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Sunday, September 02, 2007

Greg Ip from Jackson Hole: Speeches by Feldstein and Taylor

Greg Ip reports from the Federal Reserve conference in Jackson Hole on speeches given by Marty Feldstein and John Taylor:

Two Heavyweights Weigh in on Greenspan’s Legacy, by Greg Ip, WSJ Economics blog: Provocative speeches by two of academia’s most prominent economists... [Martin] Feldstein ... delivered a gloomy forecast of the impact of the unraveling housing boom and argued that if the Fed cared about unemployment and not just inflation, there should be “a major reduction now in the federal funds rate — possibly by as much as 100 basis points (one percentage point).” ...

Mr. Feldstein told the Federal Reserve Bank of Kansas City’s annual symposium in Jackson Hole that the economy faces three threats: home construction collapses as prices plunge, credit freezes up, and consumers’ spending wilts as they lose the ability to borrow against their homes’ value. “Experience suggests that the dramatic decline in residential construction provides an early warning of a coming recession. … If the triple threat from the housing sector materializes with full force, the economy could suffer a very serious downturn.”

Then, employing “risk management,” Mr. Feldstein asked what would be the consequences if the Fed cuts rates but discovers the threats didn’t materialize: “The result would be a stronger economy with higher inflation than the Fed desires, an unwelcome outcome but the lesser of two evils. ...” This “risk-based approach in the current context” he suggested, “is not an abrogation of [the Fed’s] fundamental pursuit of price stability.” ...

Stanford University economist John Taylor, author of the famous “Taylor rule,” ... says the Taylor rule would have told the Fed to raise the federal funds rate from 1.75 % in 2001 to 5.25% by mid-2005. Housing starts, around 1.6 million in 2001, would have peaked at 1.8 million (annual rate) in early 2004 then begun a gentle decline. In reality, the Fed cut the rate to 1% in 2003, then began raising it in 2004, only reaching 5.25% in mid-2006. Housing starts soared to 2.1 million by early last year and have since plummeted, to around 1.5 million. “A higher funds path would have avoided much of the housing boom … The reversal of the boom and thereby the resulting market turmoil would not have been as sharp,” Mr. Taylor said.

Mr. Taylor acknowledges the Fed had good reasons to err on the side of easy policy and that low long-term interest rates also boosted housing. But he argues long-term rates were low in part because investors may have seen the Fed’s easy policy as evidence of a permanent de-emphasis of inflation, making long term rates less responsive to the Fed. The lesson, he says, is that when the Fed departs from business-as-usual, ... it can be “difficult for market participants to deal with and lead to surprising changes in the economy.” ...

Mr. Bernanke indicated Friday that the threats Mr. Taylor warned of could lead to rate cuts. Still, the rest of the economy remains in reasonably good shape. Whether that remains true after the current turmoil has run its course will be an important factor in Mr. Greenspan’s legacy.

Markets seem far more certain of a rate cut than the signals coming from the Fed would indicate. I'll be interested to see if the rate cut probabilities change on Monday, or thereafter, though I don't expect to see much change without some important new piece of information coming to light. [More on the conference here and here.]

    Posted by on Sunday, September 2, 2007 at 12:33 AM in Economics, Monetary Policy | Permalink  TrackBack (0)  Comments (9)

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