Monday, December 13, 2004

Fed Rate Boost Won't Be to Make Room for a Cut

Caroline Baum, Bloomberg

It wasn't until early November that forecasters decided the Federal Reserve would raise the overnight federal funds rate on Dec. 14, as it has at every meeting since June.

A strong October employment report and solid non-auto retail sales (reported in early November) solidified the view that a holiday pause in the effort to normalize short-term rates was not in the cards.

It may seem strange that Wall Street research departments can forecast economic growth for 2005 and 2006 but can't figure out where the funds rate will be next month until they see the monthly jobs report.

Their defense is they are using the same guidance as the Fed, which is true or sad or both.

Growth forecasts are typically predicated on interest-rate forecasts, and vice versa: Interest rates move the economy; the economy moves interest rates.

The Fed sets the overnight rate, holds sway over the entire spectrum of short-term rates and even has some influence over long-term rates, which are the sum of the current and expected future short rates.

How can you have confidence in a growth forecast 18 months out and have no idea where the funds rate will be next month?

Long-term growth forecasts ``never really matter and no one holds us to them,'' quipped Jim Glassman, senior U.S. economist at JPMorgan Chase & Co.

Telegraphed Outcome

Tomorrow's Fed meeting holds little suspense in terms of the outcome: The Fed will raise the overnight rate by 25 basis points to 2.25 percent. That would put the rate up 125 basis points since June.

There's an iota of doubt over how the Fed will assess the risks to growth and inflation. Or, more correctly, how policy makers choose to voice those views for public consumption.

Specifically, the risks to inflation are in play, according to a Dec. 2 Wall Street Journal story. Not only is the Fed likely to keep ``raising rates at its next few meetings,'' but some policy makers are concerned about rising inflation in light of ``slowing productivity growth, the lower dollar, higher energy and commodity prices, recent inflation data and anecdotal evidence of businesses raising prices,'' according to the Journal.

The last point is apt to resonate with Fed Chairman Alan Greenspan. He may think that official inflation measures overstate inflation, but he's wired into intelligence on businesses' ability to raise prices as it portends inflation expectations. It probably won't be enough to prompt a change to the balance-of-risk assessment right now.

Rates Too Low

There are other reasons for the Fed to continue to raise the overnight federal funds rate from its current 2 percent. The rate is lower than the inflation rate, which is an incentive -- at least for banks, which borrow at the funds rate -- to create excess credit.

To be sure, the core this and the core that and the core market-based whatnot are all equal to or lower than 2 percent. But let's get real. If the goal is to ascertain the real cost of borrowing, it doesn't make sense to take out food and energy -- either for households or for businesses.

Another reason to raise rates is to avoid a misallocation of capital in asset markets -- a bubble -- which is what happens when interest rates are below some unobservable neutral rate. Whether a housing bubble is to be or not to be or already is has much to do with the cost of owning a home (home price, mortgage rates, median family income) versus the price appreciation of that asset.

Housing Is Beneficiary

In the third quarter of 2004, average U.S. home prices rose 13 percent from the same quarter a year earlier, according to an index of repeat sales compiled by the Office of Federal Housing Enterprise Oversight. It was the biggest jump in 25 years.

The oversight agency said price increases in prior quarters may have been held down by intense refinancing, which is captured in the index along with purchases, and the failure of appraisals to keep pace with market price increases.

Based on purchases alone, the House Price Index rose 10.3 percent in the third quarter from a year earlier.

Household mortgage debt rose an annualized 11.3 percent to $7.262 trillion last quarter, according to the Fed's Flow of Funds report. The value of residential real estate rose $837 billion in the third quarter and is up $7 trillion in the last five years.


Greenspan has said repeatedly that transaction costs and the nature of housing (we live in our homes) are impediments to the development of a housing bubble. Still, housing has been the clear beneficiary of low rates, aided by its tax-advantaged status. With the stock market bubble and bust still fresh in his mind and the consumer borrowed to the hilt, Greenspan probably isn't eager to put his theory to a test.

One reason that won't compel the Fed to raise rates tomorrow is the one proffered by the New York Times editorial board on Nov. 24. I clipped it because it was such a peach. Greenspan ``has to get rates up, in case he needs to bring them down,'' the editors wrote.

Come again? Does anyone reality-test such a concept before it gets into print?

Unfortunately, that idea is not confined to the Times's editorial board. Some economists spout the same nonsense, along with its theoretical kissing cousin: the idea that the Fed needs to ``keep its powder dry,'' refraining from lowering rates at a given time so that it has several rounds of ammunition for later.

Misguided Thinking

Best as I can tell, the logic goes something like this. If something bad happens, such as another terrorist attack, and rates are low, the Fed won't have the bullets to get the job done.

It's true that the economy could slump in a low interest rate environment in response to an external shock. In that case, the Fed can always crank up the printing press -- ``quantitative easing'' is the polite term.

The fix isn't to kill the economy now so you can save it later. Carried to its logical conclusion, if the Fed really needs a holster full of ammo, why not raise rates to 5 percent or 10 percent?

Similarly, withholding interest-rate medicine when the economy needs it is almost sure to warrant more medicine later.

Keeping one's powder dry may have worked well for a cowboy expecting an ambush in the wild and woolly West. As an operating principle for central bankers, it's a non-starter.


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