Roach again calls for the FED to hike 2 points immediately
I have many comments embedded in the text.
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Global: Circling the Wagons
Stephen Roach (New York)
I like Don Kohn. In ancient times, we actually used to work together as economists at the Federal Reserve Board in Washington. In fact, my final performance as a Fed staffer came in the summer of 1979 when Don and I gave a joint “pre-FOMC” briefing to the Board. The presentation actually got rave reviews. It was, at the time, viewed as something of a breakthrough from the backward-looking approach that had long characterized Fed discussions. Words like “analytical” and “forward-looking” still ring in my ears. I hopped the shuttle up to New York that summer — never to return. Don stayed and rapidly climbed the ranks. He became the Fed’s senior staff economist in 1987 and was appointed Governor in 2002. He deserves all that and more. Don Kohn is a solid economist and now a wise policy maker.
OK, there’s a “but.” In a recent speech, Governor Kohn offered a stirring defense of Fed strategy, taking aim at those who believe that the current stance of US monetary policy is far too stimulative (see his April 1, 2004, remarks at the Banking and Finance Lecture Series, Widener University, Chester, Pennsylvania available at www.federalreserve.gov). As someone who has been associated with this critique, I feel obligated to respond. This is a serious issue, with profound implications for the economic and financial market outlook — both in the US and in the world at large. My thoughts are directed less at Don Kohn and more at the institutional mind-set he now personifies. He, along with Fed Chairman Alan Greenspan and Governor Ben Bernanke, have taken the lead in articulating the Fed’s presentation of a “new macro” that is being used to justify its current policy stance. I remain unpersuaded by their arguments and stand by my seemingly radical recommendation that the Fed raise the federal funds rate immediately from 1% to 3% (see “An Open Letter to Alan Greenspan,” published in the March 1 edition of Newsweek International and the March 3 issue of Morgan Stanley’s Investment Perspectives).
Here’s my gripe: The Fed, in my opinion, is fighting a losing battle in attempting to make the case that macro imbalances don’t matter. For the record, America’s imbalances have never been this extreme. My “Top 5” list of US imbalances includes the following: A record low in the net national saving rate of 1% of GDP in 2003; a record current account deficit of 4.9% of GDP in 2003; a record budget deficit in current dollars of around $450 billion projected for fiscal 2004; a record ratio of household indebtedness to GDP of 85% in 2003; and an unprecedented cyclical shortfall of real labor income generation (wage and salary disbursements) that we estimate at $367 billion though February 2004. Imbalance number five — the real income shortfall — is, of course, a by-product of the most notorious flaw of all: America’s jobless recovery.
[Mish - OK Roach exactly how does an immediate 2% hike fix the "most notorious flaw of all: America’s jobless recovery"? How does it fix it. How many housing and trade jobs will IMMEDIATELY be killed on that news?]
According to our calculations, private sector payrolls remain 8.2 million workers below the average profile of the previous six cyclical upturns, even after the good news in the March employment report.
[mish - OK The cure is a rate hike? Are you off your rocker roach?]
The Fed is basically telling us not to worry about these imbalances. Sure, there are plenty of caveats in the public statements of Messrs. Greenspan, Bernanke, and Kohn that provide Fed officials with cover in the event of a problem. Fed speechwriters are schooled in the art of verbal and written obfuscation. Believe me, I know that from personal experience. But at the end of the day, the Fed is arguing that imbalances should not have consequences for the setting of monetary policy. Current account deficits, according to Alan Greenspan, are an inevitable outgrowth of globalization and the easy financing that integrated world financial markets provide to a nation that conveniently possesses the world’s reserve currency (see Alan Greenspan, “Current Account,” remarks before the Economic Club of New York, March 2, 2004). A similar dismissal of the perils of budget deficits has been offered, claiming that the problem is not deficits, per se, since these shortfalls will shrink as economic growth boosts revenues; the Fed, instead, has suggested that the more serious problems lie with the excesses of government spending rather than on the tax side of the equation (see Greenspan’s’ testimony on “Economic Outlook and Current Fiscal Issues” before the Committee on the Budget, U.S. House of Representatives, February 25, 2004).
And then there’s the great asset bubble debate — in my mind, the most serious issue the Fed is ducking. The central bank’s official view is that it should not pre-judge the collective wisdom of millions of investors in determining fair value for any asset class. Since bubbles are correctly identified only after the fact, according to this logic, the authorities need to focus more on the tactics of post-bubble damage containment. In this vein, Greenspan has argued that the Fed should feel “vindicated” by the success of this strategy in the aftermath of the bursting of the equity bubble in early 2000 (see his January 3, 2004, speech, “Risk and Uncertainty in Monetary Policy,” presented at the Meetings of the American Economic Association in San Diego, California). Kohn has made the related case in the April 1 speech cited above that the indebtedness associated with such asset bubbles need not be a source of concern — especially if that debt is scaled by the value of the assets that back it. Never mind the circularity of this justification — that debt is fine as long as it is measured against the inflated value of over-valued assets. And Governor Bernanke has repeatedly made the point that the Fed, even while targeting the federal funds rate at a rock-bottom 1%, has ample ammunition at its disposal to deal with unforeseen problems (see, for example, a paper by Bernanke and Vince Reinhardt, “Conducting Monetary Policy at Very Low Short-Term Interest Rates,” also presented at the Meetings of the American Economic Association, San Diego, California January 3, 2004).
This gets to the most basic issue of all — the role of policy. Stabilization policy is first and foremost a tool that enables the monetary authority to hit mandated targets on employment, growth, and inflation. The principles of deploying this arsenal are simple — use the ammunition wisely and always make certain there is plenty left to deal with the unexpected. Four years ago, when the equity bubble popped, the Fed had 600 basis points of ammunition at its disposal. It then spent 500 bp containing the post-bubble damage. The basic problem with maintaining a 1% funds rate, in my view, is that the Fed is now all but out of its conventional ammunition should another problem arise.
[Mish comments: Ok Roach - I admit the FED was stupid using up all of its ammo. But does that mean you do something stupid to get it back? Roach seems to think this economy could take a 2% rate hike and I think this economy would go to hell on a 1/2 point hike. So do you kill the economy only to have to turn anround and use up all the ammo once again to get back to where you were, with the economy in a state of depression? He ignores bankruptcies, loss of jobs in the housing sector etc etc etc. In short a 2% immediate hike would be about the dumbest thing this FED could do. Call it too much too late (as opposed to too little to late).]
The Bernanke/ Greenspan response is to speak eloquently of “unconventional” measures that could be rolled out in defense (see Ben Bernanke, “Deflation: Making Sure That ‘It’ Doesn’t Happen Here,” speech before the National Economics Club, Washington D.C., November 21, 2002). In my view, the jury is out on this critical and untested assertion. Just ask the bank of Japan.
Which takes us to the current conundrum. By insisting that it can be “patient” in maintaining unusual monetary accommodation, I believe the Fed is sending a clear message to investors and speculators that it will not stand in the way of rising asset prices. By urging investors to ignore the classic perils of macro imbalances, America’s central bank is, in effect, reinforcing the conviction of market participants that it is prepared to let the economy and the markets run.
[Mish - How about another irrational exhuberance speech as opposed to doing something insane like hiking 2 full points. Clearly the FED WANTS asset prices to rise, and I have a problem with that as well, but the cure is worse than the disease at this point. We ARE 100% back in bubbleland and the best thing to do at this point is let it play out. Yes we should not be here but the fact is we are. We have to deal with where we are. Trying to stop a bubble that is ready to go on its own accord will not cure the problem]
Such a message effectively condones further froth in financial markets, running the risk of new asset bubbles and post-bubble shakeouts that an ammunition-short Fed will be unable to counter. Not all central bankers agree with this approach. As Ottmar Issing, chief economist of the ECB, has eloquently argued, central banks should “avoid contributing to unsustainable collective euphoria” in asset markets (see his February 8, 2004, op-ed article in the Wall Street Journal, “Money and Credit”). By embracing a “new macro” that depicts imbalances as benign manifestations of a new climate, the Fed is contributing to such euphoria, essentially repeating the same mistake it made in late 1999 and early 2000.
If the Fed truly believes its official forecast of 4.5% to 5.0% real GDP growth over the four quarters of 2004 that was presented to the US Congress in February, then the time for extraordinary accommodation is over.
[Perhaps the FED does not believe 4.5% and perhaps they should tell the truth rather than the prop job they are doing - mish]
In that climate, a failure to normalize the policy rate injects excess stimulus into either the real economy or asset markets — or both. That forces the Fed to make a tough choice — leaving its policy rate unchanged in order to limit any damage in the real economy, or boosting the funds rate to prevent another wave of destabilizing asset bubbles. While both options entail risk, for me, the verdict is clear-cut: I continue to recommend that the federal funds rate be raised immediately from 1% to 3%.
[mish - Risks? No shit there are risks. Risks of trillions of dolars in derrivatives being wiped out overning, trisks of killing housing the only creator of jobs in the US at all, risks of plunging the world into an immedite depression. Hell yes there are risks. at this point how much longer is the bubble going to go on anyway. It would have died in 2000 IMO regardless of any rate hikes and this one will die soon too]
Yes, the US economy would be hurt by such an interest rate adjustment. But the Fed’s vigorous growth forecast implies that there would be considerable cushion to withstand such a blow.
[Mish - this is one of his stupidest comments. why would ANYONE assume vigorous growth would remain in the face of a 2% rate hike. He is quite simply off his rocker here]
As denial deepens at America’s central bank, I would be the first to concede that the odds of a prompt and sharp upward adjustment in the policy rate have all but fallen to zero. The Fed remains steadfast in defending its current policy stance, basing its argument mainly on the new mantra, “Imbalances don’t matter.” Senior Fed officials have turned exceedingly aggressive in their efforts to dismiss the perils of current account deficits, budget deficits, saving shortfalls, mounting indebtedness, and asset bubbles. As was the case in the late 1990s, America’s monetary authorities are, in effect, assuming the inappropriate role as cheerleaders of a “new macro.” In my view, this smacks of a recklessness that can only end in tears.
[mish - yes it was reckless - totally reckless - the Roach cure is just as reckless. There is nothing to be done here but pray]
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