Japan Again?, by Tim Duy: I understand the temptation to compare the current US situation to that of Japan in the 1990’s, as the combination of equity and property bubbles appears eerily familiar. Indeed, I would not disparage anyone who drew that analogy. I think, however, there are some critical differences between there and then and here and now:
- Japan’s banking sector recapitalized only reluctantly. There was resistance to writing down non-performing assets and courting foreign stakeholders. Currently, US banks are aggressively writing down bad assets and will take money from anyone in an effort to maintain capital to asset ratios.
- The Bank of Japan moved cautiously to stem the damage from the burst bubble. The US Federal Reserve, in contrast, has moved very aggressively.
- Japan faced the classic Keynesian problem, a high propensity to save coupled with insufficient domestic investment to utilize that saving. These dynamics were partly the result of a challenging aging profile. Demand was simply insufficient to meet the productive capabilities of the nation.
- Remember that Japan always maintained a current account surplus, which, of course, follows from point three above. Japan relied on the rest of the world to purchase its excess production. The US does the opposite, relies on the rest of the world to support it excess consumption.
- Excess internal savings gave the Japanese government more than enough room to pursue aggressive fiscal policy without relying on capital inflows from the rest of the world. The US is the opposite; our fiscal policy is entirely dependent on the willingness of foreign central banks to accumulate US Treasuries.
- China and India lacked the economic power to drive global commodity prices.
The upshot is that Japan was not facing an adjustment in its external accounts like the US. US policy is focused on maintaining domestic consumption well above domestic production, resisting adjustment in the external accounts. By my reckoning, the appropriate analogy is not Japan, but Thailand. The difference, of course, is that the Federal Reserve expects the rest of the world’s central banks to support the US via asset purchases, whereas the Fed would be unhappy offering the same support to emerging markets.
As I have said multiple times, however, this is one theory. And the safe bet given the history of the past 25 years is to expect that a deceleration of the US economy will ease any residual inflation pressures. This forecast is what gives the Fed room to continue easing.
On the pessimist side, note that the low inflation scenario relies on the assumption that monetary policy, over the medium term, will continue to have price stability as an important focus. That assumption, I believe, is increasingly dangerous. I think that we are witnessing a potential reversal of the central bank independence in this nation. Fed independence depends upon the institution’s willingness to execute its responsibilities. By failing to live up to its regulative responsibilities, the Fed opened the door to a loss of independence. And Fed Chairman Ben Bernanke lacks the political capital of his predecessor to resist the shifting currents. I hope I am wrong, but at the moment, it appears that Senators Reid and Dodd own the Federal Reserve. From Bloomberg:
The Senate majority leader said Democrats won't allow President George W. Bush's nominees to fill three vacant Federal Reserve Board posts for full 14-year terms after Bush rejected a deal for temporary appointments.
''These are all nominations where we will be unable to confirm the nominees for a full term,'' Harry Reid of Nevada said in a statement. Democrats and most Americans ''don't want to ensure that the legacy of the president's bad economic policies live on for 14 years through his Fed nominees,'' he said.
The strategy is obvious. Democrats are hoping to win the White House, and see the opportunity to place three governors on the Board. I don’t expect the nominees would be hard liners like Philadelphia Fed President Charles Plosser. The general view, I suspect, will be as follows: Inflation is not a problem. It is a straw man that allows the Fed to keep the economy at an anemic pace of growth. We need to maintain low interest rates to force the economy to grow at such a pace that the employment to population ratio regains its peak. We need Fed governors who understand this.
I also suspect that there will be substantial interest in selecting a Fed Board that is willing to accommodate growing fiscal deficits. I do not believe that a Democratic White House will restore fiscal discipline. This will be a tough sell if the economy is experiencing a protracted period of weakness, especially one that weighs heavily on household spending. Moreover, there will be campaign promises to fulfill.
And if Senator McCain takes the White House, well, he has already said that he doesn’t really understand economics, and any good Republican knows that deficits don’t matter anyway. Reagan proved it.
Note also the main topic of Dallas Fed President Richard Fisher’s speech; the title is “Defending Central Bank Independence.” Listen:
It requires more than just a law bestowing independence upon a central bank for the bank to actually be independent. It also requires that it be independent in practice. By definition, for a central bank to be independent, it must possess the ability to define its policy objectives without political pressure and it must be free to use its policy instruments without constraints. This is easier said than done.
We know from our own experience at the Federal Reserve that in times of duress, Congress or the executive branch can interfere with the workings of a central bank with disastrous consequences. In the 1960s, a populist congressman from East Texas named Wright Patman, who was chairman of the House Banking Committee, launched a comprehensive review of the Federal Reserve System that exacted an enormous strain on the System’s staff and resources. Congressman Patman was convinced that, contrary to David Ricardo, “money need[ed] to be back in politics where it was in the 19th century.” He wanted to legislate away the Fed’s independence and turn it into an arm of the executive branch. Patman’s investigation had reached a point where the 12 Federal Reserve regional banks and the Washington-based Board of Governors could no longer focus on economic analysis or other functions. Complying with Patman’s congressional subpoenas was keeping the Fed from doing its job.
At the same time, President Lyndon Johnson was escalating the U.S. military presence in Vietnam and spending a pretty penny to do so; federal defense expenditures rose to over 10 percent of GDP, more than double the burden of U.S. military spending today. Johnson needed to finance that spending and felt that the Federal Reserve could provide funds cheaply by keeping interest rates low. The Federal Reserve had a real dilemma. It could cut a deal with President Johnson, who, as the most powerful Texan, could call Patman off, but at the price of surrendering Fed policy independence to Johnson’s desires; or it could continue to endure the Patman investigation and risk the Fed’s charter and long-run institutional independence.
I should note that whether the then-chairman of the Fed, a very talented and honorable man named William McChesney Martin, and Johnson made a deal is a matter of speculation. Such an agreement would not have been documented if it did exist. What is known is that Chairman Martin met with Johnson at the White House in May 1964, and soon thereafter the Patman hearings unceremoniously ended without any legislation amending the Federal Reserve’s standing. The Fed held interest rates mostly unchanged over the next 19 months—until December 1965—despite mounting inflation fueled by government spending.
U.S. government budget deficits continued to grow, reaching their highest relative levels on record in the 1970s. Sadly, the Fed monetized these deficits for several years during the 1960s under Martin’s chairmanship and in the 1970s under his successors, Chairmen Arthur Burns and William Miller. By 1979, inflation had jumped to 14 percent and the prime rate reached 20 percent.
The Federal Reserve managed to regain control of the economy and its own independence under the firm leadership of Paul Volcker. But the cure for high inflation was a dose of harsh medicine. A severe recession ensued, followed by years of high unemployment and high interest rates. Monetary decisions made for short-term political gain exacted a heavy toll on the American people.
The Siren call for monetary accommodation to address political ends is universal and can seduce any leader.
Sounds like Fisher shares my concerns…..sounds like a warning. Why isn’t the financial press covering this topic?
The steepening yield curve signals a changing economic environment in the months ahead. The 10-2 spread now stands at 173bp after today’s dismal reception of a fresh batch of 30 year debt, on a day with decidedly weak economic data no less. Apparently, Treasuries are starting to look a little expensive. This suggests the market is sniffing stronger growth and higher inflation ahead or stagnant growth and higher inflation. It does not suggest to me a Japan style deflation.
Today’s Treasury action coincided with the hawkish elements of Fisher’s characteristically colorful speech:
Monetary policy acts with a lag. I liken it to a good single malt whiskey or perhaps truly great tequila: It takes time before you feel its full effect. The Fed has to be very careful now to add just the right amount of stimulus to the punchbowl without mixing in the potential to juice up inflation once the effect of the new punch kicks in. … My dissenting vote last week was simply a difference of opinion about how far and how fast we might re-spike the monetary punchbowl. Given that I had yet to see a mitigation in inflation and inflationary expectations from their current high levels, and that I believed the steps we had already taken would be helpful in mitigating the downside risk to growth once they took full effect, I simply did not feel it was the proper time to support additional monetary accommodation.
Note that like Plosser, Fisher is raising the specter of inflation to market participants who fundamentally believe that the Fed leadership, Bernanke and his Vice Chairman Donald Kohn, are too worried about other matters to care much about inflation. I have to imagine this will cause some steepening in the yield curve.
Bottom Line: Market participants no longer take hawkish speeches seriously, at least as far as near term policy is concerned. Similar speeches since last summer have been followed by repeated rate cuts. I don’t see a data flow emerging in the near term to forestall additional cuts. The safe bet is to expect inflation fears will subside, but the steepening yield curve is not consistent with a Japan-style outcome. I, however, am not willing to entirely discount a very different view, a rather unsettling view that I hope is entirely incorrect.