Contra Tim Duy, The Lack of Federal Reserve Maneuvering Room Is Very Worrisome...
Contra Tim Duy, The Lack of Federal Reserve Maneuvering Room Is Very Worrisome...
This, by the every sharp Tim Duy, strikes me as simply wrong: Contrary to what he says, the Fed has room to combat the next crisis only if the next crisis is not really a crisis, but only a small liquidity hiccup in the financial markets. Anything bigger, and the Federal Reserve will be helpless, and hapless.
Look at the track of the interest rate the Federal Reserve controls—the short safe nominal interest rate:
In the past third of a century, by my count the Federal Reserve has decided six times that it needs to reduce interest rates in order to raise asset prices and try to lift contractionary pressure off of the economy—that is, once every five and a half years. Call these: 1985, 1987, 1991, 1998, 2000, and 2007.
Starting in 1985 then-Fed Chair Paul Volcker and his FOMC decided that the configuration of interest rates was too high to be consistent with stable growth at full employment, and so they lowered the Federal Funds rate and the market rate on three-month Treasury Bills by fully 3%-points. The Federal Reserve could not do that today.
Starting in 1987 then-Fed Chair Alan Greenspan and his FOMC reacted to the one-day 25% collapse in the value of the stock market by opening the Discount Window so that banks could freely borrow from the Fed, and reducing the short-term rates by 1.5%-points. The Fed could do that today.
Starting in 1991 then-Fed Chair Alan Greenspan and his FOMC reacted to the wave of pessimism transmitted through financial markets by the Savings and Loan crisis by lowering the short-term rates by 5%-points, in steps. But the Fed acted behind the curve. The Fed acted late, and the early 1990s recession and subsequent "jobless recovery" were the result. The Fed could not so act today.
Starting in 1998 then-Fed Chair Alan Greenspan and his FOMC reacted to the triple whammy of the Asian crisis, the Russian bankruptcy, and the collapse of LTCM, then the world's largest hedge fund, by telling LTCM's creditors to manage the situation (and they did very well out of it indeed) and by lowering the short-term rates by 0.75%-points. The Fed could so act today.
Starting in 2000 then-Fed Chair Alan Greenspan and his FOMC reacted to the collapse of the dot-com bubble by lowering the short-term rates by 4%-points. It was, again, behind the curve. The recession of 2001 and the subsequent jobless recovery were the result. The Fed could not so act today.
Starting in 2007 then-Fed Chair Alan Greenspan and his FOMC reacted to the collapse of the dot-com bubble by lowering the short-term rates by 4%-points. The Fed could not so act today. It was, again, behind the curve. The disaster of 2008 and what followed was the result. The Fed could not so act today.
I would draw a distinction between liquidity hiccups as things that do not involve permanent revaluations of asset values, and the larger shocks that hit the economy that do. 2008 produced a permanent and substantial fall in the risk tolerance of the market. 2001 saw a permanent downweighting of the value of tech—not that the technologies were disappointing, but rather than using them to reap profits for investors turned out to be much harder than expected. 1991 saw the end of the Sunbelt's "Morning in America" decade as it became clear that much investment since the 1986 fall in oil prices had been fueled by S&Ls gambling for resurrections and that the economy needed permanently lower and temporarily very much lower interest rates to rebalance at full employment. 2008, by contrast, was triggered by events outside the U.S. and had little consequence for fundamental values inside the country. And 1987 was a market mechanisms dysfunction blip. Those things can be handled well by simply providing extra liquidity while the crisis is at its peak. The larger shocks require more: they require that the Federal Reserve have the power, capability, and will to substantially shake the entire intertemporal price system. Yet that is what the current low level of safe nominal short interest rates keeps the Federal Reserve from having right now. And unless and until the neutral real rate rises, the easiest way out of this low-rate-even-in-boom-time trap is a higher inflation target.
Yes, the Federal Reserve could handle a liquidity hiccup in financial markets. No, the Federal Reserve could not handle anything larger. The record of the past third of a century tells us that "larger things" come along every eight years or so.
And, yes, there is some reason to worry today. With the rise of passive and automatic investment strategies, there are many players in the market for whom diversification is the new due diligence. Bond covenant quality thus seems... unusually low... and many things that people presume are either well-collateralized or hedged-via-diversification... may well not be...
It is ten years since the last "larger thing" hit the economy.
Cf.: Tim Duy: The Fed Has Enough Room to Combat the Next Crisis: "The Fed has more than enough room to replicate the responses to the 1987 stock market crash or the 1997 Asian financial crisis...
...They even met the challenge of the 2015 oil price crash simply by scaling back expected rate hikes in 2016. Given the expectation among market participants that the Fed will continue raising rates over the next year, just pausing on rate hikes would be a powerful stimulus. The likely willingness of central bankers to shift to a dovish stance may help account for the overall benign response on Wall Street so far to emerging threats from a more turbulent external environment. These include not only trade wars but also potential for financial crisis among emerging markets or the euro area. The risk these events pose for the overall economy would be bigger and more worrisome if the Fed felt its hands were tied such that they could not respond to a downturn. This is not the case. Market participants should know that the Fed is in a position to cushion the impact should these risks become a reality...
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