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The Fed is steering with a faulty compass
The FT yesterday mentioned an internal report of the US Federal Reserve, that puts the ideal short term interest rate for the US central bank currently at ... -5%!
Fed study puts ideal interest rate at -5%
By Krishna Guha in Washington
Published: April 27 2009 03:00 | Last updated: April 27 2009 03:00
The ideal interest rate for the US economy in current conditions would be minus 5 per cent, according to internal analysis prepared for the Federal Reserve's last policy meeting.
The analysis was based on a so-called Taylor-rule approach that estimates an appropriate interest rate based on unemployment and inflation.
...
Fed staff separately estimated what size and type of unconventional operations, including asset purchases, might provide this level of stimulus. They suggested that the Fed should expand its asset purchases by even more than the $1,150bn (€885bn, £788bn) increase policymakers authorised at the last meeting, which included $300bn of Treasury purchases.
...
So here we are. The Fed thinks short rates have to be at -5%, which is of course impossible. But, it has calculated that this agrees with an 'unconventional stimulus' of $1,150 Bn USD. This extreme decision is based on a model. An economic model. A bit like risk management in banks was based on models. Models which have proven wrong. Ok, these were complicated mathematical models. The Fed is using econometric models. Does this reassure you? Or do you have the same uncomfortable feeling as I have, that this calculation might be based on overly simplistic and even very wrong assumptions?
The input of the Taylor rule, which is the basis of the Fed's calculation, is not so complicated. You need two inputs: inflation and potential growth.
* The first parameter - inflation - can be objectively measured, isn't it ? Unfortunately, inflation measurements in the States have been constantly revised. As a consequence, inflation has been underestimated (to a large amount).The consequence is that such an input in the calculation of the Taylor rule will yield target interest rates that are much too low.
* The second parameter is more complicated, and implies a calculation of potential growth, the so-called 'output gap'. This means that you have to have an idea what the sustainable growth path is, and how much you are currently below that 'sustainable growth path'.
As I have explained ina previous post, the US economy was on an unsustainable growth path. We are in the process of adjusting to a more sustainable growth, perhaps even the magic 'potential growth path', see chart.
The chart shows that in order to achieve the growth path of 2000-2007, the US had to create an ever increasing amount of credit. Unsustainable by definition.
If we plug in the numbers to get to a result of minus 5%, we get an idea of the assumptions used by the Fed. Given current inflation, the Fed must be thinking we are 5 to 8% below potential growth. In my view this is nonsense.
The conclusion in my view is worrying. The Fed is using simplistic models with faulty assumptions to pursue a very experimental monetary policy, which is also indicated by the expression 'unconventionalmonetary policy'.
The result will be a further increase of debt, inflation and instability.
After the insane policy of Alan Greenspan, and after the collapse of the US banking system, the US is now pursuing a big monetary experiment that will most likely end in tears.
The fact that such big risks are taken on such simple and faulty assumptions is mind boggling.
40 Comments
-
Koen Robeys
On 29 Apr, 2009
But how can we judge it will "most likely end in tears"? To me it looks like we need a set of concepts and assumptions of our own, that are just as likely to be simplifications and prejudices as any other model. In other words, you need an own model to judge the model of the FED. How do we know this own model is any better than the FED's model?
I will not speak for the owner of this blog, but it often occurs to me that people believe their model to be sophisticated if it contains no more than the simple rule "government intervention is bad".
I believe most "econometric models" are likely to be more sophisticated than this. To this degree, the fact that the FED uses "econometric models" does reassure me.
On the other hand, even our most advanced theories in physics (allegedly our most sophisticated science) are no more than simplifying models, often no more than crude approaches to reality. At least, this is what they say themselves (Lee Smolin, Brian Greene, Julian Barbour...) So what do we expect of the FED? Models that are even better than those of the "most advanced science"? Divine insight in how the economy will develop? Submission to those political prejudices that happen to coincide with - our own?
To me, using what models we are able to use looks superior to using "back of the envelope" intuitions. Using models that can be criticised by other (economic) scientists look superior to political prejudices. Criticism based on (economically) scientific considerations looks superior to political affiliation. (The latter hope is my main reason for visiting this blog.) But doing so is only possible if the FED does use specific econometric models. So yes, it reassures me that they do. -
Frank
On 29 Apr, 2009
@Geert
I agree with you on:
1.Mind blogging risks and faulty assumptions are taken by the FED
2. The FED is pursuing a big monetary experiment that will end in tears
3. The US growth path was unsustainable
I disagree with you on:
The FED is not assuming they are 5-8% below potential growth. What we see wrong is the CPI. Given current inflation, the Fed is not thinking they are 5 to 8% below potential growth because current inflation is negative; we are in deflation ...
For years the CPI has been underestimating the true rate of inflation. Why? Because it is virtually impossible to create an objective and correct basket of goods and services needed to calculate CPI. Besides, even if you could; how can you possibly calculate it in an objectve way? The FED for instance never included fast rising house prices in the CPI. If they did the CPI would have been way higher. Above that CPI numbers from the past have constantly been revised and adjusted downwards (hedonics, substitution, ...) to hide the expansionary money policy of the FED. Simply put; in the past the CPI number massively underestimated the true rate of inflation.
Now it's the opposite. Because of the miscalculation and misadjustments of the CPI number and the inobjective manner of composing a basket of goods, the CPI figure we get massively overestimates true inflation rates. House prices collapsed, commodity prices collapsed, car prices collapsed, ... The collapse in these (and other) goods is not fully calculated in the CPI. This means that the current CPI overestimates the true cost of living which is now declining. Welcome to the world of deflation. The truth is that true CPI numbers, if calculated correctly and objectively (including collapsing house prices for instance) would show us a negative number. The FED knows that which is probably why they are talking about -5%. Or they don't know and just guessed right. Who knows? This of course does'nt take away the fact that they a pursuing a road to disaster. As I said before, the guys that created the problem can not possibly be part of the solution!
Negative intrest rates are once more a sign (next to the many others) that we are in deflation. The FED is printing fast, but the value of credit is collapsing even faster. We are in unprecedented times. People who think the worst is behind us are only diluting themselves. A period of living above your means is always folowed by a period of living below your means. Few seem to understand this basic principle of economics. -
koen2
On 29 Apr, 2009
I may be mistaken but I don't think that a theoretical fed funds rate of minus 5% is nonsense (goldman sachs calculated that it should be minus 6%)
Geert seems to use sustainable growth and potential growth as synonyms, but they aren't
sustainable growth focuses, if I understood it correctly, on demand: it's growth, fuelled by demand that's not dependent on an unsustainable credit boom
while potential growth focuses on supply: it's non-inflationary growth
the problem in the US is that potential growth is much higher than sustainable growth
if the US economy doesn't reach its potential growth, inflation will turn negative
but that potential growth is not sustainable
so, the US has to choose between the pest (sustainable growth and deflation) and the cholera (potential growth via unconventional measures)
it has chosen for the cholera, and it will continue to do so, until the bitter end (hyperinflation?)
I believe that it was Kondratieff who once said that a capitalistic economy can't continue to steer a way between the scylla of deflation and the charybdis of hyperinflation
how did the US economy get into this catch 22 situation?
once you've created a credit boom, you will be confronted with too much supply (high potential growth), once the credit bubble bursts,
also, in an economy with a big gap between the rich and the poor, there can develop a gap between sustainable growth (demand side is dependend on credit) and potential growth (supply side, fueled by the money of the rich)
btw: the US has already chosen for the cholera in 2002, there was, back then, already a problem with oversupply, (this was already a problem in the late 90ties), that's why the fed lowered interest rates to below the level where they should have been according to taylor's rule
this way, a credit boom was fueled, and the problem of oversupply was made even worse:
http://www.ft.com/cms/s/2/b6b56bd6-278b-11de-9b77-00144feabdc0.html
The crisis that began in 2007 and worsened in 2008 was caused, Taylor says, because the Fed abandoned the rule earlier in the decade. Between 2002 and 2004 interest rates were cut even though the rule required them to be raised. In 2004 and 2005 the gap between the actual and the recommended interest rate was between two and three percentage points. Taylor describes a model simulation in which interest rates followed the Taylor-rule path during this period instead of diverging from it so markedly. The housing boom would have ended in 2003 instead of 2006, he says; house prices and levels of mortgage debt would not have risen so high. In short, monetary policy was the primary cause of the boom and subsequent bust. -
incognito
On 29 Apr, 2009
I may be mistaken but I don't think that a theoretical fed funds rate of minus 5% is nonsense (goldman sachs calculated that it should be minus 6%)
Geert seems to use sustainable growth and potential growth as synonyms, but they aren't
sustainable growth focuses, if I understood it correctly, on demand: it's growth, fuelled by demand that's not dependent on an unsustainable credit boom
while potential growth focuses on supply: it's non-inflationary growth
the problem in the US is that potential growth is much higher than sustainable growth
if the US economy doesn't reach its potential growth, inflation will turn negative
but that potential growth is not sustainable
so, the US has to choose between the pest (sustainable growth and deflation) and the cholera (potential growth via unconventional measures)
it has chosen for the cholera, and it will continue to do so, until the bitter end (hyperinflation?)
I believe that it was Kondratieff who once said that a capitalistic economy can't continue to steer a way between the scylla of deflation and the charybdis of hyperinflation
how did the US economy get into this catch 22 situation?
once you've created a credit boom, you will be confronted with too much supply (high potential growth), once the credit bubble bursts,
also, in an economy with a big gap between the rich and the poor, there can develop a gap between sustainable growth (demand side is dependend on credit) and potential growth (supply side, fueled by the money of the rich)
btw: the US has already chosen for the cholera in 2002, there was, back then, already a problem with oversupply, (this was already a problem in the late 90ties), that's why the fed lowered interest rates to below the level where they should have been according to taylor's rule
this way, a credit boom was fueled, and the problem of oversupply was made even worse:
http://www.ft.com/cms/s/2/b6b56bd6-278b-11de-9b77-00144feabdc0.html
The crisis that began in 2007 and worsened in 2008 was caused, Taylor says, because the Fed abandoned the rule earlier in the decade. Between 2002 and 2004 interest rates were cut even though the rule required them to be raised. In 2004 and 2005 the gap between the actual and the recommended interest rate was between two and three percentage points. Taylor describes a model simulation in which interest rates followed the Taylor-rule path during this period instead of diverging from it so markedly. The housing boom would have ended in 2003 instead of 2006, he says; house prices and levels of mortgage debt would not have risen so high. In short, monetary policy was the primary cause of the boom and subsequent bust. -
incognito
On 29 Apr, 2009
I may be mistaken but I don't think that a theoretical fed funds rate of minus 5% is nonsense (goldman sachs calculated that it should be minus 6%)
Geert seems to use sustainable growth and potential growth as synonyms, but they aren't: sustainable growth focuses, if I understood it correctly, on demand: it's growth, fuelled by demand that's not dependent on an unsustainable credit boom; while potential growth focuses on supply: it's non-inflationary growth
the problem in the US is that potential growth is much higher than sustainable growth, if the US economy doesn't reach its potential growth, inflation will turn negative, but that potential growth is not sustainable
so, the US has to choose between the pest (sustainable growth and deflation) and the cholera (potential growth via unconventional measures), it has chosen for the cholera, and it will continue to do so, until the bitter end (hyperinflation?)
I believe that it was Kondratieff who once said that a capitalistic economy can't continue to steer a way between the scylla of deflation and the charybdis of hyperinflation
how did the US economy get into this catch 22 situation?
once you've created a credit boom, you will be confronted with too much supply (high potential growth), once the credit bubble bursts, also, in an economy with a big gap between the rich and the poor, there can develop a gap between sustainable growth (demand side is dependend on credit) and potential growth (supply side, fueled by the money of the rich)
btw: the US has already chosen for the cholera in 2002, there was, back then, already a problem with oversupply, (this was already a problem in the late 90ties), that's why the fed lowered interest rates to below the level where they should have been according to taylor's rule, this way, a credit boom was fueled, and the problem of oversupply was made even worse:
http://www.ft.com/cms/s/2/b6b56bd6-278b-11de-9b77-00144feabdc0.html
The crisis that began in 2007 and worsened in 2008 was caused, Taylor says, because the Fed abandoned the rule earlier in the decade. Between 2002 and 2004 interest rates were cut even though the rule required them to be raised. In 2004 and 2005 the gap between the actual and the recommended interest rate was between two and three percentage points. Taylor describes a model simulation in which interest rates followed the Taylor-rule path during this period instead of diverging from it so markedly. The housing boom would have ended in 2003 instead of 2006, he says; house prices and levels of mortgage debt would not have risen so high. In short, monetary policy was the primary cause of the boom and subsequent bust. -
incognito
On 29 Apr, 2009
http://www.ft.com/cms/s/2/b6b56bd6-278b-11de-9b77-00144feabdc0.html
The crisis that began in 2007 and worsened in 2008 was caused, Taylor says, because the Fed abandoned the rule earlier in the decade. Between 2002 and 2004 interest rates were cut even though the rule required them to be raised. In 2004 and 2005 the gap between the actual and the recommended interest rate was between two and three percentage points. Taylor describes a model simulation in which interest rates followed the Taylor-rule path during this period instead of diverging from it so markedly. The housing boom would have ended in 2003 instead of 2006, he says; house prices and levels of mortgage debt would not have risen so high. In short, monetary policy was the primary cause of the boom and subsequent bust. -
Geert
On 29 Apr, 2009
@Koen: I agree that models are superior to political judgment or "managing by feeling".
What worries me is:
1. the assumptions used (which are not in my view correct° which gives "garbage in , garbarge out".
2. the open-ended "unconventional policy". You know where you start, but are not sure where you will end...
In such cases, taking the safe road is the best option. Bu the fed has constantly chosen the agressive policy option. -
Koen Robeys
On 29 Apr, 2009
Now to me "taking the safe road" sounds like a model (maybe implicitly, but still a model). For non-economists like me, it would be interesting to analyse this model too. For example, what would it mean? ("Doing nothing; free markets will take care of everything"? Or "Socialize the means of production"?) What are its assumptions? What would be the likely outcome?
I *believe* you when you say the FED's assumpions appear to be incorrect, and that the result is too open-ended, but all I have is still this *belief*. I have no idea whether your alternative(s?) would be any better, or why, because I never saw its description, nor its expected result, nor its assumptions, etcetera.
So what's the difference between your "opinion" and the opinions of all those people for who "government intervention is bad" sounds like a sophisticated analysis? I may *believe* there is a difference, but till the day I can *see* that difference, I just see the umpteenth opinion.
All the above is meant as an indication of the kind of thing I hope to learn here (and many thanks in advance),
Koen -
Geert
On 29 Apr, 2009
OK Koen, message understood.
It won't be all on this blog tomorrow, but your pushing us to raise the level, and that's what the blog is for !
Thanks
Geert -
Geert
On 29 Apr, 2009
@Frank: about overstating current inflation, to be further researched, but point taken
-
Theo
On 29 Apr, 2009
First of all, in my view, the T rules was not designed for extreme cases, such as deflation and hyperinflation... hence why it didn't work in Japan and it can't work in the US at the moment.
It's a Keynesian theory of inflation determination... by definition it presupposes that it can avoid wide fluctuations and keep it all humming along.
Our friend Alan used it... for every +1% in GDP you adjust by 1.5% ; for every -1% GDP you adjust by 0.5%
Geert why only 2 parameters? I thought there were 3... inflation, GDP and interest -
Ann Moons
On 29 Apr, 2009
I am not sure that current inflation is already underestimated in the States. With money growing at these rates, inflation is around the corner in the US.
Asset deflation is indeed very strong, but the negative self-feeding deflationary loop is not yet running in the US.
A brief period of deflation in the US is possible, but the difference with Japan is the very agressive monetary response, which will yield inflation over time. -
Theo
On 29 Apr, 2009
The current account balance is missing from the discussion. Since last year the trend has been reversed... it is unclear when it will be re-reversed again.
-
Geert
On 29 Apr, 2009
@Theo
Target rate was put at -5% , so recalculating inflation and output gap.
Taylor rule is :
target Fed funds rate = ∏t + equilibrium Fed rate + var1 * (∏t-∏t*) + var 2 * (Yt - Yt*)
∏t= current inflaton as measured by GDP deflator
∏t*= target inflation
Yt = current output
Yt*=potential output
var1 and var2 are weights, and Taylor proposed equal weights so 0,5
So, if inflation = 0 and target inflation is 2%, equilibrium real short rate 1,0% and output gap = -5%, then target Fed funds should equal -2,5% if my late night brains are calculating correctly.
If the output gap is -5%, current inflation = -2%, target inflation +2%, equilibrium Fed funds 1,5%, it implies target Fed funds of -3%.
So to get at -5% Fed funds target, current inflation should be around -4% and the output gap at -7%, or another combination.
That means that the Fed has rather extreme assumptions on one or both of them.
* the Q1 2009 GDP deflator was +2,9% according to the BEA, believe it or not.
** GDP in the 3 most recent quarters was -0,5%; -6,3% and -6,1% in annualized rates.
All these comments are subject to revision given my state of sharpness at this late hour... -
incognito
On 29 Apr, 2009
I may be mistaken but I don't think that a theoretical fed funds rate of minus 5% is nonsense (goldman sachs calculated that it should be minus 6%)
Geert seems to use sustainable growth and potential growth as synonyms, but they aren't
sustainable growth focuses, if I understood it correctly, on demand: it's growth, fuelled by demand that's not dependent on an unsustainable credit boom
while potential growth focuses on supply: it's non-inflationary growth
the problem in the US is that potential growth is much higher than sustainable growth
if the US economy doesn't reach its potential growth, inflation will turn negative
but that potential growth is not sustainable
so, the US has to choose between the pest (sustainable growth and deflation) and the cholera (potential growth via unconventional measures)
it has chosen for the cholera, and it will continue to do so, until the bitter end (hyperinflation?)
I believe that it was Kondratieff who once said that a capitalistic economy can't continue to steer a way between the scylla of deflation and the charybdis of hyperinflation
how did the US economy get into this catch 22 situation?
once you've created a credit boom, you will be confronted with too much supply (high potential growth), once the credit bubble bursts,
also, in an economy with a big gap between the rich and the poor, there can develop a gap between sustainable growth (demand side is dependend on credit) and potential growth (supply side, fueled by the money of the rich)
btw: the US has already chosen for the cholera in 2002, there was, back then, already a problem with oversupply, (this was already a problem in the late 90ties), that's why the fed lowered interest rates to below the level where they should have been according to taylor's rule
this way, a credit boom was fueled, and the problem of oversupply was made even worse:
http://www.ft.com/cms/s/2/b6b56bd6-278b-11de-9b77-00144feabdc0.html
The crisis that began in 2007 and worsened in 2008 was caused, Taylor says, because the Fed abandoned the rule earlier in the decade. Between 2002 and 2004 interest rates were cut even though the rule required them to be raised. In 2004 and 2005 the gap between the actual and the recommended interest rate was between two and three percentage points. Taylor describes a model simulation in which interest rates followed the Taylor-rule path during this period instead of diverging from it so markedly. The housing boom would have ended in 2003 instead of 2006, he says; house prices and levels of mortgage debt would not have risen so high. In short, monetary policy was the primary cause of the boom and subsequent bust. -
Scrutinizer
On 30 Apr, 2009
@Koen: Gezien het track record van deze lui die ons juist in deze crisis stortten, heb je m.i. juist alle reden om bezorgd te zijn, temeer omdat het er alles van weg heeft dat ze hun reeds gebruikte gefaalde model gewoon verder blijven toepassen en dat het enige "unconventional" aspect eraan niet de formule zelf is, doch het feit dat ze zonder blikken of blozen gewag maken van een negatieve ideale rente. M.a.w. een desastreus model nu nog extremer gaan toepassen dan voorheen: ja, goh, dat boezemt me pas vertrouwen in.
-
Theo
On 30 Apr, 2009
Geert I'm not questioning the calculations you make and the premises of what you say.
The T rules model is static though... it takes past data to project the future. It was designed by studying data from the 80s. It fundamentally assumes that the future will be like the past (a major point of contention in Philosophy which is finding its way in all sorts of fields today). It also doesn't take into account external shocks.
Nothing is exponential, and even the US lives in a global and dynamic world.
One of the fundamental premises of inflation targeting is the assumption that the CPI accurately represents the money supply...
In comes the current account which shows some very interesting moves since 2007-2008. Furthermore not all the money supplied to the market currently actually finds its way to the market.
There is a guy from Cyprus who interestingly wrote a critic on the T rules in 2007... it's starting to make sense.
In 2003 the BoE changed its CPI which automatically changed its inflation targeting from 2.5% to 2%... effectively bringing it in line with the ECB's even though that doesn't really make sense.
I have a question.
Why is inflation target always set at 1.5 - 2% no matter what? -
Geert
On 30 Apr, 2009
@Theo: the inflation target has not always been at 1.5-2%
Inflation has been around zero in the US for decades in the 19th and 20th century.
I think it has something to do with the fear for deflation:
* staying away with a comfortable margin from the defaltion border
* light inflation seen as a certain grease for the economy
* giving a slight margin for the central bank
It is all a question of expectations: interest rates, risk premiums, wages and salaries and other contracts are now set with an implicit expectation that stable inflation will be around 1.5-2%.
But it is not an axioma -
Koen Robeys
On 30 Apr, 2009
Theo: According to Paul Krugman (The Age of Diminished Expectations, 1,994 (1.999)), himself referring to Milton Friedman, there is an inverse relation between (low) inflation and (high) unemployment.
At that time, you needed a 4% sacrifice of GNP growth (if I understood this correctly, you can check in chapter 5, in my 1,999 copy it is on page 60) in order to obtain a 1% slowdown of inflation.
At that time, creating a recession in order to slow inflation was a matter of recent historical reality, and (according to Krugman) coming out of the Volcker-recession (which did bring inflation down, by the way) people did not feel like reducing it any further at the price of higher unemployment.
At the end of chapter 5 he writes: "Officially, the Federal Reserve insists that its goal is complete price stability. This is, however, nearly pure hypocrisy. As the experience of the 1980s shows, reducing the rate of inflation requires high unemployment. (...)".
The relevant chapters of the book are both chapter 3 and chapter 5. -
Theo
On 30 Apr, 2009
Thank you Koen.
I'll get it for the weekend.
Yep, following that logic, to fight deflation we'll need to go into employment overdrive.
How do we do that under current economic conditions?
In 2002 Alan Greenspan started lowering interest rates in order to fight off deflation.
We are in a very different hotpot today. -
incognito
On 30 Apr, 2009
I may be mistaken but I don't think that a theoretical fed funds rate of minus 5% is nonsense (goldman sachs calculated that it should be minus 6%). On the contrary: it makes perfect sense. At least from an American and short term point of view.
Geert seems to use sustainable growth and potential growth as synonyms, but they aren't.
Sustainable growth focuses, if I understood it correctly, on demand: it's growth, fuelled by demand that's not dependent on an unsustainable credit boom.
While potential growth focuses on supply: it's non-inflationary growth.
The problem in the US is that potential growth is much higher than sustainable growth.
If the US economy doesn't reach its potential growth, inflation will turn negative.
But that potential growth is not sustainable.
So, the US has to choose between the pest (sustainable growth and deflation) and the cholera (potential growth via unconventional measures).
It has chosen for the cholera, and it will continue to do so, until the bitter end (hyperinflation?).
I believe that it was Kondratieff who once said that a capitalistic economy can't continue to steer a way between the scylla of deflation and the charybdis of hyperinflation.
How did the US economy get into this catch 22 situation?
Once you've created a credit boom, you will be confronted with too much supply (high potential growth), once the credit bubble bursts.
Also, in an economy with a big gap between the rich and the poor, there can develop a gap between sustainable growth (demand side is too dependend on cheap credit) and potential growth (supply side, fueled by investments of the rich). This may be one of the most fundamental causes of the crisis.
Btw: the US has already chosen for the cholera in 2002, there was, back then, already a problem with oversupply, (this was already a problem in the late 90ties, as the economist wrote at the time), that's why the fed lowered interest rates to below the level where they should have been according to taylor's rule.
This way, a credit boom was fueled, and the problem of oversupply was made even worse:
http://www.ft.com/cms/s/2/b6b56bd6-278b-11de-9b77-00144feabdc0.html
The crisis that began in 2007 and worsened in 2008 was caused, Taylor says, because the Fed abandoned the rule earlier in the decade. Between 2002 and 2004 interest rates were cut even though the rule required them to be raised. In 2004 and 2005 the gap between the actual and the recommended interest rate was between two and three percentage points. Taylor describes a model simulation in which interest rates followed the Taylor-rule path during this period instead of diverging from it so markedly. The housing boom would have ended in 2003 instead of 2006, he says; house prices and levels of mortgage debt would not have risen so high. In short, monetary policy was the primary cause of the boom and subsequent bust. -
incognito
On 30 Apr, 2009
I may be mistaken but I don't think that a theoretical fed funds rate of minus 5% is nonsense (goldman sachs calculated that it should be minus 6%). On the contrary: it makes perfect sense. At least from an American and short term point of view.
Geert seems to use sustainable growth and potential growth as synonyms, but they aren't. Sustainable growth focuses, if I understood it correctly, on demand: it's growth, fuelled by demand that's not dependent on an unsustainable credit boom. While potential growth focuses on supply: it's non-inflationary growth.
The problem in the US is that potential growth is much higher than sustainable growth. If the US economy doesn't reach its potential growth, inflation will turn negative. But that potential growth is not sustainable.
So, the US has to choose between the pest (sustainable growth and deflation) and the cholera (potential growth via unconventional measures). It has chosen for the cholera, and it will continue to do so, until the bitter end (hyperinflation?).
I believe that it was Kondratieff who once said that a capitalistic economy can't continue to steer a way between the scylla of deflation and the charybdis of hyperinflation.
How did the US economy get into this catch 22 situation?
Once you've created a credit boom, you will be confronted with too much supply (high potential growth), once the credit bubble bursts. Also, in an economy with a big gap between the rich and the poor, there can develop a gap between sustainable growth (demand side is too dependend on cheap credit) and potential growth (supply side, fueled by investments of the rich). This may be one of the most fundamental causes of the crisis.
Btw: the US has already chosen for the cholera in 2002, there was, back then, already a problem with oversupply, (this was already a problem in the late 90ties, as the economist wrote at the time), that's why the fed lowered interest rates to below the level where they should have been according to taylor's rule. This way, a credit boom was fueled, and the problem of oversupply was made even worse:
http://www.ft.com/cms/s/2/b6b56bd6-278b-11de-9b77-00144feabdc0.html
The crisis that began in 2007 and worsened in 2008 was caused, Taylor says, because the Fed abandoned the rule earlier in the decade. Between 2002 and 2004 interest rates were cut even though the rule required them to be raised. In 2004 and 2005 the gap between the actual and the recommended interest rate was between two and three percentage points. Taylor describes a model simulation in which interest rates followed the Taylor-rule path during this period instead of diverging from it so markedly. The housing boom would have ended in 2003 instead of 2006, he says; house prices and levels of mortgage debt would not have risen so high. In short, monetary policy was the primary cause of the boom and subsequent bust. -
incognito
On 30 Apr, 2009
I may be mistaken but I don't think that a theoretical fed funds rate of minus 5% is nonsense (goldman sachs calculated that it should be minus 6%). On the contrary: it makes perfect sense. At least from an American and short term point of view.
Geert seems to use sustainable growth and potential growth as synonyms, but they aren't. Sustainable growth focuses, if I understood it correctly, on demand: it's growth, fuelled by demand that's not dependent on an unsustainable credit boom. While potential growth focuses on supply: it's non-inflationary growth.
The problem in the US is that potential growth is much higher than sustainable growth. If the US economy doesn't reach its potential growth, inflation will turn negative. But that potential growth is not sustainable.
So, the US has to choose between the pest (sustainable growth and deflation) and the cholera (potential growth via unconventional measures).
It has chosen for the cholera, and it will continue to do so, until the bitter end (hyperinflation?).
I believe that it was Kondratieff who once said that a capitalistic economy can't continue to steer a way between the scylla of deflation and the charybdis of hyperinflation.
How did the US economy get into this catch 22 situation?
Once you've created a credit boom, you will be confronted with too much supply (high potential growth), once the credit bubble bursts. Also, in an economy with a big gap between the rich and the poor, there can develop a gap between sustainable growth (demand side is too dependend on cheap credit) and potential growth (supply side, fueled by investments of the rich). This may be one of the most fundamental causes of the crisis.
Btw: the US has already chosen for the cholera in 2002, there was, back then, already a problem with oversupply, (this was already a problem in the late 90ties, as the economist wrote at the time), that's why the fed lowered interest rates to below the level where they should have been according to taylor's rule. This way, a credit boom was fueled, and the problem of oversupply was made even worse:
http://www.ft.com/cms/s/2/b6b56bd6-278b-11de-9b77-00144feabdc0.html
The crisis that began in 2007 and worsened in 2008 was caused, Taylor says, because the Fed abandoned the rule earlier in the decade. Between 2002 and 2004 interest rates were cut even though the rule required them to be raised. In 2004 and 2005 the gap between the actual and the recommended interest rate was between two and three percentage points. Taylor describes a model simulation in which interest rates followed the Taylor-rule path during this period instead of diverging from it so markedly. The housing boom would have ended in 2003 instead of 2006, he says; house prices and levels of mortgage debt would not have risen so high. In short, monetary policy was the primary cause of the boom and subsequent bust. -
incognito
On 30 Apr, 2009
I may be mistaken but I don't think that a theoretical fed funds rate of minus 5% is nonsense (goldman sachs calculated that it should be minus 6%). On the contrary: it makes perfect sense. At least from an American and short term point of view.
Geert seems to use sustainable growth and potential growth as synonyms, but they aren't. Sustainable growth focuses, if I understood it correctly, on demand: it's growth, fuelled by demand that's not dependent on an unsustainable credit boom. While potential growth focuses on supply: it's non-inflationary growth.
The problem in the US is that potential growth is much higher than sustainable growth. And that, if the US economy stays for a long time below its potential growth, inflation will turn negative. But at the same time, that potential growth is not sustainable.
So, the US has to choose between the pest (sustainable growth and deflation) and the cholera (potential growth via unconventional measures).
It has chosen for the cholera, and it will continue to do so, until the bitter end (hyperinflation?).
I believe that it was Kondratieff who once said that a capitalistic economy can't continue to steer a way between the scylla of deflation and the charybdis of hyperinflation.
How did the US economy get into this catch 22 situation?
Once you've created a credit boom, you will be confronted with too much supply (high potential growth), once the credit bubble bursts. Also, in an economy with a big gap between the rich and the poor, there can develop a gap between sustainable growth (demand side is too dependend on cheap credit) and potential growth (supply side, fueled by investments of the rich). This may be one of the most fundamental causes of the crisis.
Btw: the US has already chosen for the cholera in 2002, there was, back then, already a problem with oversupply, (this was already a problem in the late 90ties, as the economist wrote at the time), that's why the fed lowered interest rates to below the level where they should have been according to taylor's rule. This way, a credit boom was fueled, and the problem of oversupply was made even worse:
http://www.ft.com/cms/s/2/b6b56bd6-278b-11de-9b77-00144feabdc0.html
The crisis that began in 2007 and worsened in 2008 was caused, Taylor says, because the Fed abandoned the rule earlier in the decade. Between 2002 and 2004 interest rates were cut even though the rule required them to be raised. In 2004 and 2005 the gap between the actual and the recommended interest rate was between two and three percentage points. Taylor describes a model simulation in which interest rates followed the Taylor-rule path during this period instead of diverging from it so markedly. The housing boom would have ended in 2003 instead of 2006, he says; house prices and levels of mortgage debt would not have risen so high. In short, monetary policy was the primary cause of the boom and subsequent bust. -
Philip Van Hoof
On 30 Apr, 2009
You can only increase wealth by making the population create more output (if you don't enslave them). If you add more currency yet the total amount of output isn't increased, the currency will simply inflate based on the amount of useful things the population created.
In my opinion should the monetary policy of the ECB be to ensure that if there's less output for a period of time, that there's also less currency. Creating more currency (letting M3 grow) yet having a crisis that is now also hitting several industries, causing them to produce less of those useful things, will inflate the value of the EURO.
People who saved money will be fooled as the value of their cash is increasingly worth less. They wont save for big purchases as doing so makes no sense anymore. Instead they'll spend their savings and simply loan the money for the big purchases. Which the U.S. proves doesn't work very well if pushed to the limit. Also our bankers have shown to be incompetent at guiding that in the right direction.
The only way to make people do big purchases like cars and houses is to make them again feel comfortable that they can buy it. You do that by creating monetary stability. Thus lower the inflation.
It's at this moment mostly the industries providing services and goods that are the big purchases for the common people (cars, houses), that are getting hit most by the crisis. Meaning that above all should the monetary policy be creating monetary stability.
With relation to deflation: the value of the desktop computer has inflated drastically the last ten years. Compared to the monetary value has a desktop computer's worth been cut in half nearly yearly.
So if you bought a desktop computer in '01 for 2000 euros, then in '02 the economic value of the exact same desktop computer, new, shiny, in a box, was 1000 euros. A computer that is three times as fast and has four times as much storage capacity compared the the average computer of '01, was worth in '02 as much as the previous average desktop computer in '01. For example 2000 euros. Since then has this only worsened. Tomorrow's mobile phones will be more powerful than your desktop computer of '01. Yet they will cost only a fraction of those 2000 euros (on average 400 euros, I'm estimating).
My argument being that the inflation of the computer technology industry went much, much faster than the ECB's 2%. Economically that meant that your investment was financially worth far less each year. Rather 50% per year.
Surprisingly for all those deflationfobists has the desktop computer industry boomed during these technological advancements. And each and every person buying a desktop computer during those years knew very well that the technology was going to improve so fast and so much that his desktop computer wouldn't even be worth the metal and plastic used to build it, in a few years after the purchase.
And still, they bought it.
You can say the exact same about mobile phones, MP3 players, Internet connections over normal phone lines, non-flatscreen televisions, etc.
A deflation doesn't stop the consumer from buying what he wants now. People won't wait until they are old. People need to drive cars now and people need a bed to sleep in and a house to life in now. They are getting babies now. They want to raise those babies now. Not tomorrow when the price of the house they want will be lower.
You see the exact same economic worth of the laptops people are buying going down right now, too. And the same is happening for those iPhones and iPods. People are, have been and will still buy it nonetheless.
People who want to freeze their wealth don't convert it into consumables. They buy gold. -
incognito
On 30 Apr, 2009
I may be mistaken but I don't think that a theoretical fed funds rate of minus 5% is nonsense (goldman sachs calculated that it should be minus 6%). On the contrary: it makes perfect sense. At least from an American and short term point of view.
Geert seems to use sustainable growth and potential growth as synonyms, but they aren't. Sustainable growth focuses, if I understood it correctly, on demand: it's growth, fuelled by demand that's not dependent on an unsustainable credit boom. While potential growth focuses on supply: it's non-inflationary growth.
The problem in the US is that potential growth is much higher than sustainable growth. If the US economy doesn't reach its potential growth, inflation will turn negative. But that potential growth is not sustainable. So, the US has to choose between the pest (sustainable growth and deflation) and the cholera (potential growth via unconventional measures). It has chosen for the cholera, and it will continue to do so, until the bitter end (hyperinflation?). Wasn't it Kondratieff who once said that a capitalistic economy can't continue to steer a way between the scylla of deflation and the charybdis of hyperinflation?
Once you've created a credit boom, you will be confronted with too much supply (high potential growth), once the credit bubble bursts. Also, in an economy with a big gap between the rich and the poor, there can develop a gap between sustainable growth (demand side is too dependend on cheap credit) and potential growth (supply side, fueled by investments of the rich). This may be one of the most fundamental causes of the crisis.
Btw: the US has already chosen for the cholera in 2002, there was, back then, already a problem with oversupply, (this was already a problem in the late 90ties, as the economist wrote at the time), that's why the fed lowered interest rates to below the level where they should have been according to taylor's rule. This way, a credit boom was fueled, and the problem of oversupply was made even worse:
http://www.ft.com/cms/s/2/b6b56bd6-278b-11de-9b77-00144feabdc0.html
The crisis that began in 2007 and worsened in 2008 was caused, Taylor says, because the Fed abandoned the rule earlier in the decade. Between 2002 and 2004 interest rates were cut even though the rule required them to be raised. In 2004 and 2005 the gap between the actual and the recommended interest rate was between two and three percentage points. Taylor describes a model simulation in which interest rates followed the Taylor-rule path during this period instead of diverging from it so markedly. The housing boom would have ended in 2003 instead of 2006, he says; house prices and levels of mortgage debt would not have risen so high. In short, monetary policy was the primary cause of the boom and subsequent bust. -
incognito
On 30 Apr, 2009
I may be mistaken but I don't think that a theoretical fed funds rate of minus 5% is nonsense (goldman sachs calculated that it should be minus 6%). On the contrary: it makes perfect sense. At least from an American and short term point of view.
Geert seems to use sustainable growth and potential growth as synonyms, but they aren't. Sustainable growth focuses, if I understood it correctly, on demand: it's growth, fuelled by demand that's not dependent on an unsustainable credit boom. While potential growth focuses on supply: it's non-inflationary growth.
The problem in the US is that potential growth is much higher than sustainable growth. If the US economy doesn't reach its potential growth, inflation will turn negative. But that potential growth is not sustainable. So, the US has to choose between the pest (sustainable growth and deflation) and the cholera (potential growth via unconventional measures). It has chosen for the cholera, and it will continue to do so, until the bitter end (hyperinflation?). Wasn't it Kondratieff who once said that a capitalistic economy can't continue to steer a way between the scylla of deflation and the charybdis of hyperinflation?
Once you've created a credit boom, you will be confronted with too much supply (high potential growth), once the credit bubble bursts. Also, in an economy with a big gap between the rich and the poor, there can develop a gap between sustainable growth (demand side is too dependend on cheap credit) and potential growth (supply side, fueled by investments of the rich). This may be one of the most fundamental causes of the crisis. -
incognito
On 30 Apr, 2009
Btw: the US has already chosen for the cholera in 2002, there was, back then, already a problem with oversupply, (this was already a problem in the late 90ties, as the economist wrote at the time), that's why the fed lowered interest rates to below the level where they should have been according to taylor's rule. This way, a credit boom was fueled, and the problem of oversupply was made even worse:
http://www.ft.com/cms/s/2/b6b56bd6-278b-11de-9b77-00144feabdc0.html
The crisis that began in 2007 and worsened in 2008 was caused, Taylor says, because the Fed abandoned the rule earlier in the decade. Between 2002 and 2004 interest rates were cut even though the rule required them to be raised. In 2004 and 2005 the gap between the actual and the recommended interest rate was between two and three percentage points. Taylor describes a model simulation in which interest rates followed the Taylor-rule path during this period instead of diverging from it so markedly. The housing boom would have ended in 2003 instead of 2006, he says; house prices and levels of mortgage debt would not have risen so high. In short, monetary policy was the primary cause of the boom and subsequent bust. -
incognito
On 30 Apr, 2009
Btw: the US has already chosen for the cholera in 2002, there was, back then, already a problem with oversupply, (this was already a problem in the late 90ties, as the economist wrote at the time), that's why the fed lowered interest rates to below the level where they should have been according to taylor's rule. This way, a credit boom was fueled, and the problem of oversupply was made even worse:
http://www.ft.com/cms/s/2/b6b56bd6-278b-11de-9b77-00144feabdc0.html -
incognito
On 30 Apr, 2009
Btw: the US has already chosen for the cholera in 2002:
http://www.ft.com/cms/s/2/b6b56bd6-278b-11de-9b77-00144feabdc0.html
The crisis that began in 2007 and worsened in 2008 was caused, Taylor says, because the Fed abandoned the rule earlier in the decade. Between 2002 and 2004 interest rates were cut even though the rule required them to be raised. In 2004 and 2005 the gap between the actual and the recommended interest rate was between two and three percentage points. Taylor describes a model simulation in which interest rates followed the Taylor-rule path during this period instead of diverging from it so markedly. The housing boom would have ended in 2003 instead of 2006, he says; house prices and levels of mortgage debt would not have risen so high. In short, monetary policy was the primary cause of the boom and subsequent bust. -
incognito
On 30 Apr, 2009
Btw: the US has already chosen for the cholera in 2002:
The crisis that began in 2007 and worsened in 2008 was caused, Taylor says, because the Fed abandoned the rule earlier in the decade. Between 2002 and 2004 interest rates were cut even though the rule required them to be raised. In 2004 and 2005 the gap between the actual and the recommended interest rate was between two and three percentage points. Taylor describes a model simulation in which interest rates followed the Taylor-rule path during this period instead of diverging from it so markedly. The housing boom would have ended in 2003 instead of 2006, he says; house prices and levels of mortgage debt would not have risen so high. In short, monetary policy was the primary cause of the boom and subsequent bust.
The Fed had good reasons – or thought it had – for pushing rates lower even though the rule that it had followed up to that point recommended the opposite. But discretion can be dangerous. Keeping monetary policy on auto-pilot would have yielded far better results. Once the crisis had begun, the book argues, misdiagnosing the problem as one of lack of liquidity rather than heightened counterparty risk prolonged it.
Lack of predictability again played the key role when the crisis suddenly worsened in 2008. Allowing Lehman Brothers to fail was not the decisive moment, in Taylor’s view: the market took that in stride. What sparked panic, he says, was the announcement of the troubled asset relief programme several days later – a plan for massive government outlays, with no clear rationale for their use and no provision for effective oversight. At that moment, uncertainty peaked. -
incognito
On 30 Apr, 2009
http://www.ft.com/cms/s/2/b6b56bd6-278b-11de-9b77-00144feabdc0.html
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Koen Robeys
On 30 Apr, 2009
Philip: your story contains many correct elements, but it leaves out a lot more.
You state the way to make people comfortable they can spend thier money is to create monetary stability. Being true, this does not prevent other possible means resulting in the same effect. Those means may be more indicated dependent on circumstances. I believe the following article by Paul Krugman is highly recommended:
http://www.slate.com/id/1937/
It brings us to a second example of my point (you leave out too many elements). As a mirror image of money losing its value if there is too much of it, there is also the possibility of money gaining too much value by having too little of it. Since at this point you talk about "deflation", you are aware of this. However, you simply dismiss the possibility ("people do buy articles even if they go down in price"). Though I may mention that I myself tend to keep my computer several years after it's obsolete (for no other reason that they do get cheaper all the time), that is noteven the main point.
If we extend your story to the whole economy, so that (for example) prices are generally known to go down by one percent next year, this would be mathematically the same as a rise of interest rates by one percent in a stable price environment. In both cases, people could simply sit on their money and expect to be able to buy 101% of what they could buy today.
This being true, deflationfobists - of which I am a proud member - can reassure you it does *not* come as a surprise that people still buy goods, even if we know them to go down in value. We just expect people to buy them less frequently, depressing the general level of sales. Just as we expect an economy to get braked if interest rates are high.
And therefore, we deflationfobists reason more or less as follows: about the very last thing we need now is higher interest rates (braking the economy). Having higher interest rates or having a general expectation that global prices will go down by the same amount over the same period is mathematically the same thing. Ergo, the last thing we need is that general expectation... (etc). Another word for this general expectation getting realized is "deflation".
And from there, we draw our own conclusions.
Now you are not obliged to believe deflation depresses the economy. On the other hand, simply stating people do not react to lower prices by delaying purchases doesn't have to convince anybody either. -
Koen Robeys
On 30 Apr, 2009
Koen2 I do not know where that mr. Taylor was, the moment Lehman went bankrupt, but I, in the midst of "the financial markets" can tell you the markets did NOT take it in stride. "The markets" were paralyzed, depressed, neurotic and panicking like nothing I ever saw before in my life.
And I speak as one of the very few guys on the whole planet, who ever dealt (mind you: not "calculated"; *dealt*) currency options at a volatility of 200 (at the heighth of the "Asian crisis"). -
Theo
On 1 May, 2009
@Koen2
Letting Lehman Brothers fail was decisive. It signaled the market big time! Those who say it was right, have no blinking idea of the interconnectivity of the economy. Those who thought they needed to make an "example", they found out they had caused a tsunami.
What was announced subsequently, is just what the market expected to happen. It is what is keeping the whole financial system on life support.
Those whom it shocked... they just don't understand how it all works.
The most important thing was to stop a run on the banks. This exercise is still going on.
It is what happened with Fortis and Dexia.
Without the Lehman Brothers lesson, I'm sure Fortis would have been allowed to fail. It is because of the lesson learned from the Lehman Brothers failure that everything (even the illegal) was done to ensure it could open its doors on Monday morning without the fear of its Creditors. -
incognito
On 1 May, 2009
@Koen, Theo, yes, Taylor may be wrong about lehman
but he's right about 2002-2004 (although the gap between taylor's fed funds rate and the actual fed funds rate seems to have continued til 2005, according to this graph):
http://krugman.blogs.nytimes.com/2009/01/17/zero-lower-bound-blogging/ -
incognito
On 1 May, 2009
but as I said before: the fed probably had good reasons to lower interest rates that much, back in 2002-2004, it was to fend off the danger of deflation, there was certainly a lot of talk about deflation in those days (idem dito in the late 90ties and idem dito now of course)
because the potential growth of the US economy, the sum of what they can produce without overheating their economy, is in my opinion not sustainable (on the demand side of the economy): in order to be able to consume all that stuff, they need high credit growth and asset inflation (also because of the trade deficit: the potential growth of the US encompasses parts of the world economy, and in particular the Chinese economy, which produces a lot of stuff for the US)
sustainable growth isn't possible anymore, imo, with the current social-economic structure
at least not if they want to avoid a deflationary swamp: either growth is too low to fend off deflation, or it's not, but in that case, it comes at a high price (to be paid in the near future, like we're now paying for the unsustainable growth of the past couple of years)
even roubini doesn't says this, it's not politically correct to tell this truth (as is the case with many truths)
or it's not the truth of course:)
the argument might indeed be flawed, but if that's the case: where's the flaw? -
FV
On 1 May, 2009
http://blogs.ft.com/maverecon/2009/04/green-shoots-grounds-for-cautious-pessimism/ & mark Buiter's last words ;-)
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FV
On 1 May, 2009
http://blogs.ft.com/maverecon/2009/04/green-shoots-grounds-for-cautious-pessimism/ & mark Buiter's last words ...
