Federal Funds Rate: A Clarification

Just a brief follow-up on yesterday’s post on Alan Greenspan. Sleeping on it I have the feeling that for blog posting I may suffer from the failing of trying to complicate things too much, or at least of trying to say too much at once.

Really there were two central themes, and since they are a little different from what most other commentators are saying it may be worth trying to drive them home.

The first point is perhaps best illustrated by this little extract from a Reuters article:

A Reuters poll of 20 of Wall Street’s top firms — primary dealers authorized by the Fed to deal directly in government securities markets — found all anticipate another quarter-percentage-point increase to 1.5 percent on Tuesday.

“Given the mind-set in the markets that another increase is coming, the Fed is unlikely to wish to disrupt that expectation at this stage,” said economist Lynn Reaser of Banc of America Capital Management Inc. in St. Louis, Missouri.

“There might in fact be a greater risk to the economy in the Fed’s holding back simply because to do so would raise questions about what does the Fed know about the expansion’s health,” she added.

Now Let’s be absolutely clear: this view is totally eroneous.

The greater risk to the US economy doesn’t come from the Fed’s holding back in raising rates, but from the Fed bowing to market pressure to raise them when they should know better. It is not the Fed which has to adjust the rate to appease the financial markets, but the market participants who have to get their expectations back into line with a complex reality. The dangers of raising rates too quickly in anticipation of strong growth which doesn’t come are only too clearly illustrated by the Japanese experience in the 1990’s. Prudence, or downside-risk hedging, suggests it is far better to err on the side of easing than to tighten unnecessarily. Is that clear enough?

The second key issue is the so called ‘inflation problem’. This ‘problem’ is not what it sems to be. The issue is a ‘terms of trade’ one. Some parts of some key developing economies are growing extraordinarily rapidly, and this is putting a price squeeze on certain key resources, this is not the same thing at all as a general and pervasive inflation problem.

Some economists like graphs and equations: I work with images. To conduct this simple thought experiment you will need three things: an index finger, a pencil and a thick elastic band. Now string the band round your finger, insert the pencil and begin to stretch at a constant pressure. What happens? At first the band stretches, then you reach a point where you can’t stretch more, then your index starts to feel sore and you relax your grip slightly, with the pencil moving back in. Get the picture? Well no analogy is perfect :).

Now imagine that the pencil is the economy of Guandong Province in China (neo-classical economics adores partial analysis so lets keep this really simple), your index is the OECD block economies, and the rubber band is (of course) the market value of oil futures. Essentially the ebbs and flows of oil (and other commodity) prices act as a semi-automatic regulatory mechanism on global growth rates. The scarcity of these resources means that potential growth rates are lower than they would otherwise be.

This is a new factor to take into account in economic management of the OECD economies. What does it mean? Well if you swallow the inflation scare argument it means you need monetary tightening to head it off. And if, like me, you don’t buy this one, then you need a recalibration of your management tools, you need a relatively higher level of monetary easing (other things being equal) than you would have needed without the resource squeeze.

Clearer now?

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About Edward Hugh

Edward 'the bonobo is a Catalan economist of British extraction. After being born, brought-up and educated in the United Kingdom, Edward subsequently settled in Barcelona where he has now lived for over 15 years. As a consequence Edward considers himself to be "Catalan by adoption". He has also to some extent been "adopted by Catalonia", since throughout the current economic crisis he has been a constant voice on TV, radio and in the press arguing in favor of the need for some kind of internal devaluation if Spain wants to stay inside the Euro. By inclination he is a macro economist, but his obsession with trying to understand the economic impact of demographic changes has often taken him far from home, off and away from the more tranquil and placid pastures of the dismal science, into the bracken and thicket of demography, anthropology, biology, sociology and systems theory. All of which has lead him to ask himself whether Thomas Wolfe was not in fact right when he asserted that the fact of the matter is "you can never go home again".

10 thoughts on “Federal Funds Rate: A Clarification

  1. Small Update: It seems I am not the only one who doesn’t go with the rate raising obsession. I just noticed that one P Krugman has this to say in his latest Op-ed:

    “Oh, and on a nonpolitical note: even before Friday’s grim report on jobs, I was puzzled by Mr. Greenspan’s eagerness to start raising interest rates. Now I don’t understand his policy at all.”


    Nice to see I am not alone after all :).

  2. Your point about oil and growth is well taken – the potential growth rate of G7 economies is slower at today’s oil price than at last year’s. All our expectations of potential growth should be scaled back. That means accepting slower growth, rather than adopting macroeconomic policies that fight against it.

    The Fed is arguably not fighting inflation when it raises rates toward neutral. Rather, it is avoiding the creation of inflation. When rates reach neutral, then further rate hikes would be aimed at actively battling inflation. So for now, giving Fed folks the hairy eye for “fighting inflation” probably mistakes their intention. Fed officials don’t want there to be any inflation to fight.

    Fed folks are aware of the risks of accommodating higher oil prices – they did it once, and the world had to put up with Paul Volcker’s medicine as a result. The Fed is now, and one hopes, for every more, faced with walking a fine line. The days of charging off to fight inflation with high real rates are over. However, getting the real funds rate above zero and then keeping it there most of the time seems a reasonable goal. The trick is to maintain conditions that justify a positive funds rate. The Fed thinks such conditions have been achieved.

  3. The question is how seriously sluggish the economy will continue to be as far as middle class households are concerned. There was no reason for the Federal Reserve to raise interest rates and there is no reason to continue to raise at this time. Interest rates had already risen to anticipate the Fed, but it was clear employment gains were going to be slowly achieved and there is all too little gain in wages and benefits.

  4. “Fed folks are aware of the risks of accommodating higher oil prices – they did it once, and the world had to put up with Paul Volcker’s medicine as a result.”

    Yes Kevin, point taken, but that was then and this is now :). My argument is that this isn’t going to happen. What is lacking is a historical perspective.(Again, this is one of the weaknesses of neo-classical economics).

    But again, I guess you already know that is what I think. I don’t think the fed (in the shape of Bernanke and Greenspan) essentially believe the inflation story either. They are essentially being driven by the markets, who, absent rate rises, can’t grasp what is happening.

  5. Dear Edward Hugh,

    There was a time of mourning, and I lost track of your writing. Well, I have found it again and am well pleased to be able to read you regularly again. I do value your ideas, and agree with you and Paul Krugman on interest rates.

  6. There is no reason to believe energy price increases will much affect general prices in developed countries.

  7. The George Bush administration has absolutely no sense of middle class needs or there would have been a continuation of stimulus measures regarless of the deficit simply to assure the election of George Bush. An astonishing mistake. Now, there are 2 Fed rates increases and an election looming.

  8. Anne,

    You are assuming the Bush administration tells the Fed what to do. I don’t
    think they do.

  9. Well the decision is taken, and more than the decision itself, the Feds ‘optimism’ for the US economy is confirmed. This probably isn’t worth another post just now, but clearly I don’t think all this is very wise.

    The financial markets seem happy: but for how long? Till the next set of poor job data? The next consumption soft patch? Obviously this can vacilate. Next months numbers might well be good, but what about the month after?

    With fiscal tightening looming on the horizon to get the deficit under control, oil prices probably remaining stubbornly high, geo-political problems and ‘security alerts’ a constant issue, China and Japan slowing down and the Eurozone refusing to start, all realistic growth forecasts must be coming down. And just in case this wasn’t enough, US companies and consumers will be having to pay more to borrow.

    Like Krugman, I fail to see the logic.

    This has bought short-term peace with the markets, but at what mid-term price. At some moment there will be a correction, as expectations come back into line, not with what Alan Greenspan says he hopes will happen, but with what is actually happening.

    Maybe when we talk about hard and soft landings we shouldn’t be thinking about China after all, but about US consensus expectations.

  10. “You are assuming the Bush administration tells the Fed what to do. I don’t think they do.”

    What I am arguing is that a Republican Administration and Congress should have made sure there was enough fiscal stimulus for an election year speed up of growth sufficient to keep a Republican in the presidency. Not taking a fiscal insurance policy was an absurd mistake brought on by immense arrogance and lack of interest in middle class households. The Fed also raised rates when GHW Bush was trying for another term, so the Fed obviously could not be relied on.

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