How Should the Fed Interpret Expectations That Rate Increases Will Stop?

This may be a bit "wonkish," for some of you, but I believe it captures a crucial aspect of the dilemma the Fed faces right now with respect to Katrina and monetary policy.

The Fed faces a difficult decision in coming months. How should the Fed respond to a supply shock?  Theoretically, a negative supply shock should lower the natural rate of output which, for any given level of output, would decrease the output gap.  The reduction in the output gap places increased upward pressure on prices and the Fed would respond, assuming inflation targeting, by increasing rates to choke off the inflationary pressure.  Caroline Baum, in her column in Bloomberg, stated it succinctly asking, essentially, “Why would the Fed want to increase demand (lower rates) in response to a decreased supply of goods?”  That’s a good question.  For example, imagine AS=AD=1000.  Let AS fall to 900 so that AD>AS.  How should the Fed respond if the fall in supply represents a permanent fall in the natural rate?  Is there any reason to believe the Fed should pause or even decrease rates to increase demand?  Let’s turn to recent remarks by ECB president Trichet from the Symposium at Jackson Hole to begin searching for an answer:

...Why should expectations be a problem within a credible policy environment? Because the economy is never at rest. Agents have to catch up with the continuous change in their environment by an ongoing process of learning. When shocks are moderate … imperfect information and learning do not excessively complicate our interactions with the private sector. But there are times in which … a perpetual process of learning ... can have implications for the overall stability of the economic system – to some extent, independently of the monetary policy regime that is in place. If agents do not possess rational expectations, but have to re-estimate continuously the coefficients of an unknown model of the economy … it can well happen that a shock of sufficiently serious magnitude can unsettle expectations, even under credible monetary institutions. The reason for this is simple. It might become impossible for private forecasters quickly to form a reasoned guess about the scale of the shock, its duration and persistence, and the likelihood that it might not be easily washed away, so that it would become, in their eyes, embedded in the fundamental relations regulating the functioning of the economy for some time to come. Long-term expectations thus may over-react to the shock. They may drift endogenously ... These are times in which, typically, there is a disconnection between private views about the macroeconomic outlook and the central bank’s own internal forecasts. … The difficulty lies in devising a prudent way to factor such situations into policy. And here is where the fundamental tension … comes in. On the one hand we want to keep our eyes on the fundamentals and avoid being misled … by what could well be noise and unfounded overreactions. On the other hand, excess endogenous volatility in private expectations could indeed provide advance warning of pending risks that the central bank should take into account. ... This might entail serious risks of instability. Recent work done at the Federal Reserve Board … shows that, … An aggressive policy adjustment in reaction to detected signs of expectation instability can help head off the risks that one might see associated with the manifestation of such phenomenon. … However, any unexpected and possibly unprecedented action that the central bank takes in response to these risks might disorient the market. … This would suggest that action may not always be advisable. Sometimes, more optimal behaviour consists in appropriately communicating the central bank’s assessment of the fundamental state of the economy and its prospects in order to regain control of inflation expectations. In the long term, the advantages of having systematically avoided hasty reactions outweigh the benefits that might be apparent in the short term. By maintaining a steadier posture, the central bank embracing this policy views its role as that of a lighthouse or, more accurately, a lightship, in a storm. In this respect, building a reputation for a calm and firm management of the events can pay off…

That "It might become impossible for private forecasters quickly to form a reasoned guess about the scale of the shock, its duration and persistence, and the likelihood that it might not be easily washed away..." seems to describe the present situation well.  From a learning perspective, an interpretation of this is that private markets have not learned the lessons the Fed has learned from the 1970s and expect a repeat of that episode, i.e. a repeat of the policy of stimulating AD in response to AS shocks.  The Fed has made it clear recently that it does not want to see the inflation of the 1970s repeated.  The message Trichet is conveying is that with markets widely anticipating a pause in the rate increasing campaign by the Fed, to continue increasing rates would disorient the markets and potentially lead to even more instability.  Should the Fed do what it thinks is correct according to the fundamentals, or does it behave according to market expectations it disagrees with?  The answer Trichet gives is that you do not do anything rash that might upset the markets (particularly if the Fed itself is unsure of long-term consequences), it’s better to explain, explain, and then explain some more to re-anchor inflationary and other expectations  (hence these kinds of comments from the Fed today). Unless FedSpeak can convince markets otherwise (and assuming FedSpeak would want to), it may be prudent from a risk management perspective to pause and wait for expectations of the Fed and the private sector to converge before considering further rate hikes.

Comments

[William Polley]

I really do not think the Fed would lose any credibility as an inflation fighter if it simply paused at one meeting this fall or winter to acknowledge that inflation has been well contained (in spite of the supply shocks) and now especially with the many unknowns ahead. I've been saying that long before the hurricane, as you know. I'm not asking them to cut rates. I'm not even saying to stop raising them as if this is the end of the line. I would just like to see a pause to let some of the last few moves sink in before moving on. I think such a plan would even still qualify as a "measured pace" if they insist on that term.

I don't want a return to the 1970s either. But a lot of people have voiced concern about what will happen to consumer confidence if gas prices hover at $4 for a few months. A short pause in the rate hikes might give the economy a psychological boost (there go those animal spirits again!) without increasing the risk of inflation very much at all.

[Mark Thoma]

I agree and it's that expectational effect that a pause will counter. I probably didn't draw that part out well enough, but it is precisely the expectations factor - the expectational drift to use Trichet-like terminology - that motivates pausing in this story. Confidence wanes as output falls and people expect a rate cut. After all, that's how the Fed fixes a lagging economy. Becuase they expect rates to pause or fall, raising rates would really cause "doom and gloom" and make things worse, so rates must do as people expect them to do.

I too have been calling for a pause. Long ago I thought 4.25, then recently thought the Fed would push beyond that to 4.50, and maybe should, but this will cause yet another reassessment downward. Howeve, on the other side, it does seem like as officials look forward to when a rate cut would be effective they see very little variation from the pre-hurricane path of inflation and output, i.e. all effects are short-run. I think it's too soon to make that assessment.

And I agree with another thing. It seems like some believe that once on the measured path there is "path inertia" for exactly the same reason. People expect rates to go up, so go up they will. I think that is relatively easy to address with transparency. A few statements from Fed officials about thinking of a pause and blogland and the press would be all over it immediately. We'd discuss it to death. The Fed has been pretty good about sending clear signals and has the credibility to do so.

[Edward Hugh]

I more or less agree. I think the Fed needs to be what Trichet calls the lighthouse here (I just wish he would be what he advocates). I do however think there is an implicit ceiling built into the measured increases by slow growth in Europe and the CA deficit. At some stage the rising yield curve between the ECB and the Fed (and of course the impact of the 10 year German bund on global bond yields which impact the US yield curve), and the growing pessimism about the eurozone, could trigger a dollar correction upwards of some magnitude (Stephen Len guesses 1.10 euro to the dollar). This would complicate Greenspan's life enormously, so my guess is he will try and avoid that. The question is can he?

[Edward Hugh]

What was I saying about the 10 year bund:

"European bonds advanced, with the German 10-year bund yield falling to a record, on concern rising oil prices will slow the economies of the dozen nations using the euro... The yield on the 10-year bund fell 2 basis points, or 0.02 percentage point, to 3.05 percent, the lowest ever on a bund of that maturity, according to data compiled by Bloomberg. The yield has fallen 10 basis points so far this week. The Bundesbank uses a nine- to 10-year yield for its records, which go back to 1973, and that measure previously reached a record of 3.06 percent on June 24."

These 10-year bund values are bound to influence US 10 year treasuries, I think there is no other way of reading it. I don't want to stick my neck out too far, but I still think there is more possibility of the next ECB rate move being downwards, especially given the specific weight of Germany and Italy together in the eurozone.Of course, Trichet being Trichet, the most probable of all outcomes is that it stays at 2%, out, out, out into the horizon. Marty Feldstein (indeed Bernanke in The Euro at Five) is right in this sense: the euro is primarily a political entity. And with the situation in Germany and Italy (both economically and with the challenges to the very existance of the euro) I think it would be virtually political suicide for the ECB to raise rates unless there was a lot stronger recovery momentum in Germany and Italy than I personally contemplate.

And Philippe Douste-Blazy is already calling for more political control of the ECB - and this comes from France, the relative success story.

http://fistfulofeuros.net/archives/001824.php

[dali lama]

I think the case for a rate pause or even a cut is compelling. It seems to me that high energy prices will reduce demand for all goods not just energy. The fed will need to restore some of that demand in order to achieve respectable GDP numbers. Undoubtedly, that will generate inflation in the short term. However, the alternative seems quite risky to me. High energy prices combined with high (or too high) rates could prove to be dis-inflationary in the long run. The fed wants to fight inflation, but I think they are outright terrified of deflation.

[anne]

From the post to comments, all are thoughtful. I am concerned and lean to caution, but not sure how I would vote at the coming meeting. Likely I would let the long term bond market lead me. For now, I am thinking.

Notice the household saving rate is now negative, but we do consume and Australians have had negative household saving rates.

[anne]

A fine column:

http://www.nytimes.com/2005/09/01/business/01scene.html

September 1, 2005

The Opportunity Cost of Economics Education
By ROBERT H. FRANK

SHORTLY after I began teaching, more than 30 years ago, three friends in different cities independently sent me the same New Yorker cartoon depicting a woman introducing a man to a friend at a party. "Mary, I'd like you to meet Marty Thorndecker," she began. "He's an economist, but he's really very nice."

Cartoons are data. That people find them amusing usually tells us something about reality. Curious about what drove responses to the economist cartoon, I began asking about the disappointed looks that appeared on people's faces when they first discovered I was an economist. Invariably they mentioned unpleasant memories of an introductory economics course. "There were all those incomprehensible graphs," was a common refrain.

Needless to say, a course can be valuable even if unpleasant....

[bailey]

You ask appropriately, "How should the Fed respond to a supply shock?" But your reference to "permanence" presupposes the catastrophe will have permanent negative repercussions for the country. I don't think you can argue that at this time. In short, I believe the Fed should interpret the Market's "expectation for a pause" for the arrogance it suggests. Market investors don't care about anything outside their six month investment horizons. Doubt this? Take a look at the investment turnover of a few of the MOST conservative funds available. It's obvious to me money center banks believe they can continue to wag the Fed as they have since the early nineties. If anything, this catastrophe INCREASES the need for the Fed to retake control of monetary policy, & the only way is for AG to continue the methodical increases of Fed Funds back up to a 5% neutral rate. To do otherwise would be to compound the problems that have been building since the repeal of Glass-Stegall.

[Mark Thoma]

I agree with that - it is looking temporary at this point. When I wrote this is wasn't quite as clear, but it looked that way, and more importantly when the markets were reacting and probabilities of a rate hike were falling, it was less clear whether the effects would be permanent. As I've read things today, there are still quite a few analysts asking if people are underestimating the permanence of this, but it looks like sentiment is shifting to temporary. It will be interesting to see if the rate hike probabilities move again (and in what direction).

[Joe Rotger]

I would like to take up on Robert Frank's remarks on his veiled contempt of economists’ capabilities.

" But there is an even more troubling explanation for students' failure to learn fundamental economic concepts. It is that many of their professors may have only a tenuous grasp of these concepts, since they, too, took encyclopedic introductory courses, followed by advanced courses that were even more technical."

This is the article:
http://www.nytimes.com/2005/09/01/business/01scene.html

Although, I think this is a very generalized problem –it’s not privy to economists, I think Mr. Frank makes a very interesting point. Namely, that an exposure to what he calls "an encyclopedic list of technical topics", may be counterproductive to understanding the fundamental nature of what is really going on with the economy, which undoubtedly cripple economists chances to finding the appropriate solutions.

I would add, that economists are quite removed from the real world. I understand it's the necessity of their job, how would they otherwise be able to see the forest of the economy, if you will? GDP, unemployment numbers...but these aggregate numbers tell a very poor and incomplete story of what goes on. For instance, the breakdown of the new bulging job number tells otherwise a pitiful story, in short: people are finding lots of jobs at McDonald's. Or, the quality of the new jobs is in frank deterioration.

Furthermore, I don't know how their models would respond to the many endogenous and significant situations, which I can think of to affect the economy. For instance:

How would they take into account King Abdallah's politically fragile situation in Saudi Arabia and its effect on oil prices? How would they consider his demise?

Would they consider the Fed short-selling oil? To actively intervene over one of the markets worst behaved variables? Or, having the government intervene by selling oil from their SPR reserves, as they are doing?

I could go on and on…

But, the question is:

Are economists seeing the crux problems faced by the US economy with their limited economic models?

And mostly, will they’re heavily weighed and complex sets of tools solve the issues, or plain and simply, aggravate the problems?

Can economists think out of the box?

I have mentioned before what I consider the three crux problems of the US economy: Government overspending, low wages in China and high oil prices.

Mr. Bush is fortunately fixing the oil problem –we have Katrina to thank for, and no, I don’t remember any economist coming forward with the obvious solution of selling oil to counter rising prices. If the Fed can act over the Fed funds rate, reserves…why can’t the Fed short-sell oil or the economists suggest the solution of selling it?

US troop withdrawal in April –rumors, I’ll admit-- should start to take care of government overspending.

So, we’re stuck with the low wages in China issue…let’s sweep this one under the rug…like it’s been happening for a few years now.

The solution is to lower wages in America. Higher productivity is a requirement…But we can go so far…The Chinese will counter with an increase in their productivity too…

I’ll repeat this one more time, the easiest --and less painful way of achieving competitive US wages is to devalue the US dollar. The alternative is to devastate jobs --as well as have investment flee or avoid the US.

If no action is taken, or mistakes are made –like raising US interest rates, the erosion of the US economy will continue. We will go through an intermediate phase where we will live from our wealth, but not capable of producing anything, eventually, we will default on our assets and this will be a very sour day for our children.

Can any of you answer as to why we should raise interest rates?
To contain inflation? To contain the US dollar’s devaluation?

Will it help US prices? Will it help US exports? Will it help the trade deficit?
Lord, no!

I can see the banker’s point of view, and I can also see that a healthy environment is required for investment –a non-inflationary one.

But, what good will it do to have a non-inflationary environment if investments will prefer to park in China anyhow, because of their low wages?

As a consequence, no investment in the US and major devastation of US jobs…

First, lower US wages, then we’ll see the models…

[hans]

I agree with lowering INCOMES not wages. May I suggest raising taxes on the wealthy as the preferred way of doing it? It will not reduce aggregate demand, except for investment goods. It will increase national savings by reducing or eliminating the deficit. It will bring an end to the great robber baron age Ronald Reagan ushered in with his tax cuts for billionaires. It will deflate bubbles. It will restore the IRS component of law enforcement. Why is this not on anyone's economic agenda? Are you all apologists for GREED, GREED, GREED?

[Joe Rotger]

Hans,

As they say, the devil is in the details... I honestly know very little of the tax issue to carry on an intelligent discussion --only what I read in the news.

But, intuitively --whatever this means, I tend to agree with the recognition of the consensus that the entrepreneur is unquestionably a very rare and valuable commodity. And, with globalization, this very slippery fish takes very little time in moving to more amenable waters.

Maybe this is why the USSR ceased to exist, and most socialist governments have a heavy free market component in their economic administration.

Why do I get the impression that the lower tax argument is the bait to lure this investor fish into the US economic waters?

Historically, capital has moved to areas of underdeveloped resources, from our ancestors’ migratory patterns, the colonies, and more recently China, with its unlimited supply of –underdeveloped-- labor.

Hans, like I said before, I'm an ignorant in tax matters. If you have the numbers to prove your case, please go right ahead, and prove me wrong.

But, if you are trying to punish the evil wealthy...I will hold on to my belief that there is a solid argument that the investor-entrepreneur deserves to receive more in exchange for his creative contributions to society, of which the most important would be job creation...

BTW, when I argued for the necessity of lower wages in the US, which is going to happen anyhow, through job destruction or not, --the Chinese and Indian low wages are taking care of this—, I really meant to make the case for a US dollar devaluation.

A gradual and targeted US dollar devaluation makes US export prices more competitive. If these prices are competitive enough, they will allow displacement of US competition, and US export volumes will increase, in its turn, reducing the trade deficit imbalance.

If, on the contrary, Mr. Greenspin continues to raise the Fed fund rate, the US dollar will appreciate with the obvious and predictable continuation of the erosion of good quality US jobs.

The US dollar devaluation is an easier solution, it is also more palatable to the politicians –it’s better than layoffs and lower wages in US dollars. But, most importantly, it is a quick way to conserve the jobs that are disappearing from the US at an alarming rate.

Does anybody think those jobs will ever come back to the US?
Does anybody think the US can sell with higher export prices than its competition?
Can anybody explain how the US will solve its trade deficit with a higher US dollar and diminishing exports, or do we give a blind eye at this fallacy?
Will anyone invest in the US with the wage disparity issue in favor of China? --because it's not happening, low inflation and all?
Time is running out, gentlemen…