The Most Important Thing to Remember as the Federal Reserve Counts Down Toward Liftoff...
Four times in the past 40 years, the Federal Reserve has begun what it expected at the start to be a substantial tightening of monetary policy: one that would leave interest rates markedly higher and asset prices significantly lower than when it started.
All four of these times--every single one--the tightening has triggered processes that reduced employment and production, and impoverished nations, by amounts significant larger than the Federal Reserve had anticipated when it began the tightening cycle.
Over 1979-1982, the expectation was--or at least Paul Volker, then Chair of the Federal Reserve, said the expectation was--that a shift to operating procedures based on money-stock targeting would make the Federal Reserve's promises to reduce inflation much more credible, and thus allow a larger reduction in inflation to be achieved with less in terms of idle capacity and higher unemployment than the then-standard long-in-the-tooth Keynesian models were predicting. But in the United States the then-standard long-in-the-tooth Keynesian models still had bite: their forecasts of the costs of disinflation were dead on. Moreover, unexpectedly, in the tightening cycle institutions like Citicorp found that only regulatory forbearance kept them from having to declare bankruptcy. And, unexpectedly, the tightening cycle sent pretty much all of Latin America into a more-than-five-years-long deep depression.
Over 1988-1990, then Fed Chair Alan Greenspan had no clue how much of an impact the tightening cycle would have on the balance sheets of overleveraged, undercapitalized, and already gambling-for-resurrection southwestern S&Ls. The federal government had to establish the Resolution Trust Corporation and commit a substantial amount of money--three months' worth of total Texas state income transferred to Texas S&Ls and their depositors who had been chasing high yields--in order to clean the situation up, and keep the recession of 1990-1992 from becoming deeper and longer.
Over 1993-1994, then Fed Chair Alan Greenspan was once again surprised by how much of an impact what he saw as small policy moves had on the prices of long-duration assets and the terms on which businesses could capital. Fortunately he was willing to shift policy and cut the tightening cycle short (over the protests of many on his committee), and so avoided sending the U.S. economy into recession.
And, of course, over the 2004-2007 tightening cycle neither Fed Chair Alan Greenspan nor his successor as Fed Chair Ben Bernanke had much inkling of how fragile mis- and un-regulation had left both housing finance and the New York money-center universal banks. We are still paying a very heavy price for that failure of first regulation and then monetary policy, and will probably be paying it for the rest of our lives.
The tightening cycle that the Federal Reserve is now about to embark on is unusual in several dimensions:
First, nobody 10 years ago would have seen an employment-population ratio like that of today as calling for any sort of monetary tightening. While the current unemployment rate is flashing a tightening signal, the disconnect between the unemployment rate and employment as a sharp of population adjusting for demographic and sociological trends has never before been nearly this large. So far at least, wage patterns seem to tentatively suggest that the employment-population ratio is giving a better signal of the amount of economic slack than the unemployment.
Second, this tightening cycle will be undertaken with inflation not just lower then the Federal Reserve's long-term target but expected to stay below the long-term target for at least the next three years.
Third, this tightening cycle will be undertaken even as the Federal Reserve currently judges that fiscal policy is inappropriately restrictive.
Fourth, this tightening will be undertaken with greater adverse economic headwinds abroad--financial instability in China and economic depression in Europe--headwinds that would make monetary tightening right now clearly inappropriate were the Federal Reserve to view its role as one of a Kindlegians global monetary hegemon rather then as focused exclusively on internal balance in the U.S. domestic economy.
It would be tempting to say that the Federal Reserve's relative eagerness to begin a tightening cycle even given the likely presence of adverse unknown unknowns in tightening's effects, and even given the four major dimensions in which this tightening cycle will be unprecedented, reflects an excessive voice of commercial banks in the counsels of the Federal Reserve. Commercial banks' business model makes sense only if they can earn via passive and relatively safe long-term investments at least a 3%/year spread over what they pay depositors. And that is only possible with Treasury rates higher than they are now. But if so this reflects a failure of bankers to understand their industry's material interests: what commercial banks ought to seek is not higher interest rates now, but rather interest rates low enough for long enough to be capable of supporting higher interest rates in the long term. For the Federal Reserve to raise interest rates in the near future only to find itself returning them to the zero lower bound in the medium term is, or ought to be, ever commercial bankers' nightmare.
