Should the Fed Pause and Catch Its Breath?

Here’s another view of Fed policy from John Makin of AEI, but not one I fully agree with since it implies the Fed is focused on housing.  The Fed has made it very clear that it does not intend to manage the housing sector, or any other sector in isolation. 

Nevertheless, it does give an answer to the question posed by Jim Hamilton at Econbrowser who is concerned about the housing and auto sectors (and the potential for problems to spread beyond those areas).  Econbrowser asks why the Fed shouldn't pause and take a breath.  Makin argues this could exacerbate the problem in his argument below.  I’ve argued the Fed may want to pause and catch their breath at 3.5% so I would not object to a pause.  I believe the Fed, given its credibility and its commitment and transparency objectives, can convey its intentions clearly and prevent a speculative outburst so that Makin's concerns are unlikely to materialize.  If I put myself in the Fed’s shoes, I believe they see strong growth and the potential for inflation so, for now, rates are likely to increase.  If the GDP growth data remain strong and other indicators support this view as new data arrive, I doubt they will move off the current path.

Can the Fed Achieve a Goldilocks Tightening?,  By John H. Makin, AEI: …For the economy to avoid recession, the Federal Reserve will need to pull off a “Goldilocks tightening” that just cools the housing sector without freezing it. ... Causing the increase in housing prices merely to slow and not drop requires a degree of policy precision that few at the Fed would claim they possess. In fact, the Fed may be required to overshoot in the tightening process. The reasoning is as follows. ... Were the Fed to hint at its next meeting that a 3.5 percent Fed funds rate represented the top, markets would quickly conclude that the next interest rate move would be downward and asset markets, especially the housing market, would experience another leg up. … a larger bubble would only increase subsequent instability.

The Fed is forced to signal continued rate increases until it observes a marked slowdown in the housing sector and a leveling of price increases in the numerous “hot” real estate markets. Given the lags involved in collecting data on the housing sector and the lags involved in enacting monetary policy, it may be that by the time a slowdown in the housing sector is clearly obvious, the Fed will already have induced a sufficient housing decline to result in a sharp slowdown of the economy. … We need a “Goldilocks Tightening” that sets the temperature in the real estate sector just right: not too hot and not too cold.

Comments

[CalculatedRisk]

I don't want see to the economy slide into recession, so I'm hoping the FED can negotiate a soft landing. But, as I asked Dr. Hamilton: What is so wrong with the economy that the FED has had to hold interest rates at emergency levels for almost four years and can't return rates to neutral?

I think it is time to find out if the economy can stand on its own without FED accommodation. If raising rates exposes structural economic problems, them we need to fix them.

Best Wishes!

[Tim Duy]

CR's point is intriquing - a similar argument was often used by Japan watchers. Just let the economy collapse by stopping easy money and loose fiscal policy, then let the resulting recession trigger structural change. Interesting, but not exactly a politically acceptable policy.

The point is important. To what extent are there structual problems in the economy, and how much has easy money covered them up? And can they get resolved with accomodative policy? Is there a Greenspan put on the economy? If so, should the Fed act to end such moral hazard? Or is the Greenspan put simply just good policy? Etc...so many important questions on this point.

[CalculatedRisk]

Dr. Duy, I agree with Keynes: "I do not understand how universal bankruptcy can do any good or bring us nearer to prosperity ..." and not arguing for a Mellon style liquidation.

I'd like to see us identify the structural problems and fix them before raising rates (like the budget deficit and current account deficit). But listening to the current administration - everything is great.

Where does that leave us?
Best Regards!

[Movie Guy]

I agree that the Fed is chasing down the runup in housing. i believe that could have been accomplished by other ready means.

I assume, as well, that it has reason to be concerned about inflation. I'm probably more concerned, but my amateur model (price observations, actually) can't fully make the case. Yet.

I agree also with Calculated Risk. I haven't understood why the rates were on the floor that long. But I don't know where neutral rates should be right now. Not really. I know what I read, but it stops there.

I'm not sure what the Fed goal is with its current exercise. As the Fed tightens its rates, which entities are affected the most?

What happens this fall if auto sales go flat? And then housing begins to roll over?

I have plenty of other questions, but I will hold fast until someone can explain to me where we are on monetary policy.

I am confused by some of the increases in the money supply since April and yet see a further tightening of interest rates.

Help...

[anne]

So, we return to the Stephen Roach no pain no gain approach to economics. Of course there will be no pain for Stephen, who I rather like and have tald as much to. The Japanese have repeatedly followed the no pain no gain approach since 1992, and have ruined 15 years of development as a result. A sign of life in Japan, and there was sure to be a tax increase or 2 or 3 in 1994 and 1996 and ... Low interest rates in Japan by the way have generally not been accompanied by more private lending.

[anne]

Alan Greenspan usually has a clear sense of near term economic movements, and if there continues to be the sense that better than 3% growth will be sustained there can be reason to continue the minimal movement of short term interest rates insuring a reponse in long term rates when there is need for a policy reversal.

[anne]

What I want is for the fed to be able to move to lower short term rates in future in a decided way should a problem in the housing market call for such a move. A sharp slowing in housing activity should that occur could quickly lead to a spike in unemployment.

[anne]

Again, thinking about bonds. Bond funds have been the perfect protection for investors for 25 years, but it is unclear that this can be so going forward unless low returns are accepted readily. I do not know what this will mean, and that bothers me.