Kansas City Fed's Hoening thinks the current Fed is setting stage for the next bubble
The Kasas City Fed's Hoenig is the lone dissenter for the current Federal Reserve free money policies. One thing that is lost in all the debate is what is the effect of the Federal Reserve's zero interest rates policy. What happens when there is easy money on the short end of the curve is Banks can print money by mismatching the durations of their assets and liabilities. They take out long term assets and issue short term liabilities for which they earn a spread.
This is easy to do. I was looking at the expected profit a bank earns by doing a fixed for floating swap which reduced the the duration of their liabilities from 5 years to 6 months. For a swap on $1.5 Billion, the expected profit was $100 Million, in 5 minutes they can earn monster profits. So much for getting new deposits or writing new loans. It pays to be a bank.
Many explain this by saying that the banks can essentially print money. That's not true. That money comes from somewhere. Where might it come from? Me and you and everyone that saves. Instead of you making a 2% return on your savings account, you earn zero. Bernanke et al, think that it is more important to give money to the banks than to place it in your hands. With all the talk of stimulus and getting money into people's hands, it seems like they are more interested in taking what would be your money and giving it to the banks.
The Kansas City Fed chairman is calling for a less accomodative policy. He thinks that the current Fed is setting the stage for future bubbles. See the whole via The Kansas City Fed:
We are recovering from a horrific set of shocks, and it will take time to “right the ship.” Moreover, the financial and economic shocks we have experienced did not “just happen.” The financial collapse followed years of too-low interest rates, too-high leverage, and too-lax financial supervision as prescribed by deregulation from both Democratic and Republican administrations. In judging how we approach this recovery, it seems to me that we need to be careful not to repeat those policy patterns that followed the recessions of 1990-91 and 2001. If we again leave rates too low, too long out of our uneasiness over the strength of the recovery and our intense desire to avoid recession at all costs, we are risking a repeat of past errors and the consequences they bring.
Here are some important figures regarding just how out of balance our economy became and what might have contributed to these imbalances between the early ‘90s and today:
Obviously, the effect of these trends on our economy has been significant and we must accept that they will not be corrected quickly.
- The real fed funds rate averaged 1.6 percent between 1991 and 1995, 0.37 percent between 2001 and 2005 and -1.0 percent from 2008 to the present, hardly a tight policy environment.
- Gross federal debt increased from 60 percent to 75 percent of nominal GDP.
- Consumer debt increased from 63 percent to 94 percent of nominal GDP.
- Nonfinancial debt increased from 189 percent of nominal GDP at the start of the decade to 234 percent by December 2008.
- Between 1993 and 2007, the average leverage of the 20-largest financial institutions in the U.S. (total assets-to-tangible equity capital) increased from 18-to-1, to over 25-to-1, reaching as high as 31-to-1.
- The U.S. increased its debt to the rest of the world dramatically from 4.87 percent to 24.32 percent of nominal GDP.
It is not time for tight policy
In my view, maintaining an accommodative monetary policy is necessary at this time, but a clear policy path toward a less highly accommodative policy will encourage a more sustained recovery. Under such a policy, financial deleveraging will evolve slowly and many of the remaining economic imbalances will rebalance. Under such a policy, the economy will expand at a sustainable moderate pace with similar moderate job growth, but job growth that will be stable and resilient. There may be ways to accelerate GDP growth, but in my view, highly expansionary monetary policy is not a good option.
To be clear, I am not advocating a tight monetary policy. I am advocating a policy that remains accommodative but slowly firms as the economy itself expands and moves toward more balance. I advocate dropping the “extended period” language from the FOMC’s statement and removing its guarantee of low rates. This tells the market that it must again accept risks and lend if it wishes to earn a return. The FOMC would announce that its policy rate will move to 1 percent by a certain date, subject to current conditions. At 1 percent, the FOMC would pause to give the economy time to adjust and to gain confidence that the recovery remains on a reasonable growth path. At the appropriate time, rates would be moved further up toward 2 percent, after which the nominal fed funds rate will depend on how well the economy is doing.
If such a path were chosen, then how might GDP and important components perform? Let me start with consumption, which for decades amounted to about 63 percent of GDP. During the boom it rose to 70 percent. It seems reasonable that the consumer will most likely return toward more historical levels relative to GDP and then grow in line with income. If so, the consumer will contribute to growth but is unlikely to intensify its contribution to previously unsustainable levels.
To view the role of the consumer from another perspective, I would note that personal savings declined from nearly 10 percent of disposable income in 1985 to less than 2 percent in 2007. It is now closer to 6 percent, better in many ways, but still below historical norms. Assuming it stabilizes and personal incomes grows as it has so far this recovery, you get a clearer sense of how consumption will contribute to the economy’s expansion but also why it is unlikely to play a dominant role as it did in this past decade.
While businesses need to rebalance as well, they are essential to the strength of the recovery. Fortunately, they are in the early stages of doing just that. Profits are improving and corporate balance sheets for the nonfinancial sector are strengthening and are increasingly able to support investment growth as confidence in the economy rebuilds. Also, although credit supply and demand may be an issue impeding the recovery to some extent, a shortage of monetary stimulus is not the issue. There is enormous liquidity in the market, and it can be accessed as conditions improve.
Finally, the federal government needs to rebalance its balance sheet as well. Federal and state budget pressures are enormous, and uncertain tax programs surely are a risk to the recovery. This adds harmful uncertainty upon both businesses and consumers. However, while these burdens are a drag on our outlook, they are not new to the U.S. and, by themselves, should not bring our economy down unless they go unaddressed.
I believe the economy has the wherewithal to recover. However, if, in an attempt to add further fuel to the recovery, a zero interest rate is continued, it is as likely to be a negative as a positive in that it brings its own unintended consequences and uncertainty. A zero policy rate
during a crisis is understandable, but a zero rate after a year of recovery gives legitimacy to questions about the sustainability of the recovery and adds to uncertainty.
We were reminded of the critical nature of our financial markets when they locked up during the crisis. We need markets to function smoothly. However, market participants should not direct policy. When mixed data are reported as systematically negative results, and the more positive, long-term growth trends fail to be adequately acknowledged, it is an invitation to hasty actions. Of course the market wants zero rates to continue indefinitely: They are earning a guaranteed return on free money from the Fed by lending it back to the government through securities purchases.
The current recovery in its first year saw GDP grow an average of 3.2 percent. The GDP growth rate for the 1991 recovery was 2.61 percent; and for the 2001 recovery, it was 1.92 percent. We would all like to see a stronger recovery, but slow growth is not a decline in growth and we should not react hastily.
The summer of 2010 has seemed strikingly familiar to me. I recently went back and looked at news reports for the spring and summer of 2003, just prior to when the FOMC lowered the fed funds rate to 1 percent, where it remained until 2004. I’ll provide just two examples.
In June 2003, one prominent economist noted in USA Today: “The Federal Reserve Board recently warned that America faces a risk of [deflation]. Japan has been suffering from it for more than a decade. Europe may be heading toward it. The entire world economy could succumb to it. …This could be the first round in a deflationary cycle. The Commerce Department reports orders to U.S. factories slipped 2.9% in April from March, the largest decline in 17 months. …With fewer jobs and stagnant wages, Americans won’t be able to buy enough to keep the economy going.”
Also in June 2003, a Boston Globe columnist noted: “On the surface, one can make the case that the Fed doesn’t have to do anything at all. Interest rates are incredibly low….Still, the Fed will not sit on its hands. Chairman Alan Greenspan and his deputies have done everything but advertise the coming rate cut on the Goodyear blimp. Their motivation is to avoid deflation. …Another rate cut, even a cut of one-half point, doesn’t guarantee that there won’t be an economic collapse. But it makes that collapse less likely—hence the notion of rate cut as an insurance policy. As insurance, a rate cut is pretty cheap. Lower rates aren’t going to trigger a burst of inflation, and if they give the economy an extra boost, well, who is going to complain about that?”
In the third quarter of 2003, immediately following these and many similar articles, GDP expanded at what turned out to be nearly a 7 percent annual rate, yet rates were left at 1 percent for several months. With the low rates very low for a considerable period, credit began to expand significantly and set the stage for one of the worst economic crisis since the great depression. In my view, it was a very expensive insurance premium. Unemployment today is 9.5 percent. I fully acknowledge that I was on the FOMC at that time. That’s why I believe that zero rates during a period of modest growth are a dangerous gamble.
The Great Depression of the 1930s was a traumatic event. We need to be aware of its lessons. We need to avoid its mistakes. For example, the Fed should never again double reserve requirements overnight. However, I urge us not to forget other more-recent lessons from the great inflation and the financial crisis of 2008: Real interest rates that are negative 40 percent of the time create severe consequences.
One final note about deflation: The consumer price index was a mere 18 in 1945 but was 172 at the start of this century. Today, despite our most recent crisis, the CPI is over 219. Not once during more than half a century has the index systematically declined. I find no evidence that deflation is the most serious threat to the recovery today.