I’m baffled that Greenspan is baffled
I’m certainly an optimist. I think the expected interest rate increase is a mistake, but on balance I don’t think it will push the US back into recession. I suppose I’d say I’m 80-20 growth in 2016. But even that is an unnecessary risk in my view, with essentially no upside from raising rates:
1. It will hurt the unemployed.
2. It will move the Fed further from its 2% PCE inflation target.
3. If you are worried about savers (I’m not) it will lead to lower interest rates in years 2 through 20 than would an easier money policy that led to faster NGDP growth.
The only argument in favor seems to be that rates for savers would be 1/4% higher for a year or two. And that gain is worth all the downsides?
I’m 80% sure this will not push us into a double dip recession, despite the fact that history shows exactly the opposite. Of the 5 previous attempts to exit the zero rate bound (or perhaps I should say what Keynesians regard as the zero bound) 4 were failures, which pushed the economy back into recession and/or deflation. The failures were the US in 1937, Japan in 2000 and 2006, and the ECB in 2011. (That 2011 rate increase wasn’t quite at the zero bound, but generally regarded as close.) In three cases it was a 1/4% increase, and in 2011 a 1/2% increase. The only success was in 1951, when the Treasury-Fed Accord ended the low interest rate pegging policy.
And yet despite all of this history, Alan Greenspan is “baffled”:
Greenspan also said he’s “baffled” that a 25 basis point hike by the Fed would have a major impact on economic conditions around the world.
So almost every previous time central banks do a tiny interest rate increase at the zero bound, it blows up in their face. And yet we are shocked that markets might be a tad worried?
What’s the downside of waiting until the Fed actually needs to raise rates to achieve its target path?
It’s really very simple. Basic monetary theory says that interest rate pegging makes the price level indeterminate. A peg slightly above the natural rate eventually sends you into deflation. A peg slightly below the natural rates starts a cumulative process that sends the economy into hyperinflation. Monetary theory says that a 1/4% can make a massive difference, or it might make very little difference at all (it depends what happens next). If you read any news or opinion articles where the writer wonders how a 1/4% change can be such a big deal, just stop reading. You are wasting your time.
PS. Just as I am a US economy optimist, perceived as a pessimist, I’m a China pessimist perceived as an optimist. I’m currently more pessimistic about China’s growth prospects for 2016 than every single member of The Economist’s expert panel. Every one of them expects at least 6.3% growth for China in 2016. What a bunch of pollyannaish apologists for the Chinese Communist Party!
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4. September 2015 at 11:28
Oh c’mon Dr. S – “Basic monetary theory says that interest rate pegging makes the price level indeterminate. A peg slightly above the natural rate eventually sends you into deflation. A peg slightly below the natural rates starts a cumulative process that sends the economy into hyperinflation. Monetary theory says that a 1/4% can make a massive difference, or it might make very little difference at all (it depends what happens next).” – clearly nothing in nature is this unstable. Do you really believe this or is this another artful dodge of yours? I can see how you might say: ‘oh, NGDPLT did not work this time because the rate was just below his knife-edge of criticality!’
PS–your PS seems like backtracking, just in case Tyler Cowen is right about China. Clever.
I think you’re funny and a real economist. The two go hand-in-hand.
4. September 2015 at 11:32
Scott, Greenspan has always benn “baffled”: From Chapter 20 of Age of Uncertainty – The Conundrum”:
“To judge success in containing inflation, central banks look to changes in inflation expectations implicit in nominal long term interest rates. Success is evident when long term rates slip in the face of aggressive monetary tightening. But as I recall, during most of our initiatives to confront rising inflation pressures, aggressive tightening was unnecessary. Even a slight “tap on the brake” induced long term rates to decline. It seemed too easy, a far cry from the monetary policy crises of the 1970s…”
https://thefaintofheart.wordpress.com/2011/09/22/straight-from-the-horse%C2%B4s-mouth/
4. September 2015 at 11:42
Japan in 2000 and 2006? Haven’t heard that one. Certainly don’t remember any Japanese recession during that time.
I suspect the link between miniscule short-term rate interest rates and poor economic outcomes is far more spurious than the link between the inversion of the yield curve in the U.S. and poor economic outcomes.
I just haven’t seen any evidence for the idea tiny changes in short-term rates can lead to hyperdeflation or hyperinflation. If monetary theory is inconsistent with reality, I discard the theory.
Also, I doubt there’s much point in trusting Chinese government GDP numbers. All they can tell us are general trends, not their severity. I think growth was almost certainly less than 7% last year.
Also, I am more pessimistic about China in the long run than Scott, and am more optimistic about it in the short run.
4. September 2015 at 12:01
Scott, who perceives you as a pessimist on the US economy?
4. September 2015 at 12:03
More Greenspan bafflement (financial crises edition):
“Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity, myself included, are in a state of shocked disbelief,” he told the House Committee on Oversight and Government Reform.
http://www.nytimes.com/2008/10/24/business/economy/24panel.html?_r=0
4. September 2015 at 12:20
E. Harding, the yield curve has been flattening. In 2014, when the Fed was tapering QE3, the long end of the Eurodollar futures curve came down from 5% to less than 3%. But, during the first half of 2015, the Fed kept moving back the expected date of the hike, and forward rates moved back to 3.5%. Since the end of June, expectations of a hike in 2015 were solidified, and long term rates fell back below 3%. They had started to move back above 3% after volatility brought hope of a reprieve, but with today’s decent employment report, they are back below 3%. (I’m using Dec. 2021 rates as a reference).
To me, far forward rates falling when the short term rate is expected to rise suggests that the FFR is already above the natural rate. Also, the ZLB probably distorts forward rates, pushing all rates upward to the extent that any part of the distribution of forward rates hits the ZLB. So, I think it is plausible that forward rates will drop more if the FFR is hiked. It may be the case that a FFR at 0.5% with long term rates at 1.5% is equivalent to a flat yield curve when rates are higher because the ZLB skews the distribution of forward expectations higher.
The problem is, there is roughly 0% chance that if they hike, and forward rates drop to 2% or something, that the Fed will hold an emergency meeting and correct their error. Even worse, they will probably conclude that they can continue to raise the FFR because they will consider lower long term rates to be stimulative.
4. September 2015 at 12:23
foosion:
“a humbled Mr. Greenspan admitted that he had put too much faith in the self-correcting power of free markets and had failed to anticipate the self-destructive power of wanton mortgage lending.”
That is so infuriating.
4. September 2015 at 12:59
My psychoanalysis of the Fed is that they have a dream that they can guide the economy in such a way that unemployment asymptotically approaches full employment while the Fed gradually raises the Fed Funds rate to a point where they don’t have to change the Fed Funds rate for 10 years all the while that US employment remains 1 person below full employment. And inflation finds a steady rate that happens to be greater than 1% but less than 2%. That’s the dream. It doesn’t matter much to them that the number of unnecessarily unemployed people from 2008 to 2015 was in the millions. Personally, I would have preferred to see in 2008: announce 5% NGDPLT, start negative IOR, and put a QE program in place. Overshoot on NGDP and then get it under control. Of course, the getting it under control would have meant ending QE, going back to 0% IOR and raising the Fed Funds rate. And then eventually the FFR would have fallen again. It would have all looked so messy, but we could have had full employment by 2010 and stayed near full employment. Many people would have had better lives, but the Fed members wouldn’t have looked cool.
4. September 2015 at 13:57
I thought Greenspan made perfect sense. He’s merely saying that we’ve got bigger problems with future expenditures on SS, Medicare and Medicaid, and an underfunded military, than we do with what the Fed Funds rate will be next month.
4. September 2015 at 14:26
I think you forgot Sweden. They raised the repo rate from 0,25% (in 2010) to 2% (in 2011) and now the repo rate is -0,35%!!
4. September 2015 at 14:36
Kevin, it certainly is infuriating.
4. September 2015 at 14:38
Tim Duy had a good take on why 25bp makes a difference.
Bottom Line: I am coming around to the belief that the timing of the first rate hike is more important than Fed officials would like us to believe. The lack of consensus regarding the timing of the first hike tells me that we don’t fully understand the Fed’s reaction function and, importantly, their confidence in their estimates of the natural rate of unemployment. The timing of the first hike will thus define that reaction function and thus send an important signal about the Fed’s overall policy intentions.
http://economistsview.typepad.com/timduy/2015/08/does-25bp-make-a-difference.html
4. September 2015 at 15:58
Ray, What growth rate is Tyler predicting? Close to zero, AFAIK. I may be too high at 6%, but I think I’ll be closer than zero. If not, I’ll give him mucho credit.
I’m not a forecaster, I just do these predictions to annoy other people, like you.
E. Harding, You are implying I made lots of claims that I never made. Did I say anything about 1/4% rate cuts leading to hyperinflation? Did I say Japan had recessions in 2001 and 2007? No, I did not. Stick to what I said please.
Marcus and foosion, Good quotes.
Chuck, I’m claiming that a rate increase will cause the Fed to continually undershoot it’s target, so I’m certainly more pessimistic than they are. And presumably more pessimistic that all those clamoring for rate increases (which is most of the editorials I read.)
Kevin, That makes me even more convinced the “maestro” just got lucky being in power during a stable period. He really didn’t know what he was doing.
Bill, Yes, if only they’d done NGDPLT.
Patrick, I’m not objecting to the entire piece, just that quote.
Thanos, Yes, Sweden is another one.
Foosion, That’s a great Tim Duy quote, much better than this post.
4. September 2015 at 16:29
I’m baffled that turning the steering wheel 10 degrees to the left made me run off the road!
4. September 2015 at 16:55
“Stick to what I said please.”
-[grumble]. Missed that “or” in that “and/or”.
Also, I wasn’t implying that, if you look closely.
“A peg slightly below the natural rates starts a cumulative process that sends the economy into hyperinflation.”
isn’t saying a quarter-point rate cut can lead to hyperinflation?
4. September 2015 at 17:45
Sumner wrote:
Basic monetary theory says that interest rate pegging makes the price level indeterminate. A peg slightly above the natural rate eventually sends you into deflation. A peg slightly below the natural rates starts a cumulative process that sends the economy into hyperinflation.”
A few things to keep in mind here.
First, the above idea is not only basic monetary theory, it is what ABCT makes more clear. And strangely enough, when this idea is explained in terms of basic monetary theory, Sumner accepts it, but when the exact same idea is explained using ABCT, Sumner claims the idea is false.
The business cycle occurs by way of the Fed influencing interest rates to be lower than the natural rates, which does indeed set the economy off on a “process” towards hyperinflation, in which case the economy will enter the biggest correction that can be caused by state intervention in money. But before that occurs, the Fed raises rates back up, so as to avoid spiralling the economy towards hyperinflatiom. And that raising of rates then allows the correction to occur sooner rather than later. And then we hear false statements that the tightening of money, not the previous loose money, causes recessions.
Second, yes a peg below the natural rate sends the economy on a “process” towards hyperinflation. But should the capital structure be so distorted, we would not see extremely loose money having the symptom of skyrocketing prices, but instead propping up a massively distored capital structure that has declining “velocity” and low consumer price inflation and high capital prices inflation.
Third, it is almost certainly the case that the rates the Fed has brought down by its intervention, are significantly lower than natural rates. How can we know this? Well, one has to understand the mainndterminant of interest rates. Interest rates are determined primarily by the difference between money spent on all goods and services, and money spent on factors of production. That is, by time preference. The more people invest as compared to consumption, the more dollars are spent on factors of production relative to total spending. Or, in other words, the higher the ratio between investment spending to total spending.
This difference is what Mises called “originary interest” in a monetary economy. If on average for every $1000 spent on all goods there is $900 spent on factors of production, then the average rate of profit on capital invested would be ($1000 – $900)/$900 = 1/9 = 11%.
Now if businesses begin earning 11% ROI on average, from a previous ROI of say 1%, then there would be an upward pressure on interest rates if those interest rates started at 1% on average. This is because business owners would be faced with reinvesting their revenues directly for 11% return, or else lend the money. But in order for lending to be competitive, it would have to earn in the neighborhood of 11% (adjusted for risk and other factors).
Similarly, if profits fell from 11% to 1%, then interest rates would undergo downward pressure, since business owners would have little incentive to borrow at 11% when they are earning only 1%.
Back to the main point: Interest rates right now are in the neighborhood of about 4% (including both Treasury AND risky debt). The hypothetical rate of profit on capital invested that is consistent with these low rates would be in the neighborhood of 4% (4% plus an equity risk premium). Let’s say 11%.
But in order for the rate of profit to be kept at 11%, that would mean inthe aggregate, people would have to spending about $900 on factors of production for every $1000 that is spent on all goods and services. For that is what profits are. Money revenues ($1000) minus money costs ($900), divided by money invested ($900).
But is that really what is happening on average throughout the economy? That for every $1.00 spent on all goods (including capital goods), there was $0.90 saved and spent on factors of production in particular?
This is highly, highly unlikely given the extremely low savings rate in the country. Therefore, we can surmise that the high natural rates of interest that would have otherwise pushed interest rates up, are a LOT higher than the interest rates the Fed has brought about.
But then why hasn’t such a large difference between the low prevailing rates, and the higher natural rates, brought about hyperinflation? The answer is that the capital structure is so warped, so distorted by the Fed, that the amount of monetary inflation that has taken place has not manifested in high price inflation, but rather in propping up a capital structure that is in need of a steep correction. The misleading of investors has postponed much of the needed corrections, but investors have accumulated huge cash balances. That’s why the absence of hyperinflation at this particular time.
If the economy was not distorted, if say the economy started completely laissez faire but then coercion backed central banking laws were imposed on the innocent’s property, then with the amount of inflation the Fed has actually brought about in our world, would have liekly caused hyperinflation in that hypothetical uplaissez faire up until now economy.
This is why I think some Austrians got their prices predictions wrong. Contrary to having a flawed model, they in fact completely underestimated just how distorted the Fed can make the economy. Some Austrians did not correctly judge just how distorted the economy was, and why it was able to absorb so much additional money printing without sparking hyperinflation. It is because the money printing went to propping up prices that otherwise would have gone -10%, or -20%, or -30% negative, or even lower.
5. September 2015 at 02:09
Sumner: “Ray, What growth rate is Tyler predicting? Close to zero, AFAIK. I may be too high at 6%, but I think I’ll be closer than zero. If not, I’ll give him mucho credit.” –
I hope you win Scott.
BTW your NGDPLT scheme I’ve concluded is at worse harmless (money is neutral) and at best might even give a beneficial small shock to the economy, along the lines of Bernanke et al (2003) econometrics paper that found the Fed has a 3.2% to 13.2% effect on the economy. If the market perceives NGDPLT as ‘not the same old thing’ it might give a positive boost to companies that are Fed watchers, mostly finance companies I imagine.
So go for it. You’re a good man. I’ve picked on you enough and you deserve better, being a pioneer of the NGDPLT framework whose time has come. NGPDLT is probably OK after all. I was unfair all this time.
I’m in a good mood for personal reasons. And Proverbs 25:22
5. September 2015 at 05:59
E. Harding, Sure, a quarter point cut can lead to hyperinflation if the central bank is insane enough to hold it below the natural rate for decades, but how likely is that? You seemed to suggest that the lack of hyperinflation was some sort of argument against the standard model.
And someone please find the real Ray Lopez and bring him back, I miss him!!
5. September 2015 at 07:00
Major Freedom:
It’s as if you’re trying to demonstrate all the steps of an equation that you’re forbidding everyone else from trying to solve.
5. September 2015 at 10:19
For the sake of argument why do you think a rate hike won’t lead to a recession?
Even if it doesn’t could it slow down growth from what it is now?
6. September 2015 at 04:54
Mike, Yes, it will slow growth, but AFAIK the markets are not forecasting a recession . . . . yet.
7. September 2015 at 03:05
I agree with you that economic conditions do not warrant a rate increase as Fed policy has been largely neutral in the aftermath of the Great Recession.
But something you talk about piqued my interest. Could you discuss in a bit more detail the notion of natural rate? What determines the natural rate and is it subject to short-term fluctuations?
8. September 2015 at 05:24
H. Publius, The natural rate is affected by inflation, RGDP growth, the level of RGDP, Asian savings rates, and other factors. It can change quickly, for instance it fell sharply in 2007-08
8. September 2015 at 06:49
@Major.Freedom:
> Now if businesses begin earning 11% ROI on average, from a previous ROI of say 1%, then there would be an upward pressure on interest rates if those interest rates started at 1% on average. This is because business owners would be faced with reinvesting their revenues directly for 11% return, or else lend the money. But in order for lending to be competitive, it would have to earn in the neighborhood of 11% (adjusted for risk and other factors).
There’s your problem, you’ve confused the average investment with the marginal investment. Financial interest rates reflect the marginal ROI.