by Jerome a Paris
Sun Aug 7th, 2005 at 06:58:38 PM EST
Why Federal Reserve must raise interest rates (FT)
The writer [Stephen Cecchetti] is professor of international economics and finance, International Business School, Brandeis University
The story starts with the internet boom of the late 1990s. At the time, Fed policymakers concluded that since it was so difficult to identify bubbles as they are inflating, it is best to wait and clean up the mess after the crash. In 2001, that is what they did. The FOMC lowered the short-term interest rate from 6 per cent to 1 per cent.
The predictable result was a housing boom. The value of residential housing in the US is 55 per cent higher today than it was only five years ago. Since household consumption reacts quickly and strongly to increases in property wealth, a recession was nearly averted.
Fed policy replaced the internet bubble with a housing bubble.
Just another bitter guy?
The problem is that equity and property are very different. When stock prices rise, it signals improved future profitability. Faster growth means higher incomes and more resources to devote to current (and future) consumption.
Note this: the Clinton bubble (i.e. the dotcom bubble) came from real wealth creation as new technologies were harnessed. It was a bubble, because out of sheer enthusiasm, too much was invested in what ended up being silly or useless, but still, a lot was invested in businesses that thrived and created new industries, jobs, and wealth.
A pause to clean up the extra investment was needed, and by and large, that's what companies did.
The problem is that consumers were artificially shielded from that adjustment by Greenspan's aggressive interest rate reductions.
Housing is different. We all have to live somewhere. When housing prices rise it does not signal any increase in the quantity of economy-wide output. While someone with a bigger house could move into a smaller one, for each person trading down and taking wealth out of their home, someone is trading up and putting wealth in. A rise in property prices means people are consuming more housing, not that they are wealthier.
That's an important distinction, because it is linked to the next item - these higher housing prices are not caused by increased wealth, they are caused by increased debt, made possible by the lower interest rates.
(...) an increase in housing wealth has about twice the impact on consumption of an equivalent increase in stock market wealth. For the US economy, the $6,500bn increase in housing wealth since 2000 amounts to a $200bn rise in consumption - enough to push GDP up 1.5 per cent and drive the household savings rate to zero.
The $200 billion increase in consumption is very real, and that's what makes the current economy appear sound, but it is is pretty small bang for the buck - one thirtieth of the apparent wealth increase. The problem is that such increase comes at what is also a very real price:
Much of this added consumption has been financed by increased borrowing. This means that as interest rates rise, an increasing portion of household incomes will have to be devoted to repaying the $4,000bn in additional debt incurred during the first half of this decade. Low interest rates have encouraged borrowing from the future. And the more we borrow, the larger the debt and the bigger the adjustment.
With long term rates at 4%, the interest burden on such new debt is only about $160 billion per year. But each 1% increase on the long term rates will cost the US economy $40 billion on that chunk of the debt (and another $50 billion or so on the debt which was previously incurred) per year, or about 1% of GDP in all ...
The most troubling aspect of this is the Fed's reaction. The minutes tell us that the FOMC spent a portion of their June meeting discussing housing, concluding that since there is no way to know if there is a housing bubble, there is nothing to be done. These conclusions bear an eerie resemblance to comments made at the height of the internet bubble in the late 1990s.
Greenspan in denial... Whodda thunk?
But to be fair to him, the Fed has at least been increasing rates for the past year or so (from 1% to 3.25%, with another 0.25% increase expected this week). The problem is that these increases are still too slow, and come from such a low base that the world is now, after several years of incredibly cheap money, awash in dollars. Hence the incredible amounts spent by Americans on imports, the incredible amounts of reserves held by Asian countries, and the desperate attemps by the financial world to invent new (and riskier) products, like CDOs or massive high-yield bonds, that pay just a little bit more than US Treasuries.
There is so much money sloshing around that the long term rates have actually gone down (by about 1% in the past year) even though the Fed has raised the short term rates by more than 2%. That means that markets are either pricing in deflation, a nasty recession, or both (or that they don't listen to Greenspan anymore, i.e. they don't know what to do anymore - invest - with all that money in the real economy, and are simply parking it in the safest place, i.e. the US government, which nevertheless gayly blows that money in the Iraq grinder).
Household spending levels are simply unsustainable and something has to be done. The policy prescription is simple: raise interest rates. Higher interest rates both make borrowing more expensive, reducing household demand, and raise returns on alternative assets for yield-chasing financial institutions.
Following this lead, the FOMC should (1) increase interest rates at the coming meeting; (2) signal that they are far from done; and (3) warn people that the best we can hope for is that housing prices stop rising, but that there is a real risk of collapse.
We are seeing an economy with unprecedented imbalances, and the amazing thing is that there are several very different parameters which are at very unusual levels today, each of which threatens the whole edifice:
- unprecedented levels, both absolute and relative, of debt, both for the private sector and the government;
- unprecedented levels, both absolute and relative, of the trade deficit;
- the starkest increase in commodity prices, starting with oil, in at least a generation, and the prospect of more to come, starting, again, with oil, where we see, for the fisrt time ever, a lack of spare production capacity;
- unprecedented increase in inequality in the US, with the biggest increases in 150 years in the absolute and relative income and wealth of the top 1% of the population.
I know I am beginning to sound like a broken record on this, but we are literally like the coyote over the abyss - still running hard, not having realised yet that they is no ground beneath our feet anymore.