The Fed’s biggest hawk is back.
The President of the KC Fed, Thomas Hoenig, easily the biggest hawk on the board is back with a speech entitled “Hard Choices” warning about the destabilizing effect of ongoing low interest rates.
The speech, which has been delivered in Lincoln Nebraska, covers financial reform and monetary policy.
Here is the part on monetary policy:
I want to spend my remaining time on monetary policy. I acknowledge that there are different perspectives on the array of economic data we receive and analyse, and therefore there are legitimate, differing views about what is best for the economy. The Federal Reserve has a dual mandate to pursue stable prices and stable long-term growth. The entire FOMC is committed to pursuing those goals, but there are differing views on the causes and fixes to our current situation.
I have been at the Fed through past swings in the business cycle. There is today a familiar theme as I listen to the media, various economists and “market experts.” They say we are entering the era of a “new normal” in which we have to accept high unemployment and low income growth and that interest rates will remain at zero indefinitely. They warn that deflation is a serious risk and that the U.S. could become another Japan, which must be avoided at all costs.
Before this week’s FOMC meeting, The Wall Street Journal wrote that the Fed would add more stimulus into the economy—including the purchase of long-term treasuries. It turns out that reporter was remarkably prescient.
I share these concerns about our economy. Economic conditions are far from satisfactory, unemployment is simply too high, and we want a stronger recovery. But as much as I want short-term improvement, I am mindful of possible longer-term consequences of zero interest rates and further easing actions. Rather than improve economic outcomes, I worry that the FOMC is inadvertently adding to “uncertainty” by taking such actions. Remember, high interest rates did not cause the financial crisis or the recession. Let me summarize four key points that I judge relevant in choosing among monetary policy options.
Trend data show modest recovery
The recovery is proceeding as many economists earlier this year outlined that it would. It is a modest recovery, with mixed results. Yet, GDP is likely to expand at somewhere around a 3 per cent rate through the remainder of the year. Month-to-month data will be mixed, as is typical during recovery. For example, industrial production was down 0.3 per cent for April, up 1.3 per cent for May, and up 0.1 per cent for June. New orders for non-defence capital goods
excluding aircraft were down 2.8 per cent in April, up 4.7 per cent in May, and up 0.6 per cent in June. Durable goods orders were up by 2.9 per cent in April, down 0.7 per cent in May and down 1.2 per cent in June. Corporate profits are being reported as consistently strong, month after month. What these data points tell me is that volatile monthly data should not drive policy actions.
While monthly data may be mixed, the trend data are consistently positive. Private job growth has been less than hoped for but positive nonetheless. Private payrolls increased 630,000 since January 1. In the first half of the year, private labour income increased in all components: hours worked, employment and wages. Hours worked have risen more rapidly than employment, which is typical for the early stages of an economic recovery. In fact, we are experiencing a better pace of recovery this time than at this point in our previous two economic recoveries.
In addition, since the second quarter of 2009, personal income growth has increased 2.8 per cent, consumption is up 1.6 per cent, investment in equipment and software is up 15 per cent, and housing is up 5.3 per cent. Year-over-year, industrial production is up 8.2 per cent, high tech is up 20 per cent and manufacturing is up 8.3 per cent. Corporate profits are up 57 per cent since the fourth quarter of 2008. While we are not where we want to be, the economy is recovering and, barring specific shocks and bad policy, it should continue to grow over the next several quarters.
Corrections take time
We are recovering from a horrific set of shocks, and it will take time to “right the ship.” Moreover, the financial and economic shocks we have experienced did not “just happen.” The financial collapse followed years of too-low interest rates, too-high leverage, and too-lax financial supervision as prescribed by deregulation from both Democratic and Republican administrations. In judging how we approach this recovery, it seems to me that we need to be careful not to repeat those policy patterns that followed the recessions of 1990-91 and 2001. If we again leave rates too low, too long out of our uneasiness over the strength of the recovery and our intense desire to avoid recession at all costs, we are risking a repeat of past errors and the consequences they bring.
Here are some important figures regarding just how out of balance our economy became and what might have contributed to these imbalances between the early ’90s and today:
The real fed funds rate averaged 1.6 per cent between 1991 and 1995, 0.37 per cent between 2001 and 2005 and -1.0 per cent from 2008 to the present, hardly a tight policy environment.
Gross federal debt increased from 60 per cent to 75 per cent of nominal GDP Consumer debt increased from 63 per cent to 94 per cent of nominal GDP Nonfinancial debt increased from 189 per cent of nominal GDP at the start of the decade to 234 per cent by December 2008.
Between 1993 and 2007, the average leverage of the 20-largest financial institutions in the U.S. (total assets-to-tangible equity capital) increased from 18- to-1, to over 25-to-1, reaching as high as 31-to-1.
The U.S. increased its debt to the rest of the world dramatically from 4.87 per cent to 24.32 per cent of nominal GDP.
Obviously, the effect of these trends on our economy has been significant and we must accept that they will not be corrected quickly.
It is not time for tight policy
In my view, maintaining an accommodative monetary policy is necessary at this time, but a clear policy path toward a less highly accommodative policy will encourage a more sustained recovery. Under such a policy, financial deleveraging will evolve slowly and many of the remaining economic imbalances will rebalance. Under such a policy, the economy will expand at a sustainable moderate pace with similar moderate job growth, but job growth that will be stable and resilient. There may be ways to accelerate GDP growth, but in my view, highly expansionary monetary policy is not a good option.
To be clear, I am not advocating a tight monetary policy. I am advocating a policy that remains accommodative but slowly firms as the economy itself expands and moves toward more balance. I advocate dropping the “extended period” language from the FOMC’s statement and removing its guarantee of low rates. This tells the market that it must again accept risks and lend if it wishes to earn a return. The FOMC would announce that its policy rate will move to 1percent by a certain date, subject to current conditions. At 1 per cent, the FOMC would pause to give the economy time to adjust and to gain confidence that the recovery remains on a reasonable growth path. At the appropriate time, rates would be moved further up toward 2 per cent, after which the nominal fed funds rate will depend on how well the economy is doing.
If such a path were chosen, then how might GDP and important components perform? Let me start with consumption, which for decades amounted to about 63 per cent of GDP. During the boom it rose to 70 per cent. It seems reasonable that the consumer will most likely return toward more historical levels relative to GDP and then grow in line with income. If so, the consumer will contribute to growth but is unlikely to intensify its contribution to previously unsustainable levels.
To view the role of the consumer from another perspective, I would note that personal savings declined from nearly 10 per cent of disposable income in 1985 to less than 2 per cent in 2007. It is now closer to 6 per cent, better in many ways, but still below historical norms.
Assuming it stabilizes and personal incomes grows as it has so far this recovery, you get a clearer sense of how consumption will contribute to the economy’s expansion but also why it is unlikely to play a dominant role as it did in this past decade.
While businesses need to rebalance as well, they are essential to the strength of the recovery. Fortunately, they are in the early stages of doing just that. Profits are improving and corporate balance sheets for the nonfinancial sector are strengthening and are increasingly able to support investment growth as confidence in the economy rebuilds. Also, although credit supply and demand may be an issue impeding the recovery to some extent, a shortage of monetary stimulus is not the issue. There is enormous liquidity in the market, and it can be accessed as conditions improve.
Finally, the federal government needs to rebalance its balance sheet as well. Federal and state budget pressures are enormous, and uncertain tax programs surely are a risk to the recovery. This adds harmful uncertainty upon both businesses and consumers. However, while these burdens are a drag on our outlook, they are not new to the U.S. and, by themselves, should not bring our economy down unless they go unaddressed.
I believe the economy has the wherewithal to recover. However, if, in an attempt to add further fuel to the recovery, a zero interest rate is continued, it is as likely to be a negative as a positive in that it brings its own unintended consequences and uncertainty. A zero policy rate during a crisis is understandable, but a zero rate after a year of recovery gives legitimacy to questions about the sustainability of the recovery and adds to uncertainty.
We were reminded of the critical nature of our financial markets when they locked up during the crisis. We need markets to function smoothly. However, market participants should not direct policy. When mixed data are reported as systematically negative results, and the more positive, long-term growth trends fail to be adequately acknowledged, it is an invitation to hasty actions. Of course the market wants zero rates to continue indefinitely: They are earning a guaranteed return on free money from the Fed by lending it back to the government through securities purchases.
The current recovery in its first year saw GDP grow an average of 3.2 per cent. The GDP growth rate for the 1991 recovery was 2.61 per cent; and for the 2001 recovery, it was 1.92 per cent. We would all like to see a stronger recovery, but slow growth is not a decline in growth and we should not react hastily.
The summer of 2010 has seemed strikingly familiar to me. I recently went back and looked at news reports for the spring and summer of 2003, just prior to when the FOMC lowered the fed funds rate to 1 per cent, where it remained until 2004. I’ll provide just two examples. In June 2003, one prominent economist noted in USA Today: “The Federal Reserve Board recently warned that America faces a risk of [deflation]. Japan has been suffering from it for more than a decade. Europe may be heading toward it. The entire world economy could succumb to it. …This could be the first round in a deflationary cycle. The Commerce Department reports orders to U.S. factories slipped 2.9% in April from March, the largest decline in 17 months. …With fewer jobs and stagnant wages, Americans won’t be able to buy enough to keep the economy going.”
Also in June 2003, a Boston Globe columnist noted: “On the surface, one can make the case that the Fed doesn’t have to do anything at all. Interest rates are incredibly low….Still, the Fed will not sit on its hands. Chairman Alan Greenspan and his deputies have done everything but advertise the coming rate cut on the Goodyear blimp. Their motivation is to avoid deflation.
…Another rate cut, even a cut of one-half point, doesn’t guarantee that there won’t be an economic collapse. But it makes that collapse less likely—hence the notion of rate cut as
insurance policy. As insurance, a rate cut is pretty cheap. Lower rates aren’t going to trigger a burst of inflation, and if they give the economy an extra boost, well, who is going to complain about that?”
In the third quarter of 2003, immediately following these and many similar articles, GDP expanded at what turned out to be nearly a 7 per cent annual rate, yet rates were left at 1 per cent for several months. With the low rates very low for a considerable period, credit began to expand significantly and set the stage for one of the worst economic crisis since the great depression. In my view, it was a very expensive insurance premium. Unemployment today is 9.5 per cent.
I fully acknowledge that I was on the FOMC at that time. That’s why I believe that zero rates during a period of modest growth are a dangerous gamble.
The Great Depression of the 1930s was a traumatic event. We need to be aware of its lessons. We need to avoid its mistakes. For example, the Fed should never again double reserve requirements overnight. However, I urge us not to forget other more-recent lessons from the great inflation and the financial crisis of 2008: Real interest rates that are negative 40 per cent of the time create severe consequences.
One final note about deflation: The consumer price index was a mere 18 in 1945 but was 172 at the start of this century. Today, despite our most recent crisis, the CPI is over 219. Not once during more than half a century has the index systematically declined. I find no evidence that deflation is the most serious threat to the recovery today.
I agree that the Federal Reserve needs to keep its policy rate accommodative. For a while longer, it should remain even below the long-run equilibrium rate. However, the economy is improving and is growing at a rate faster than the last two recoveries. Importantly, the recent financial crisis and recession was not caused by high interest rates but by low rates that contributed to excessive debt and leverage among consumers, businesses and government. We need to get off of the emergency rate of zero, move rates up slowly and deliberately. This will align more closely with the economy’s slow, deliberate recovery so that policy does not lag the recovery.
Monetary policy is a useful tool, but it cannot solve every problem faced by the United States today. In trying to use policy as a cure-all, we will repeat the cycle of severe recessionand unemployment in a few short years by keeping rates too low for too long. I wish free money was really free and that there was a painless way to move from severe recession and high leverage to robust and sustainable economic growth, but there is no short cut.
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