Why Fed’s steering of economy is ‘hazardous’
KV Prasad Jun 13, 2022, 06:35 AM IST (Published)
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Summary
Coming from mere financial market practitioners, this statement would have no particular resonance. But when it comes from distinguished economic scholars, one is intrigued about what they really make of economics and monetary theory.
The data-driven policy actions that the US Federal Reserve (Fed) says it uses to steer economic growth, employment and price stability perfectly fit the metaphor of visual navigation.
Coming from mere financial market practitioners, this statement would have no particular resonance. But when it comes from distinguished economic scholars, one is intrigued about what they really make of economics and monetary theory.
(Read more: Fed heading wrong way: Kocherlakota)
Let me explain. If you say that you will begin raising interest rates when you start seeing rising inflation pressures, you don’t need any particular training in the field of economics. As a famous French lawyer once snapped at me, all you need is a bit more than a general level of education (my sloppy translation of the elegant French: “culture générale améliorée).
If you think that is too harsh and foolhardy, think of what Milton Friedman, the father of modern monetarism, a Nobel laureate in economics and a social philosopher had to say about the Fed’s policies. Essentially, his message was this: Since we don’t know where the economy is at any point in time, stop destabilizing economic activity with inappropriate policy moves.
Taking that as a postulate, Friedman then advocated an economic policy based on what became known as the “monetary rule.” He said that the Fed should set one of the monetary aggregates – his preference was for M2 – to grow at a constant rate that would, over the medium term, deliver economic growth and price stability.
Don’t blame the Fed: ‘Animal spirits’ did it
The Fed tried this, some would say half-heartedly, by targeting the quantity of money between October 1979 and October 1982, and the whole world had breathless Thursdays when the vagaries of the US money supply (measured by M1) would hit the airwaves. Needless to say, the practice was abandoned allegedly because – contrary to Friedman’s findings – money supply fluctuations were seen as being unrelated to economic conditions.
Whatever the truth, the Fed was back in charge with its data-driven interest rate targeting whose grave blunders in the run-up to the last financial crisis are now blamed by its former leadership on, among other things, uncontrollable “animal spirits” – an egregious pleonasm that betrays unflattering views of people’s intelligence.
(Read more: Yellen punches through ‘glass ceiling’ at Fed)
So, here we are in a situation where Fed leaders were discussing in the middle of last month the “marginal efficiency” of their monthly asset purchases as several indicators were taken to signal some firming of economic activity. And there was instant action: the expansion of the Fed’s balance sheet in December was reduced to USD32.9 billion from a monthly average of USD100 billion in the previous three months.
One wonders whether the Fed leaders might now have second thoughts about such a sharp “tapering” in light of last week’s rather discouraging employment numbers, and the ISM (Institute of Supply Management) index of the 90 percent of American economy hurtling toward the “bust line” of 50 since last August. Reserve movements in the weeks ahead will say something about that, and we may also hear Fed’s dovish statements as bond traders continue to scream about an impending economic disaster.
Meanwhile, the picture of the US labor markets emerging from last month’s numbers should give some pause for thought – even though labor demand is a lagging indicator of whatever might be the current cyclical position of American economy. The huge decline of the unemployment rate to 6.7 percent, from 7 percent in November, was mainly the result of job seekers’ continuing exit from the labor force. Indeed, the participation rate fell to 62.8 percent — a number last seen during the stagflation of the late 1970s — tracing out a steadily declining pattern from 63.6 percent over the previous twelve months.
Adding the involuntary part-time workers (7.8 million) and people who left the labor force because they were unable to find a job (2.4 million) to the headline unemployment number of 10.4 million, the actual jobless rate is well over 13 percent, double the reported rate of 6.7 percent.
The only positive detail in this latest batch of labor market statistics is a decline in the number of people without a job for 27 weeks or more. Still, that is a rather small consolation because these people account for nearly 40 percent of the officially reported unemployment data.
(Read more: Job growth weak, raising questions about Fed move)
Thick clouds and low visibility
Taking these lackluster labor market conditions with a virtually stagnant growth in households’ real disposable income over the first nine months of last year, it seems that private consumption (70 percent of gross domestic product), the key engine of economic growth, is unlikely to provide the support the economy needs to rise from the present growth path of 1.7 percent to 3 percent, or higher, that would be needed for a significant and sustainable improvement in job creation.
On this evidence, therefore, nothing seems to recommend a rush to drastic cuts in the monetary stimulus.
But a true believer in the power of monetary policy might have a more nuanced view. The reason is that the bank lending to households – 41 percent of total consumer lending – has begun to take off after a long period of puzzling doldrums. It is currently growing at an annual rate of nearly 6 percent. Adding to that a 9 percent growth of nonbank lending to consumers, the total consumer credit is soaring at an annual rate of 7.3 percent.
And with USD2.4 trillion of excess reserves (aka loanable funds), the banks’ lending firepower is truly awesome, however they decide to use it.
It just may be, then, that this new development now calls for instrument navigation because the policy horizon is clouded, and the visibility for data-driven actions may be unacceptably low.
Why?
Because a strong and effective monetary stimulus has begun to feed into the real economy. In other words, the monetary policy is beginning to work; it is no longer spinning its wheels because the transmission mechanism – the banking system – is back in action.
And here comes the problem: the impact of this credit expansion is not instantaneous. There are long and variable lags in the way the monetary policy affects economic activity. Nobody knows how long these lags are. Estimates range from two to four quarters, or even longer, depending on the nature of particular financial markets and their intermediation systems.
(Read more: Yellen hopeful for 3% GDP growth in 2014)
You can now see that a consummate debater Milton Friedman is back with a smirk and a self-assured: “I told you so.”
Yes, because by the time this stimulus begins to move the real economy, it might not be needed since the economy may already be accelerating on its own steam. That, of course, would just be adding oil to fire, causing an inflationary flare-up that would force the Fed to keep raising interest rates until the inflation begins to calm down. But by that time, the economy would also be down into an irretrievable tailspin.
And here is the Friedman corollary: booms and busts are always created by errors of monetary policy because the stimulus (restraint) is maintained longer than necessary.
This is not the usual Fed-bashing. I have the greatest respect for the very difficult job my former colleagues are struggling with. It is my sincere and fervent wish that they exit this crisis-ridden period with flying colors.
But savers cannot live of pious hopes. I believe they should stay in equities and, selectively, in commodities, including some of that yellow stuff, just in case the navigation gets too bumpy.
Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia.
Follow the author on Twitter @msiglobal9
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