One Quarter Percent – Has the Fed Learned Nothing?!!
Earlier this year I showed how this entire credit crisis is the fault of the Federal Reserve due to their completely inept handling of interest rates as we came out of the last recession. See http://themoderatevoice.com/22860/guest-voice-the-federal-%e2%80%9canything-but%e2%80%9d-reserved-911-terrorists-strike-again/ . Now they are doing it again. How can we let them?
Major Screw-Up Number One: In summary, in response to the last recession, the Fed lowered the Fed Funds Rate, which drives or influences all interest rates world wide, including LIBOR. This rate had not been below 3% for 40 years, yet the Fed lowered the rate from 6% in January 2001 to 1.75% in December and 1% in June, 2003. It was below 3% for 3 years and 8 months and at 1% for a year, both absolutely unprecedented.
Free money spurred out-of-control mortgage lending, which dramatic increased home demand, which increased home prices, which further increased mortgage lending and of course home building. It also revved up the bundling and selling of mortgage backed securities and spurred the creation of synthetic CDOs and the like. Subprime, Alt A, Auction Rate Securities, CDOs and all that existed prior to 2001. This action by the Fed just put all of this on steroids and unleashed the inherent creative survival-of-the-fittest greed alive and predictable in all people.
Major Screw-Up Number Two: Then, they REAALLLYY screwed this up. The Fed raised the Fed Funds Rate by 4.25% in 2 years. The last time rates were this low the Fed took 8 years to raise rates by this much. The rapid increase in rates ruined fragile home mortgages throwing them into foreclosure, ruining home demand, causing home prices to fall, lending to dry up, mortgage companies to fail and fire people, lenders to fail and fire people, insurers to fail and fire people and home builders to fail and fire people. Higher unemployment leads to less spending and that kills the whole economy.
So what is the NEW answer to the current recession they caused, do the same thing as last time.
Lower interest rates to a new record low.
It is too late. This has already happened. Since it has, what is the next right thing to do?
What to Do? Announce right now that rates will begin to rise, one quarter percent every 4 months until rates hit 5.25%. This is about the average Fed Funds Rate over time. First raise will be April, then August, then December, like clockwork for 6 years and 8 months.
Lenders and borrowers will have certainty. Borrow now or the rates will go up in April. Everyone can plan. Lenders can make loans that predict future known increases in rates.
Why are interest rates shrouded in mystery? Who does that help? It provides the Fed with some kind of secret power over the economy that they hate to relinquish.
I suggest that if the Fed will not do this itself, then Congress should take this power from them and do it legislatively. The Fed screwed this up once. We cannot afford for them to do it again. Good luck America.
6 Responses to “One Quarter Percent – Has the Fed Learned Nothing?!!”
A correction. You showed how in your opinion low interest rates were the problem. This is not the same as proving it to the general public or to economists who aren't of the Chicago or Austrian schools.
Right now, an interest rate increase would be anti-stimulatory, same as tax increases or new taxes (which is what people in New York are about to learn, though they'll probably just expect Washington, DC, to bail them out soon, anyway), the opposite of what we desire.
Not only is willingness to go to a zero-interest-rate policy (or close to it) the right thing now, but the conventional argument (and it is Keynesian, not Chicagoan or Austrian) is that government spending would be in order, too. (And what about interest rate reductions not only for credit cards but more interestingly, for fixed-rate home mortgages?) In addition, governments (not only our federal government but the European Central Bank and other agencies elsewhere) are likely to engage in monetary expansion (inflationary monetary policy) before too long. That's even with decades-long fear and revulsion of inflation by the public and by governmental authorities, in addition to many economists. The time for any interest rate increase (Federal funds rate and so on, not certificate-of-deposit and savings-account and Treasury securities rates only) is in conjunction with inflationary (as well as _successfully_ stimulative) policies in the future, when it is confidently known that there is “reflation” (it belongs in quotes because deflation remains to be proven, though I suspect it's going to be proven, not merely likely).
Going ultimately to a long-term-fixed interest rate policy (corresponding to real economic growth rate or some other measure, ideally in conjunction with a gently varying economic growth rate or change in price levels, sometimes upward, sometimes downward) is intriguing, but it's not the thing to seek yet.
good article ned. I thinbk that's why it's been called voo doo econ. That the under the table, 'not seen in sunshine' guesses, flying leaps, ungrounded steps, are a mystery to 'the uninitiated.' Seems trying to keep people 'in the dark' is part of the jig. I think anything you can do to give us Econ 101 will help. Frankly, most persons, including myself, dont know what exactly to look for in terms of signs of gross guessing, and dont know what to do to protest or mediate. We only see it coming when find our wallets filled with air.
dr.e
I disagree and think the policy makers have it all wrong. Large inflation and deflation are just two sides of the same coin, which is reducing standard of living to make up for past excess. They just have different side effects: namely deflation punishes debtors and inflation punishes savers. Considering that our main problem is how we are going to accommodate our rapidly aging populace, attempting to inflate dramatically doesn't make sense at all as they will be out of the work force and thus see huge hits to their income stream (this is assuming that monetary expansion leads to wage inflation, which it hasn't the past 20 years and little reason to think it will any time soon with current dynamics).
Also our problem is consuming too much and punishing savers is not the right way to go. I think that inflationary policies will also require more international collaboration to avoid complete failure, and this seems unlikely.
Finally, from a systems theory perspective, volatility can be just as important as the actual values. Indeed, a lot of the structural damage that is going to be around for years is because of the massive whipsaws in the currency and bond markets. By the Fed setting an explicit policy of using an open positive feedback loop that they will have to determine when to hit the breaks, it's only going to make the volatility way worse. They'd be much better off doing what Ned suggests even if it means deflation. At least deflation is a closed feedback cycle where at some point the feedback switches from positive to negative.Once we get down to that new steady state is when we should try to reinflate.
“Large inflation and deflation are just two sides of the same coin, which is reducing standard of living to make up for past excess.”
I would disagree that significant (or substantial, or severe) inflation or deflation are reducing standard of living to make up for past excess. I would say that they can be and have been independent of them. To the extent that they may be desired and actually sought, they may be for “good” reasons. In the case of inflation, the illusion of prosperity, and exploiting true prosperity — the post-World-War-II inflation began by being subdued and was not considered a problem, and as a source I've lately enjoyed calls it, was a “Golden Age” in the USA and the rest of the developed world as it recovered from the war.
“Also our problem is consuming too much and punishing savers is not the right way to go. I think that inflationary policies will also require more international collaboration to avoid complete failure, and this seems unlikely.”
If anything, my normal beef is the age-old conflict between the Chicago and Austrian schools, and I've become wise enough to prefer the latter insofar as I would rather see things resolve themselves in the economy right now. However, and I'm not a sensationalist, but one who paid attention to Japan as a model for others later, this could take years, and I fully sympathize with those who don't want to accept waiting that long for resolution and would prefer to risk intervention now. Hence I accept the reasoning behind even those like Bootle who are English and have a basic liberartarian goodness and sensibility behind him (he objects strongly to the notion that people who work every spare moment to enrich themselves greatly should be heavily taxed, for example, on the grounds of individual freedom, i.e., liberty, as well as of [true rather than bogus leftist misuse of the terms] fairness and justice). Bootle is among those who say what's needed now is a basically unrestricted willingness to intervene to prevent the worst kind of deflation from taking hold. He even is willing to rely on sources like Paul Krugman, who has supplemented his quiet respectable academic work with notorious Democratic Party hack scumminess. He also has referred to the “helicopter drop” mentioned elsewhere on this site, as well as on the Keynesian concept of stuffing money in bottles, burying the bottles, and employing people (presumably the otherwise-unemployed) to retrieve them. (Unsaid was that others, as well as the retrievers, could be employed to stuff money into the bottles and bury them.) I'm strongly on the side of the thrifty and the otherwise virtuous, and in conceiving the “liquidity trap” and “paradox of thrift” and pain of deflation I'm strongly in the savers' camp, as well as the cheerleader wanting people (including me) to wait, wait, wait for lower, lower, lower prices before buying. It's why I am among those who have stated on here that there's not only error in expecting lenders to lend, but for individuals to borrow more or to spend if they're given money. Why _not_ save or reduce debt first and foremost? That's what anyone sensible would do, and one cannot be hated for that even in deflationary times (as well as deferring spending in hopes of lower prices later). That's even without accounting for the development of deflation-oriented thinking and mindsets among people. I'm the last person to be against thrift, which is a virtue.
“volatility can be just as important as the actual values”
This is the distinction between substantial and less-substantial inflation as well as how it relates to predictability, in most people's lives to date. I would add that it would be nice to have economic stasis ideal predictability, but that will never be possible. And in my years to date I've come to believe that a stable price level around zero (the ideal) is often not practical and what's realistic is bounded, but still fluctuating, price stability going both ways around zero change. Sometimes prices will rise, and at other times they will fall, but they will not diverge to the point where the change itself affects people's lives (as it did in the 1970s) or interferes markably with decision making.
archangel,
If you're really interested in reading more about economics I wouldn't suggest Ned as a source. Try Robert Reich, Calculated Risk, Econbrowser or Brad DeLong.