Short-Run Actions Have Consequences
In the spring of 2003 there was worldwide concern that the U.S. economy was falling into a “Japanese-like” malaise; the recovery was stalling, deflation was likely to occur and unemployment was too high. This was the prevailing view despite the fact that the U.S. economy was growing at a 3.2 percent annual rate and the global economy’s average growth was nearly 3.6 percent. In addition, the fed funds policy rate was 1 ¼ percent. Although most knew that such a low rate would support an expanding economy, in June 2003 it was lowered further to 1 percent and was left at that rate for nearly a year, as insurance.
Following this action, the United States and the world began an extended credit expansion and housing boom. From July 2003 to July 2006, the monetary base in the United States increased at an average annual rate of 4.9 percent, credit increased at an annual rate of 9 percent, and housing prices increased at an annual rate of about 14 percent. The long-term consequences of that policy are now well known. The United States and the world have just suffered one of the worst recessions in decades.
The crisis has sometimes been described as a “perfect storm” of unfortunate events that somehow came together and systematically undermined the financial system. Such events included, for example, weak supervision and a misguided national housing policy. While these factors certainly contributed to the severity of the crisis, monetary policy cannot escape its role as a primary contributing factor.
-Thomas Hoenig, 30 Mar 2011, London School of Economics
This is about as direct a condemnation of the Fed’s easy money policies as you are likely to see from a senior Fed official. Hoenig is saying that the financial crisis has been avoidable. "Weak supervision and a misguided national housing policy" are not the only causes of the financial crisis. So too is monetary policy.
Here’s how I put it in March 2008, six months before the panic:
The global economy outperformed our wildest expectations on all counts during the late 1990s. We did experience a shallow recession in 2001. But, since 2003, we have been in full recovery. The Fed’s attempt to reflate the economy after the Tech Bubble by reducing the Fed Funds rate to 1% was successful beyond our wildest dreams. However, this aggressive policy never allowed the inherent disequilibria in the 1990s macro economy to dissipate. As a result, we have what appears to be an ‘echo’ bubble in housing which has just popped. As asset price inflation has been the major factor holding up the economy, this does not portend well for sustained robust economic growth in 2008.
The asset bubble of the late 1990s was one of the largest in history. Rather than allow this bubble to fully unwind, the Greenspan Fed created more asset bubbles, especially in housing, leveraged finance, private equity and asset-backed securities. It is possible that the U.S. will escape with a garden-variety downturn, but, in the face of one of the largest asset bubbles of all time, this is unlikely. In the end, a margin squeeze from high energy prices or a dollar shock could be crucial factors tipping us into a downturn. However, ultimately these factors will be merely the catalysts; the true cause of the expected malaise in 2008 lies in the imbalances in an asset-driven economy.
This downside scenario was not predestined. Unfortunately, crucial policy errors by the U.S. Federal Reserve all along the way have had led us to a ‘point of no return.’ The global economy, now supported in the main only by the overextended U.S. consumer, finds itself at stall speed, susceptible to any number of potential exogenous shocks. Ultimately, the economic malaise created by this confluence of events will take years to unwind. A positive outcome to this process is dependent wholly on liquidation of excess credit and consumption.
It’s good to see this view validated by the Fed. Let me add a few comments.
Low rates didn’t put a floor on risk assets during the panic, obviously. Right now, that’s what the Fed is worried about – asset price declines and the associated debt deflation. They have done all they can to support the housing market – to no avail. The price declines will continue. But other asset prices have responded to easy money. The Fed will want to see that their ending QE2 will not precipitate some sort of asset price decline and economic weakness that leads to a recession because if the U.S. did get another recession, then risk assets would not have a floor.
Therefore, the Fed will not want to make a hasty exit from QE2. I think they will see it out through June and then pause. My sense from the totality of Fed communications – from both hawks and doves – is that they will stick to their original timetable and then pause. At that point they have to decide whether to mop up the excess reserves. If the economy is OK, they will start to sell Treasuries. If the economy is too fragile they will simply do nothing and wait. If the economy really sucks, the QE3 speculation can begin. The timetable depends entirely on the economy, of course. And Bernanke has said so. Bottom line: we are a long way away from either QE3 or raising rates. Over the near term, it’s a question of what to do after QE2 is over.
Hawks like Bullard, and now Hoenig, are saying the Fed should cut QE2 short in order to anchor the discussion. That’s significant. If Bullard is saying they should stop QE2, let alone not do QE3, that is going to get everyone talking about whether QE2 will meet an untimely demise. Personally, I think that’s the goal because it makes QE3 a non-starter right now. Basically, the QE2 trade is officially over and people are now thinking about its end. In a sense, that’s a good thing because it can help determine how markets behave without QE as a backstop. As you can tell from my comments above, I think low rates and QE are distortionary and will have negative consequences down the line (see my post on how quantitative easing really works).
But, Hoenig and Bullard are not in control. The centrists and doves are in control of the FOMC. Bullard is anchoring discussion but that won’t change Fed policy in my view. I do think rates will be low for an extended period. So I don’t see Hoenig’s comments or his retirement as a big deal in terms of policy.
The full speech is embedded below.