'Fool in the Shower' to Give Fed a Good Scalding
Long and variable lags. That's all I could think of yesterday when I read the Federal Reserve statement and learned that economic conditions "are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014."
My first instinct was to mark the date on my household calendar, but I couldn't find one that goes out that far!
What the Fed is saying, in essence, is that as the economy improves, it's appropriate to provide as much stimulus, or support, as it did in late 2008, when the economy was contracting and the financial system was imploding.
This is a dramatic shift. Given the long and variable lags with which monetary policy operates, past Fed officials at least paid lip service to the notion of acting preemptively: withdrawing excess stimulus -- a fancy way of saying they will raise interest rates -- as the economy improved.
Not so the current committee, which is tilted toward doves after the annual rotation of voting members. This group seems to think it should "continue to ease as long as there is economic slack," said Stephen Stanley, chief economist at Pierpont Securities LLC in Stamford, Connecticut. "It's a classic, elemental mistake," he said, one described by the late Nobel economist Milton Friedman as the "fool in the shower."
The fool turns on the water in the shower, steps in and finds that it's still cold. So he turns the knob all the way to hot, only to get scalded when the water heats up with a predictable lag.
The application to monetary policy is obvious. Yet Fed chief Ben Bernanke and his committee seem certain they can use their communication strategy to placate the bond market.
Good luck with that. The market is as data-driven as the Fed -- and reacts a whole lot faster. When the economy turns, and turns with a vengeance, the Fed won't know what hit it. It will be staring at a $2.9 trillion balance sheet, including a portfolio of mortgage and Treasury securities. More than 90 percent of its Treasuries carry maturities of one year or more and are subject to bigger losses from rising interest rates than the short-term bills the Fed traditionally holds.
In addition, the Fed will face a chasm between the current funds rate and something close to the long-term neutral rate of 4 percent to 4.5 percent, according to the Fed's long-run interest-rate projections, released for the first time yesterday. It will have to contend with the consequences of negative inflation-adjusted interest rates, and all the risk that implies.
Think of the incentives the Fed is creating. In explaining how monetary policy works when the overnight rate is at zero, Bernanke relies on something known as the portfolio balance channel theory. The idea is that when the Fed buys long-term Treasuries, it depresses yields and forces investors to buy other assets that carry increased credit or interest-rate risk, such as long-term corporate bonds, mortgages and equities.
To the extent that higher stock prices and lower bond yields facilitate investment, employment and production, it's beneficial for the economy. Often the result is too much of a good thing, such as a misallocation of capital into a tax- advantaged, nonproductive asset such as housing. Or Wall Street may create risk with some new, financially engineered product.
The bottom line is, when financial institutions can borrow for free and are encouraged, verbally and nonverbally, to take risk, eventually they will.
Why should we expect the outcome to be any different than the last time, when the Fed held the benchmark rate too low for too long in 2003 and 2004 and fueled a housing bubble? No one knows what kind of risk investors will take. (Don't tell anyone: Neither do the regulators.)
That's not all. The Fed is bound to find itself with what academics refer to as a "time inconsistency problem," according to Stanley. Often it may be advantageous to advertise one policy -- in this case, holding interest rates low for years -- in order to steer expectations and get maximum effect. But the Fed "can't follow through on its promise if conditions dictate something else," Stanley said.
The choice, then, is: "stick to the promise and run bad policy, or change policy and lose credibility."
Then there's the small matter of forecasting accuracy. Anyone who's perused the recently released transcripts from 2006 knows that to err is human. The housing bubble that was already in the process of deflating and about to engulf the U.S. and global economy was a tiny blip on the Fed's radar screen.
Former Governor Susan Bies, a banker by training, was one of the lone voices expressing concern about mortgage risk. (Maybe real world experience matters.) Meanwhile, the Fed's econometric models were mum.
Asked about the Fed's track record at yesterday's news conference, Bernanke said the ability to forecast several years out was "limited." The Fed's projections are "not unconditional pledges" and are "subject to revision," he said.
Two policy makers -- no names were attached to the forecasts -- expect the funds rate to first begin rising in 2016. (My money is on New York Fed President Bill Dudley and Governor Janet Yellen.) That would mean eight years of 0 percent interest rates. There will be a revolution in this country before then if the economy is lousy enough to warrant 0 percent interest rates for that long. Even the fool in the shower knows that.