Economy | - Part 30

Why the Fed May Again Fail

We might be hearing a little less talk from the Federal Reserve about how much “slack” there is in the economy (Fedspeak for the “output gap”, or the difference between real and potential growth) after a new report by Commerzbank as detailed in this Bloomberg story.

The Federal Reserve, Bank of England and European Central Bank have started using the level of spare capacity in their economies as a way to foretell when they will start reversing easy monetary policies. The more capacity, the bigger the output gap between actual and potential economic growth and the longer officials can keep interest rates low because price pressures will be sluggish.

Bloomberg“While this sounds plausible, past experience suggests that central banks tend to hike rates too slowly, with corresponding risks for price inflation,” Christoph Balz and Bernd Weidensteiner, economists at Commerzbank AG in Frankfurt, said in a March 21 report.

The problem is that output gaps are hard to estimate and better done in hindsight. To demonstrate that, the Commerzbank economists looked at what the Fed would have estimated for the output gap in the early 1970s, given the data they had available from the prior three decades.

The initial impression was of an output gap of minus 1 percent for 1974, which would have encouraged the U.S. central bank to be “moderately expansionary,” said the report.

In reality, the economy was later shown to have been slightly over-stretched in 1974. Repeating the exercise for 1983, the output gap the Fed would have calculated at the time was minus 1 percent, versus the minus 4 percent it proved to be.

“A more restrictive policy would have been appropriate in 1974, but in 1983 a more expansionary policy was required,” said Commerzbank. “This demonstrates the uncertainty when monetary policy conclusions are drawn from the current data set.”

With the Fed’s new lines of communication aimed at damping expectations of rate hikes, the risk is the Fed “will again probably raise rates too late and too cautiously,” said the economists. This time the “greater danger” may be that loose monetary policy fans inflation in asset prices.

This idea that, it doesn’t matter how economic growth arrived at a particular level (e.g., in 2007 after the biggest credit bubble since the 1930s) and that you should somehow gauge future economic growth against past growth (regardless of how artificial it was) – this is one one of the stupidest things that economists have ever come up with.

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Shiller on Bubbles and Busts

Rounding out today’s troika of stories on rapidly inflating financial bubbles (that in some parts of the world, for example the U.K., are seen as genuine progress for the economy) comes this Wall Street Journal interview with Nobel Laureate Robert Shiller who talks about the recent history and future of bubbles and busts.

Shiller minces no words in blaming his own (economics) profession, calling it “unnatural” when asked how to explain what we’ve seen in financial markets over the last few decades.

It’s pretty hard to argue with that assessment and it’s laughable to think that some dismal scientists still believe in such folly as “efficient market theory”, “rationale actors”, and the value of economists’ vaunted “models” today given the perverse incentives that are provided on Wall Street and condoned by the Federal Reserve where, once, it was believed that investment banks are “self-regulating”.

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In his commentary A depressingly familiar reality lies behind the UK’s economic miracle in the U.K. Telegraph, Jeremy Warner laments how the economic recovery engineered by Chancellor George Osborne and Prime Minister David Cameron looks a lot like the last economic recovery a few years back that ended in, well, you know, tears.

True enough, the economy is recovering fast, with a growth spurt which ought, absent of external shocks, to last well beyond the next election.

Unfortunately, it’s the wrong kind of growth again. What is more, Office for Budget Responsibility forecasts give little reason to suppose it’s about to change into something more lasting. The hoped-for revival in exports remains almost entirely absent from the feast of more upbeat OBR forecasts.

For at least the next five years, growth is predicted to depend entirely on rising household spending, a recovering housing market, and the questionable assumption of a trampoline-like bounce in business investment. Net trade is not expected to make any contribution at all.

More worrying still for those who think of the pre-crisis economy as a debt-fuelled ponzi scheme, rising private consumption looks as if it will again be bought with a return to very high levels of household debt and a pitifully inadequate savings rate.

This guilty return to pre-crisis norms is compounded by another surge in household indebtedness, which because of low mortgage market activity since the start of the crisis, had been mercifully moving back to tolerable levels.

Not any longer, according to the OBR. With a pronounced shove from government, mortgage lending is storming back. So too is double-digit house price inflation, necessitating larger average mortgages and rising household indebtedness.

Growth in unsecured credit, too, has picked up sharply, boosted by loans for car purchases, which have been flying off the books as if the recent banking crisis never really happened.

On both sides of the Atlantic, poicymakers are saying, “Hey, bubbles are all we got”.

Also, the question of the sustainability of the U.K. economic recovery notwithstanding, there’s not been much from Nobel Laureate economist and NY Times author Paul Krugman on the recent success of the austerity measures in the U.K. that were once thought to be doomed to fail. If there has been and I missed it, leave a comment…

The Fed’s Bubbles

There is absolutely nothing new in the graphic below from this commentary(.pdf) by IceCap Asset Management, but something about the simplicity of the message being conveyed was striking and it seemed worth reproducing here today. Of course, it wasn’t all about interest rates, but you’d think that by now someone at the Fed would acknowledge rates that were too low for too long played some kind of role in the many recent boom-bust cycles.

Picking up the story at the beginning of item 2 above, they note:

Of course 4,000 Dow Jones Industrial and NASDAQ points later, the sheep started to lazily admit that perhaps this new post-Y2K economy wasn’t all that it was cracked up to be. Not to worry, once again the American central bank mounted their ponies and rode the global economy straight into several years of ultra-low interest rates. The hope (there’s that word again) was that really cheap money would encourage people, companies and governments to borrow and spend again.

And borrow and spend they did – right smack into the biggest housing bubble in economic history. Day traders became passé, and the newest game in town was flippin’ houses. Rich people flipped mansions, plumbers and teachers flipped suburban homes and even Vegas strippers got in on the act and flipped condos among other things. By the time it was over, the entire world was flipped upside down – courtesy of the US Federal Reserve and their interest rate machine.

And this brings us to the next global crisis, which we assure you is on its way.

Fed Now Completely Tone Deaf

Well, this isn’t a good sign…

Philadelphia Federal Reserve President Charles Plosser (one of the more hawkish members of the central bank) says they were all a bit surprised by the market reaction to last week’s comments by Fed Chair Janet Yellen that moved up the timetable for the start of interest rate hikes to as soon as next spring, rather than next summer or fall.

Says Plosser:

There was a lot of evidence and a lot of surveys that suggest six months wasn’t a wildly unexpected timeframe. But it is better to get away from talking about timeframes. Talking about economic conditions is a much better way to think about it. I was surprised the market reacted as much as it did.

Wow. With things as dicey as they could be with the Fed attempting to extricate itself from the greatest monetary policy experiment in human history and with the central bank making it up as it goes regarding what “economic conditions” it’s looking at (i.e., the fallen jobless rate target), Plosser thinks saying  something that “wasn’t wildly unexpected” is just fine.

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