"The real solution has nothing to do with the Fed"
A couple days ago I commented that The Fed Can Do More...But It Won't Do Much in response to Stephanie Kelton’s question, Can the Fed Really Do More? Edward Harrison furthers the argument against Fed action...
First, as I said previously, the Fed’s actions have not lowered rates. The Fed’s QE2 raised inflation expectations, causing interest rates to rise and nullifying the effects of lowered risk premia. Second, low rates are toxic to savers and bank net interest margins. When credit demand is weak, the loss of interest income overwhelms the reflationary effects of low rates. Third, as Yellen herself has noted, it is conceivable that accommodative monetary policy could provide tinder for a buildup of leverage. Low rates encourage releveraging, not deleveraging.
Despite having have been highlighted previously, these points are worth rehashing. Edward’s conclusion succinctly states the real problem that needs to be addressed:
the demand for credit is still weak. Some point to the importance of the psychology of balance sheet recessions. Others like myself point to the debt stress from falling asset prices and weak job and income growth. Either way, absent a rebound in incomes or a reduction in private debt, the recovery will remain weak irrespective of how many supply side solutions the Fed implements. If the US (the UK, Ireland or Spain) wants to get the credit ‘transmission mechanism’ working again they will need to increase demand for credit by reducing real debt burdens as a percentage of income or increase income and job security enough to allow debtor’s to focus instead on today’s low debt service costs. If these countries focus on deleveraging instead of releveraging, that would necessarily mean large private surpluses and therefore large government deficits in the absence of significant currency depreciation.
Bottom line: The real solution has nothing to do with the Fed because the constraints are demand side and not supply side. But people will continue to exhort the Fed to do more and so they will do more.
"the Fed’s actions have not lowered rates. The Fed’s QE2 raised inflation expectations, causing interest rates to rise and nullifying the effects of lowered risk premia. Second, low rates are toxic to savers and bank net interest margins. When credit demand is weak, the loss of interest income overwhelms the reflationary effects of low rates. Third, as Yellen herself has noted, it is conceivable that accommodative monetary policy could provide tinder for a buildup of leverage. Low rates encourage releveraging, not deleveraging."
ReplyDeleteHey Woj. This is an area that always gets confusing. Sumner is always going on and on about the idea-that Friedman used to say-that low rates indicate tight monetary policy.
That if the ecnomy starts to get juiced up you expect to see rates rise. I think Sumner's idea is that high interest rates won't cause growth, but rather growh causes higher interest rates.
One more queston:
"The real solution has nothing to do with the Fed because the constraints are demand side and not supply side. But people will continue to exhort the Fed to do more and so they will do more."
What does it mean to say that Fed solutions are supply side solutions? Usually Monetarists frame monetary solutions as fighting a demand shortfall.
Mike,
DeleteI tend to agree Sumner/Friedman's claim that interest rates are strongly correlated with growth, but remain unconvinced that is indicative of monetary policy. If the Fed is targeting inflation/growth, then it makes sense that as growth/inflation rise the Fed will raise rates (similarly as growth/inflation fall, the Fed will lower rates). Stabilizing growth/inflation therefore necessarily implies adjusting interest rate policy in the same direction as growth/inflation (and the Fed tends to be reactive since it's generally poor at forecasting).
As for the question about supply versus demand side, Monetarists view the Fed as promoting demand because of an apparent belief in the money multiplier stemming from increase in base money. I have shown previously that the money multiplier doesn't exist and that most changes in growth/inflation today stem from expansions and contractions in credit. Altering interest rates can marginally effect the demand for credit but is least effective when private demand is constrained by excessive debt. IMO, the Fed is more effective at curing the supply side for credit by preventing bank illiquidity from constraining the supply of credit. Currently I view the supply side as a non-issue and don't think interest rates pose a constraint on demand for credit.
Let me know if this helps or any follow up questions that arise.
Very true. Fed is not the solution. Fed’s monetary policy might accelerate the destruction of the U.S. dollar with QE3.
ReplyDeletePlease this article posted by Ed Butowsky, "Obama Chose Monetary Policy - And You're Feeling It"