign that the market has been fooled into thinking the economy will grow because interest rates are low, even though it is fashionable to worry that an early move by the Fed to raise rates would threaten the recovery. If easy money guaranteed a strong economy, I would be even more optimistic than I am today, but it doesn't. When money is too easy it creates distortions in the economy, and it eventually leads to real trouble because the Fed has to raise interest rates sharply (effectively strangling the economy) to bring down the ensuing inflation pressures. The market knows this. A huge increase in interest rates is already priced in, via the historically steep Treasury yield curve.

Furthermore, I think it's clear that markets worry more about inflation than the Fed's model suggests: breakeven spreads are in the range of 2-3%, which implies inflation at the upper end of the Fed's target, and the consensus outlook for growth, which is in the range of 2-3% per year, is far below the growth rate that one would normally expect following such a steep recession as we've just had. When the private sector expects a big increase in future tax burdens, that severely depresses animal spirits and that is a big reason the economy is not likely to enjoy a strong recovery.

Today's easy money and profligate fiscal policy add up to a bad combination, no matter how you slice it. That is a big reason why I think markets are still very pessimistic about the future. In order to be optimistic, you have to believe that monetary policy and fiscal policy are going to change for the better, and I do. I think the Fed is going to be forced to tighten sooner than expected, and I think that will be a big plus, since it will restore confidence in the dollar and reduce the risks of future inflation. I think that fiscal policy is going to be much less expansive (on the spending side) than current projections suggest, and that therefore tax burdens are going to be lower than the market currently fears. That will also be a big plus, because anything that shrinks the future size of the economy will increase the willingness of the private sector to invest in the future.


Anonymous said...

So, what set of data will force FED to tighten earlier in your opinion? (btw, typical inflation hedge i.e. gold stocks are lagging the current rally)

Scott Grannis said...

Lots of possibilities here. Rising 3-mo. T-bill yields; rising commodity prices, rising breakeven spreads on TIPS (especially the 5-yr, 5-yr forward rate, currently 2.6%), housing construction and housing prices, core inflation, unemployment rate. Most of these are already moving in a direction which increases the Fed's discomfort level (by making hawks more nervous). Nothing is imminent, but we could see action by this summer, vs. the market's expectation of late this year.

Benjamin Cole said...

I just don't see commodities predicting inflation anymore. Too much speculation in those markets, and gold is strictly for the the tin-foil hat crowd.
Right now, unit-labor costs are going down, not up. Rents for all types of commercial space are very soft. All manufactured goods get cheaper all the time (except for military hardware, which always get more expensive all the time).

There may be some faux inflation ahead, as really beaten down markets recover, like, say, housing in Las Vegas. But once a new plateau is reached, those price increases will stall.

Inlfation is not a concern. It just ain't.

I hope the Fed prints money until the plates melt.

Moreover, given the chronic and eternal inability of the federal government to run a balanced budget, we have to inflate to "pay down" debt.

I wish it was different, but then again I wish for a lot of things.

septizoniom said...

you discount continuously the deflation fears. in fact inflation ultimately will lead to deflation, so maybe the market is not so wrong.

Scott Grannis said...

How can inflation lead to deflation?

septizoniom said...

Inflation puts some goods and services out of
reach for consumers. Rarely do wages increase the same rate as inflation,
so consumers have less money to spend. As the gap between income and
expenses closes, so does spending. That situation could eventually lead to

Scott Grannis said...

It's true that wages tend to lag other prices in a high inflation environment. But this does not lead to deflation. It merely results in a declining standard of living--your income buys less and less. I experienced this exact process while living in Argentina from 1975-79. This process can go on indefinitely. Deflation can only occur if monetary policy becomes extremely tight.

Burak T said...

I agree with Scott here, i wish the process worked in the real world as septizoniom theorized. In Turkey, we've been living with high-inflation for many years and yet to see deflation. Once the inflationary expectations sets in it's really really hard to change the direction. Inflation distorts almost every part of the economy, both financial sector and the real economy. It leads to lower growth rates. The economy starts to dollarize and that increases uncertainty and thus volatility which increases real interest rates. One way ticket to sovereign default... We have seen this again and again.

Now some prominent economists and talking heads suggesting a 4-6% inflation will be good enough to pull debt/GDP ration back to 50-60% range. IMHO this is a dangerous path and a hard to navigate policy. I hope this is not the case.