Saved by the markets
Hmm. Time to admit I was wrong, again? Maybe. And maybe not.
Since the Fed surprisingly announced a rate increase, surprising because of a flat yield curve, long term rates rose along with the short term. This is not exactly in line with expectations. The implication is as ambiguous as the rest of the economic news this week.
Economic growth last quarter was the strongest in three years (but in the previous quarter, was anemic.) Unemployment is down (4.7%). Housing starts were down to the lowest rate in three years also, and median price of housing down. Perhaps it is not surprising that Bernanke has been giving mixed signals about “pausing” in the increase in interest rates, but not being “soft” on inflation.
I had predicted that the higher rates would exert too much drag on the economy, and the economy would slow substantially this year. Could still happen. But like Bernanke, I have to pause and think carefully. The latest long-term interest rate increases may be indicating that the economy is just fine and the Fed’s increase was at least not a problem.
First, there is good reason to believe that long-term rates rose because of a coincidence, that foreigners slowed their stampede to park money in the U.S. in the same week as the interest rate increase. Theory would have predicted the opposite: interest rates rising would attract finance. All other things equal, of course. The monetary tightening should have raised short-term rates, but by thereby attracting foreign capital, it would raise the exchange rate (the dollar would rise.) The actual fall in the dollar, therefore, tells us plainly that a shift in motivation to invest in the U.S. was responsible.
But be a little careful. Evidently there was a similar fall in January, but a big increase in the inflows in February. So even if these signs are genuinely pointing to a slowdown in inflows in March, it does not appear to be part of a strong or gathering trend.
The depreciation, however unconnected to the monetary tightening, may inspire further withdrawal, say of Arab money suddenly facing the prospect of a 10% fall in the value of money they were just parking short-term anyway. If so, then as they say, panic could turn into a rout. A 30% fall in the dollar this year is not at all out of the realm of possibility, but I would not expect it, for reasons to be discussed below.
Theory would have predicted little rise in the long-term rate for another reason. Once upon a time we taught that long and short-term rates moved together because long and short-term loans are substitutes, so that higher short-term rates push borrowers toward longer-term loans and cause long-term rates to rise from the new demand. However, the short-term rates are much more volatile, and long term rates are determined much more by the inflation rate and the availability of private funds. Unless the Fed is ordering a truly massive reduction in funds, their tightening would not have raised the long-term rates by as much as the short-term. Yet they did rise as much. And if most economists were predicting the effect on long term rates they would have guessed that the expectation of lower inflation from monetary tightening would have caused long term rates to fall. This has been the effect of higher short term rates with growing frequency over the last decade.
So long term rates probably rose due to foreign money slowing its supply, at least in part. Might it also be due to a growth spurt? It is certainly possible. The most reasonable interpretation of the connection is that faster growth is inspiring investment activity, and that is raising demand for credit. We should look closely at the housing market, though, if only because it has been so overheated so recently.
Housing results have also been mixed. Permits are down from February, but up 2% from last March. Starts are in the same position, but up 7% from last March. Sales of existing homes, however, were up 14% from February but down 7% from March. Interpreting very liberally, new home construction is catching up to demand, after a delay due to worries of a bubble. Add to this that the decline in median price from February was almost 7%, the largest in a series of declines since last October, and average prices dropped 7% month-on-month, for the first real decline in years. It appears that the growth has been at the high end, but is now easing there and the medium and low price segments are filling in.
From a macroeconomic view the news is that quantity of housing is increasing, but not price. This is clearly a supply increase. (Although, we do not know that the price of a given property was falling, but mainly that more were transacting in the lower portions of the distribution.)
Does all of this mean the Fed read the trends better than I did? Momentum in the economy is strong – doesn’t it need to be restrained? Won’t the multiplier effects of the production increase create a demand overhang that might melt suddenly if not restrained beforehand? Well, first, let me note that that kind of talk is pretty Keynesian. Monetarists are supposed to believe that if the central bank is not actively creating credit, which they are not doing much of when there is a flat yield curve, then demand swings can take care of themselves. So if the Fed policymakers are taking an active approach with Keynesian consciousness feeding in, it may be worth the sacrifice of 50 basis points.
Second, even if they are reading the situation better than I am, I don’t mind very much. They have access to way more statistics and stuff than I have. My point would be, however, that the surge in demand doesn’t necessarily matter as much as the threat of the dollar decline. The first is short-term, and monetarists assure us it doesn’t matter in the long run. (It doesn’t even matter to the price level, if the Fed doesn’t accommodate the demand with extra money growth. M2 has been growing a bit fast, but who believes that the Fed is still fostering demand?) So we need to worry more about the supply side. I read the willingness of foreigners to buy American goods and American debt as supply, as I would capital inflow to a metropolitan area.
The huge financing of US trade deficits by foreigners will undoubtedly come to an end. It has to eventually, because the debt is growing faster than the real economy. The implications will be higher prices (but not sustained inflation) in the US. But also a shift back toward manufacturing, and thus an improvement in job prospects, especially for the less educated. It will also carry its own demand side drag. As a result real estate prices will undoubtedly fall in world terms, and may fall in dollar terms. Although this may seem like a threat, the idea of propping up interest rates to support the dollar doesn’t really look attractive by comparison. Rather, it might make more sense to nudge the markets in that direction by easing credit and thus decreasing the attractiveness of the dollar.
The fundamental question still seems to me to come back to whether there is any problem in the field of view that was created by excess credit creation by the Fed. Seeing none, I conclude that there is no justification for intentionally slowing down growth.
Might a drastic dollar fall (30%?) create a financial panic or depression? Of course it might. But the late 80s saw a bigger fall in the dollar (supposedly managed by Accords, but obviously not well if so,) and without any great adverse impact. (Although come to think of it, someone ought to look into its role in hitting the Japanese bubble economy.) In general, the effects aren’t likely to be so serious, and the likelihood isn’t that high anyway.
In fact, to portray a scenario in which a plummeting dollar creates a financial panic, you have to come up with institutions whose assets are heavily in dollars but whose liabilities are in foreign currencies. Lots of people hold dollars, but I don’t know any outside the US that are dependent on them for income, to meet domestic bills. Probably Japanese banks are beginning to hold enough dollar assets to be exposed to significant risk, but I would bet that now that the rest of their portfolio is performing again, they could absorb the hit pretty well. (Someone should check.)
The concern is more for the rest of those assets. If the dollar falls too fast, can Japanese firms handle the loss of competitiveness? Can Chinese? The answer depends a lot on domestic demand, and whether either one is at last becoming independent of US demand. My guess is that both can, for the unexpected reason that the rest of the world is finally sufficiently on track to want the goods, especially capital goods, and that the US can finally get off the dance floor and let someone else be their partner for awhile. Maybe even each other.
But we are unlikely ever to find out. Both governments got enough scare the last time the dollar dropped, a few years ago, that they will probably let it down only very easy, increasing their buying if necessary when others sell. Look for a steady (managed in East Asia) decline in the dollar of 2 to 5 percent per year for the next five years. It would be very interesting to plot the path of asset holdings implied by such a shift. Probably Tokyo already has.
Bottom line, the Fed did not screw up. Especially not on the scale I thought. They have already been vindicated by the news, to show that they didn’t add much to restraint. Not even enough to give an inverted yield curve. The question is whether they will somehow draw the wrong conclusion, that demand is out of hand and must be restrained even more, or whether they already knew what was happening and have already announced the steps they think are appropriate. If the latter, as Bernanke’s remarks would suggest, I gladly stand aside and salute them. But if they get all hyper about the latest growth, they could still wreck things.
Since the Fed surprisingly announced a rate increase, surprising because of a flat yield curve, long term rates rose along with the short term. This is not exactly in line with expectations. The implication is as ambiguous as the rest of the economic news this week.
Economic growth last quarter was the strongest in three years (but in the previous quarter, was anemic.) Unemployment is down (4.7%). Housing starts were down to the lowest rate in three years also, and median price of housing down. Perhaps it is not surprising that Bernanke has been giving mixed signals about “pausing” in the increase in interest rates, but not being “soft” on inflation.
I had predicted that the higher rates would exert too much drag on the economy, and the economy would slow substantially this year. Could still happen. But like Bernanke, I have to pause and think carefully. The latest long-term interest rate increases may be indicating that the economy is just fine and the Fed’s increase was at least not a problem.
First, there is good reason to believe that long-term rates rose because of a coincidence, that foreigners slowed their stampede to park money in the U.S. in the same week as the interest rate increase. Theory would have predicted the opposite: interest rates rising would attract finance. All other things equal, of course. The monetary tightening should have raised short-term rates, but by thereby attracting foreign capital, it would raise the exchange rate (the dollar would rise.) The actual fall in the dollar, therefore, tells us plainly that a shift in motivation to invest in the U.S. was responsible.
But be a little careful. Evidently there was a similar fall in January, but a big increase in the inflows in February. So even if these signs are genuinely pointing to a slowdown in inflows in March, it does not appear to be part of a strong or gathering trend.
The depreciation, however unconnected to the monetary tightening, may inspire further withdrawal, say of Arab money suddenly facing the prospect of a 10% fall in the value of money they were just parking short-term anyway. If so, then as they say, panic could turn into a rout. A 30% fall in the dollar this year is not at all out of the realm of possibility, but I would not expect it, for reasons to be discussed below.
Theory would have predicted little rise in the long-term rate for another reason. Once upon a time we taught that long and short-term rates moved together because long and short-term loans are substitutes, so that higher short-term rates push borrowers toward longer-term loans and cause long-term rates to rise from the new demand. However, the short-term rates are much more volatile, and long term rates are determined much more by the inflation rate and the availability of private funds. Unless the Fed is ordering a truly massive reduction in funds, their tightening would not have raised the long-term rates by as much as the short-term. Yet they did rise as much. And if most economists were predicting the effect on long term rates they would have guessed that the expectation of lower inflation from monetary tightening would have caused long term rates to fall. This has been the effect of higher short term rates with growing frequency over the last decade.
So long term rates probably rose due to foreign money slowing its supply, at least in part. Might it also be due to a growth spurt? It is certainly possible. The most reasonable interpretation of the connection is that faster growth is inspiring investment activity, and that is raising demand for credit. We should look closely at the housing market, though, if only because it has been so overheated so recently.
Housing results have also been mixed. Permits are down from February, but up 2% from last March. Starts are in the same position, but up 7% from last March. Sales of existing homes, however, were up 14% from February but down 7% from March. Interpreting very liberally, new home construction is catching up to demand, after a delay due to worries of a bubble. Add to this that the decline in median price from February was almost 7%, the largest in a series of declines since last October, and average prices dropped 7% month-on-month, for the first real decline in years. It appears that the growth has been at the high end, but is now easing there and the medium and low price segments are filling in.
From a macroeconomic view the news is that quantity of housing is increasing, but not price. This is clearly a supply increase. (Although, we do not know that the price of a given property was falling, but mainly that more were transacting in the lower portions of the distribution.)
Does all of this mean the Fed read the trends better than I did? Momentum in the economy is strong – doesn’t it need to be restrained? Won’t the multiplier effects of the production increase create a demand overhang that might melt suddenly if not restrained beforehand? Well, first, let me note that that kind of talk is pretty Keynesian. Monetarists are supposed to believe that if the central bank is not actively creating credit, which they are not doing much of when there is a flat yield curve, then demand swings can take care of themselves. So if the Fed policymakers are taking an active approach with Keynesian consciousness feeding in, it may be worth the sacrifice of 50 basis points.
Second, even if they are reading the situation better than I am, I don’t mind very much. They have access to way more statistics and stuff than I have. My point would be, however, that the surge in demand doesn’t necessarily matter as much as the threat of the dollar decline. The first is short-term, and monetarists assure us it doesn’t matter in the long run. (It doesn’t even matter to the price level, if the Fed doesn’t accommodate the demand with extra money growth. M2 has been growing a bit fast, but who believes that the Fed is still fostering demand?) So we need to worry more about the supply side. I read the willingness of foreigners to buy American goods and American debt as supply, as I would capital inflow to a metropolitan area.
The huge financing of US trade deficits by foreigners will undoubtedly come to an end. It has to eventually, because the debt is growing faster than the real economy. The implications will be higher prices (but not sustained inflation) in the US. But also a shift back toward manufacturing, and thus an improvement in job prospects, especially for the less educated. It will also carry its own demand side drag. As a result real estate prices will undoubtedly fall in world terms, and may fall in dollar terms. Although this may seem like a threat, the idea of propping up interest rates to support the dollar doesn’t really look attractive by comparison. Rather, it might make more sense to nudge the markets in that direction by easing credit and thus decreasing the attractiveness of the dollar.
The fundamental question still seems to me to come back to whether there is any problem in the field of view that was created by excess credit creation by the Fed. Seeing none, I conclude that there is no justification for intentionally slowing down growth.
Might a drastic dollar fall (30%?) create a financial panic or depression? Of course it might. But the late 80s saw a bigger fall in the dollar (supposedly managed by Accords, but obviously not well if so,) and without any great adverse impact. (Although come to think of it, someone ought to look into its role in hitting the Japanese bubble economy.) In general, the effects aren’t likely to be so serious, and the likelihood isn’t that high anyway.
In fact, to portray a scenario in which a plummeting dollar creates a financial panic, you have to come up with institutions whose assets are heavily in dollars but whose liabilities are in foreign currencies. Lots of people hold dollars, but I don’t know any outside the US that are dependent on them for income, to meet domestic bills. Probably Japanese banks are beginning to hold enough dollar assets to be exposed to significant risk, but I would bet that now that the rest of their portfolio is performing again, they could absorb the hit pretty well. (Someone should check.)
The concern is more for the rest of those assets. If the dollar falls too fast, can Japanese firms handle the loss of competitiveness? Can Chinese? The answer depends a lot on domestic demand, and whether either one is at last becoming independent of US demand. My guess is that both can, for the unexpected reason that the rest of the world is finally sufficiently on track to want the goods, especially capital goods, and that the US can finally get off the dance floor and let someone else be their partner for awhile. Maybe even each other.
But we are unlikely ever to find out. Both governments got enough scare the last time the dollar dropped, a few years ago, that they will probably let it down only very easy, increasing their buying if necessary when others sell. Look for a steady (managed in East Asia) decline in the dollar of 2 to 5 percent per year for the next five years. It would be very interesting to plot the path of asset holdings implied by such a shift. Probably Tokyo already has.
Bottom line, the Fed did not screw up. Especially not on the scale I thought. They have already been vindicated by the news, to show that they didn’t add much to restraint. Not even enough to give an inverted yield curve. The question is whether they will somehow draw the wrong conclusion, that demand is out of hand and must be restrained even more, or whether they already knew what was happening and have already announced the steps they think are appropriate. If the latter, as Bernanke’s remarks would suggest, I gladly stand aside and salute them. But if they get all hyper about the latest growth, they could still wreck things.
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