Another wind egg from the Fed

At its regular meeting yesterday, the Fed opted to keep the target for the Federal Funds rate unchanged at 2.00 percent. With the most recent figure for headline CPI inflation coming in at 4.2 percent yoy, US monetary policy continues to be strongly stimulating.

From a macroeconomic stability perspective – price stability and the highest sustainable levels of employment and growth – monetary policy is far too expansionary. Inflation has been persistently above the Fed’s comfort zone for years. Inflation expectations have now moved up sharply. Dislocating these inflationary expectations will require either a period of low inflation brought about by excess capacity and high unemployment or a miracle. The Fed apparently believes in miracles. I only hope and pray for miracles. I don’t consider them a substitute for the right policies.

According to recent OECD estimates, the path of potential output for the US has shifted down by around 4 percent as a result of an increase in the real price of energy and other primary inputs. Therefore, even if one condones (does not try to reverse) the ‘first-round’ one-off price level effect (or temporary inflation effect) of higher energy prices, and even if there are no ‘second-round’ effects at all (no pass-through of the first-round headline price level increase into wages and core prices), the increase in the real price of energy increases the output gap and will be inflationary. This ‘zeroth-round’ effect of an increase in relative energy prices on potential output plays no role in the Fed’s discussion of the inflationary consequences of oil price shocks.

Interest rates will have to rise to bring down the path of actual output to the lower path of potential output. Because the increase in real energy costs is likely to be permanent and may even be the precursor to future further real energy cost increases, the negative effect on US productive capacity may well be persistent and could even be amplified in the short run. This effect of higher real energy and other primary input costs on the output gap appears to be ignored by too many central banks. The Fed and the Bank of England both appear to be wedded to this specification error in their views on the transmission of energy price shocks.

As regards economic activity, it is clear that the Fed interprets the real economy part of its dual mandate not as the highest sustainable levels of employment and growth, but as the highest short-run levels of employment and growth, regardless of whether these levels are sustainable. The Fed appears to be scared to death of any increase in unemployment now, regardless of what the actions prompted by this obsessive fear imply for unemployment further down the road. I have not before encountered such obsessive myopia in a leading central bank.

The US consumer continues to be excessively indebted/over-leveraged. Other than defaulting on household debt, there is but one way to reduce indebtedness: save more and consume less. US households are threatening to to the right and unavoidable thing at last: they appear to be saving a bit more and reducing the (growth rate of) of consumption a bit. Nowhere near enough to restore balance in the household finances, but it is a beginning. As soon as there is any indication that household consumption may be weakening, the Fed charges in with interest rate cuts, with the Treasury and Congress not far behind with ad-hoc tax cuts. Both actions slow down the necessary reconstruction of the US household balance sheet and may even prevent it altogher, thus creating the pre-conditions for a future financial disaster.

A slowdown in household consumption (I believe this requires lower levels of consumption for a number of years and not just a lower growth rate) is a necessary part of the restoration of financial sanity for US households. In a world with perfect wage and price flexibility, lower household consumption would free resources that would seamlessly flow into investment and the trade balance. Reality is different. Reality is Keynesian in the short run. There will be a prolongued slowdown in economic activity – low or negative growth for a number of years and rising unemployment. That is extremely tough on those who will lose their jobs, their homes and their businesses, but there is no other way in a market economy like the US.

US policy makers of both parties have lectured us for years on the need for the US to move to a higher national saving rate equilibrium. Well folks, it’s happening at last. Please don’t screw it up by unleashing the dogs of loose monetary and fiscal policy at the first sign that households may be planning to save more. We cannot get to the new, desirable and sustainable equilibrium with its higher saving rate and lower inflation rate, without passing through the valley of the shadow of unemployment and excess capacity. Denial is a common human behavioural characteristic. It is not a good guide to policy.

There could be two other reasons for keeping the Fed Funds target rate as low as it is. The first is continuing concerns about liquidity in key financial markets, including the interbank market. The second is fears about financial instability based on concerns about the solvency of a material chunk of the US banking system.

As regards a continuing liquidity crunch, the risk-free short nominal interest rate is a poor instrument. Liquidity problems should be addressed by increasing the scale and scope of discount window operations and open market operations at whatever the level of the risk-free short nominal interest rate happens to be. Broadening the range of eligible collateral, lengthening maturities and increasing the set of eligible counterparties are the instruments.

A punitive valuation/pricing of illiquid collateral offered at the discount window or in repos is, of course, a necessary condition for minimizing the moral hazard involved in the liquidity enhancing activities of the Fed. The Fed should therefore immediately end the ludicrous, adverse-selection-inviting practice of letting the clearing banks (acting as agents for primary dealers), price the collateral offered to the Fed by the primary dealers at the TSLF and PDCF (and in any other clearer-mediated transactions between the Fed and the primary dealers).

As regards fear about the solvency of a sizeable chunk of the US banking system, I share these concerns. They should not be addressed, however, by the Fed acting as a quasi-fiscal agent of the government. Allowing the banks to recapitalise themselves by keeping rates articifically low is deeply market-distorting. Insolvent banks that are not systemically significant should be allowed to fail – and the sooner the better. Those who are at risk of failure but are deemed too large or too interconnected to fail (TLATIF) should be put in a special resolution regime (SRR), so prompt corrective action (PCA) can be taken. Because investment banks now fall into the TLATIF category, a SRR should be designed forthwith for them, mirroring that for insured deposit taking banks regulated at the federal level, run by the FDIC.

The injection of public funds into vulnerable TLATIF banks, should be an open, fiscal intervention, on the budget and balance sheet of the Treasury. The special purpose vehicle shenanigans used by the Fed to put the tax payer on the hook for $29 billion as part of the rescue of Bear Stearns, has no place in an open and transparent political system where proper accountability for the use of public fundsis is even more important than financial stability. The explicit fiscalisation of bank recapitalisations should be a no-brainer when, as was the case with the Bear Stearns rescue, there is no inherent conflict between financial wreck-clearing and accountability.

Macroeconomic stability calls for higher rates in the US. Higher rates need not endanger market liquidity or financial stability. I cannot understand why the Fed remains mired in this reckless monetary policy stance.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website