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Saturday, August 13, 2005

The Insurance Value of Increasing the Federal Funds Rate

There is a lot of discussion concerning the potential costs to labor markets from increasing the federal funds rate.  I want to add to the discussion by noting a potential benefit to balance against this cost.  This is not an exhaustive list of costs and benefits, for example I am not addressing international finance aspects of changing domestic interest rates, prices, and so on, I am focusing on just two elements to highlight a particular tradeoff.  Let’s start with the cost.  A well known and widely recognized cost of increasing the federal funds rate and in the process interest rates generally (setting aside recent troubles influencing long-term rates) is the general economic slowdown that accompanies it.  This, of course, is harmful for employment relative to an economy with lower interest rates and this is the objection of many who oppose further increases in interest rates or worry the Fed might overshoot at some point in the near future. But there is a potential benefit that has not received enough discussion. 

The extraordinarily low interest rates we have seen have caused a sectoral imbalance in the economy.  In models with sluggish prices and wages as the source of short-run fluctuations, it is the change in relative prices brought about by the accommodative money that causes the imbalance.  We hear stories about the imbalance all the time, the high number of workers in housing construction, the rising number of realtors, all of the secondary jobs, and so on.  It is very clear that there is a general perception that the relative price distortion between sectors brought about by low interest rates has led to an economy that is very unbalanced towards interest sensitive sectors and much concern is expressed for our vulnerability due to that imbalance. If the imbalance was caused by low interest rates, then the solution is to raise interest rates to take away the incentive that caused the imbalance to begin with.  Until the incentive that caused the imbalance is removed, until rates are raised, the imbalance and the vulnerabilities that come with it will remain.

Paying the fiddler is always painful.  If we intentionally unbalance the economy to attenuate a recession, then much like the Keynesian policy of running a surplus in good times to pay for the deficits used to smooth the bad times, rising interest rates and slower economic growth are the costs that must be paid to attain a healthier more balanced economy during the recovery period.  But it's always tempting to avoid such costs.

It is not clear to me which is worse from labor’s perspective, slowing the economy during the recovery to rebalance which has the benefit of reducing the chance of a bigger calamity later, or more employment but higher risks from allowing the imbalance to remain.  Think of the housing sector as a balloon with too much air, a balloon ready to pop if subjected to additional stress.  The chance of the balloon bursting is reduced if we let the air out very slowly and carefully.  Thinking further of the escaping air as resources flowing out of the housing sector, we shouldn't allow the air escape, but instead use it to re-inflate balloons representing other sectors of the economy to the extent possible. There are lots of policies that can be implemented to facilitate this structural change outside of monetary policy, policies that allow as little air to escape as possible during the sectoral reallocation, and those ought to be pursued vigorously.

As I see it, commentators cannot simultaneously complain about Fed policy regarding both the potential for the housing bubble bursting, which requires higher interest rates as a remedy, and a sluggish labor market, which calls for a leveling or lowering of rates.  We can debate whether past Fed policy got us into this predicament, and we should review the game film carefully to correct any errors in policy, but now that we are here we have to choose a problem to work on, the Fed cannot solve both at once.  Currently I see the need for rebalancing as greater than the need for leveling or lowering rates, but it is not an easy call, and there are arguments on both sides.

The goal here is not to say that rates should be raised for sure in the next few FOMC meetings, for one thing new data could change the outlook.  The focus is on the rebalancing aspect because I believe that getting the air out of the balloon at a slow, measured pace so as to re-inflate other sectors, with everybody warned that it is happening so that if the balloon pops loudly nobody jumps out of their seat, is best for now.  The goal is to highlight that there is a potential benefit from higher rates that has nothing to do with slowing the economy out of fear of inflation.  Inflation in and of itself is not, nor has it ever been, my worry.  I want labor and other resource and output markets to be as robust as possible against shocks when the next one hits, and one will hit someday, and rebalancing the economy is an essential insurance policy against such risks.  Slower output growth during the rebalancing period is the cost of the insurance premium for labor and I understand that some feel the insurance is far too expensive.  For now, I do not.

[Update:  The purpose of writing this was to generate discussion on "bubble" policy and this is my attempt to make a case for it.  I was happy to see the discussion continue with comments from Glenn Rudebusch, a researcher with the SF Fed, on "bubble" policy who discusses this topic further and sets conditions that must be met prior to the implementation of policy directed at bubble management.]

    Posted by on Saturday, August 13, 2005 at 12:24 AM in Economics, Monetary Policy | Permalink  TrackBack (0)  Comments (8)


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