December 18, 2007
The Fed must not play Santa to the markets
By Kenneth Rogoff
US Federal Reserve officials were jolted last week by the cacophony of booing that greeted their quarter-percentage-point interest rate cut. Markets badly wanted double the amount. It is part of a growing town/gown rift between a model-oriented Fed and a profit-oriented financial community.
Market commentators, including some former Federal Open Market Committee members, almost unanimously expressed deep disappointment that the Fed did not seem more attuned to the growing risk of recession. The critics were especially peeved that the Fed’s statement did not contain a clear acknowledgement that short-term growth risks easily trump short-term risks to core inflation.
The negative rhetoric cooled a bit later in the week as the big central banks announced new measures to maintain market liquidity, and as high November inflation readings made the Fed’s balance of risk assessment seem somewhat more plausible.
Nevertheless, markets remain extremely sceptical. As housing prices sink and the credit crunch grinds on, top private forecasters have been scurrying to downgrade their 2008 growth estimates.
The remainder of this column can be read here. Debate from our panel of economists appears below.
Martin Wolf: Yes, yes, yes. This is much the same message as the one in my column last Friday on the British economy (A stress-test for the British economy). Of course, it may be too late to avoid some very big bail outs. But they should be explicit, not generated through inflation.
Posted by: Martin Wolf | December 18th, 2007 at 1:47 pm | Report this commentKenneth Rogoff: Thanks for comment. Well, yes but no. Martin seems to broadly share the market view when he argues that the Bank of England is being “far too conservative”, and that it has “vast room for maneuver.” The market has the same view of the Fed, but as my column clearly indicates, I don’t share it.
The current rate is probably already in the middle of the neutral zone. Many Wall Street analysts have long argued that we need a different, lower, concept of neutral when there is a credit crunch. Perhaps, but this is a seat of the pants argument; there is not a lot of analytical or empirical support. It is hard to separate how much of the rise in credit spreads is “crunch” and how much is “normalization” of spreads that central banks should allow to play out. Overall, it is probably reasonable for both the Fed and the Bank of England to keep cutting as their economies slow, but I don’t think either is nearly so far behind the curve as the markets believe.
What really matters, of course, are inflation expectations, which right now are very well anchored in both countries. Either the Fed or the Bank of England can juice up their economies by slashing rates (say 100 basis points) without suffering any huge further inflation spike – in the short run. However, as I argue in my piece, the main price is to be paid a couple years down the road, as inflation expectations gradually ratchet up, after which they will prove costly to bring down. When will we know the central banks have gone to far? The flashing red light will be if short-term rate cuts start driving up nominal interest rates at the long end, due to rising inflation expectations. Unfortunately, the flashing red light might not turn on until after it is too late to change course.
As for calibrating British interest rates against the rest of the OECD: we agree that the pound is overvalued, and it will likely come down in real terms over the next several years. But if the market agrees, then isn’t it reasonable for British short term rates to be somewhat above the rest of the OECD?
Posted by: Kenneth Rogoff | December 19th, 2007 at 9:48 am | Report this commentMartin Wolf: I think Ken and I are nothing like as far apart as he believes (or fears).
First, I do not believe either the Bank of England or the Fed is much “behind the curve”. The Fed has already cut a great deal (possibly too much). Moreover, when I said that the Bank had “vast room for manoeuvre”, I meant that it has substantial room to cut interest rates if the economy weakened dramatically, as some fear, but only provided inflationary expectations remain under control. That is why I stressed the latter point so much at the end of my column. I may not have been as clear on this proviso as I should have been.
Second, I did not wish to argue that the Bank was being far too conservative. On the contrary, I reported that view as one of the points made by pessimistic observers about the UK economy. I largely support the Bank’s caution, as I said, though I think it may now be a little too conservative. Thus, I would argue for a further modest interest rate cut now. The reason for this is that the widening in inter-bank spreads has, whatever the reasons for this development (largely solvency concerns, no doubt), tightened monetary conditions substantially. I cannot see a good monetary policy reason why the Bank should want that to have happened, given the events of the past five months and the likely economic downturn next year, as the housing market weakens. So either the Bank should act to lower these spreads (a policy I am not very keen onlly) or it should lower its official intervention rate.
I do not see why this position is unreasonable. Nor do I see why it is inconsistent with the position that Ken and I share, namely, that maintaining credibility over inflation is crucial, particularly when any creditor can see the temptation to bail out the highly overindebted.
Posted by: Martin Wolf | December 20th, 2007 at 9:54 am | Report this comment