Thursday, July 22, 2004

Monetary Policy: "Greenspeak"

As everyone and their grandmother now knows, Greenspan has testified to Congress. What a slippery fish he is! He seems to be wanting to have it both ways, warning the market about raising interest rates but suggesting that the economy is strong even though the recent data was fairly negative. He just may end up holding on to nothing. (NYT)

Alan Greenspan, chairman of the Federal Reserve, said on Tuesday that the economic expansion appears to be "self-sustaining," and warned that interest rates could rise more swiftly if inflation turns out to be worse than he expects.

"We cannot be certain that this benign environment will persist and that there are not more deep-seated forces emerging as a consequence of prolonged monetary accommodation," Mr. Greenspan told the Senate Banking Committee. [emphasis added]

Translation: I know we shoved a whole lot of money out the door, and it's all got to go somewhere. I understand that this is going to create either a dollar crash with a debt crisis, a monetized inflation surge, or a split somewhere with some pain in both the dollar dropping and monetized inflation. We let it go too long and now somebody's got to pay.
In a carefully hedged presentation, Mr. Greenspan veered little from the Fed's basic message when it raised interest rates on June 30 and said in a statement that it hoped to keep raising them at a "measured" pace over the next year.

But Mr. Greenspan dashed hopes of those on Wall Street who thought the Fed might proceed to raise interest rates more slowly in response to evidence that has emerged recently that consumer price increases moderated in June and economic growth appears to have cooled in the last two months.

If anything, he stepped up his warning about the uncertainties that surround both the outlook for growth and inflation.

"If economic developments are such that monetary policy neutrality can be restored at a measured pace, a relatively smooth adjustment of businesses and households to a more typical level of interest rates seems likely," Mr. Greenspan said.[emphasis added]

Translation:I reserve the right to jack up interest rates quickly. However I'm really hoping that all of you will get the hint, and act so that I don't have to pull that trigger. Unfortunately you idiots think that I'm not going to pull the trigger, and are going back to over-exposed carry trades.
He also refused to be pinned down on what is in many ways the most basic question: What constitutes a "neutral" interest rate that neither provokes inflation nor slows down the economy?

Many economists have suggested that a "neutral" fed funds rate - the rate charged on overnight loans between banks and the key policy tool the Fed relies on to guide the economy - is 4 percent to 5 percent. That would be a big increase from today's level of 1.25 percent.

Like the famous description of pornography from Supreme Court Justice Potter Stewart, Mr. Greenspan said people would know the rate when it arrived.

"You can tell whether you're below or above, but until you're there, you're not quite sure you are there," he said. "And we know at this stage, at one and a quarter percent federal funds rate, that we are below neutral. When we arrive at neutral, we will know it."[emphasis added]

Translation: I know from all economic theory and history that my rates are way too low. However because I think of myself as God even though I'm an appointed and not an elected official, I thought I could sidestep the political policy apparatus and save the entire country by providing enough credit for the private sector to restructure itself. I really hope that all you idiots didn't spend it all on a binge of speculation and asset-stripping.

Is the oldman's critique of Greenspan too harsh? Consider as an alternative viewpoint, The Economist:
What is beyond doubt is that interest rates have been unnaturally low for an unusual length of time. Some fear that Mr Greenspan’s “accommodative” monetary policy has given households too much room to acquire debt. Now that rates are rising, households that have overstretched themselves may begin to feel the strain. Mr Greenspan disagrees. Far from tempting Americans to spend recklessly, low interest rates have helped them improve their balance sheets, he says. Even as they acquire new debt, they have shifted old debt to longer, cheaper rates. In the space of a year, between mid-2002 and mid-2003, homeowners refinanced almost half of their outstanding mortgage debt at more favourable rates, he points out.

If monetary tightening proceeds at the “measured pace” Mr Greenspan deems likely, he expects businesses and households to cope admirably. Financial strain will be confined to “individual instances”. Capital losses, particularly on bonds, will fall primarily on financial institutions that are well capitalised and well prepared.

The question whether American households have acquired too much consumer debt is a question which I will be addressing in another post, but for now suffice it to say based on overall household obligation numbers that I think the honored Chairman of the FOMC to be very much wrong. I understand that for the sake of the economy he hopes it is otherwise, but the matter of the fact is that every succesful intervention has only put off and worsened rather than resolved the day of reckoning. By preventing true market pricing corrections in the past, the Federal Reserve system has allowed an inflated and untenable balance sheet for the American economy. The results have been diffused, shifted, and delayed but they have not been disappated.

What the oldman divines from the "Greenspeak" is something quite potentially disasterous. Greenspan is signalling that he is ready to proceed with interest rate hikes. His reasoning for this is that despite his poo-pooing otherwise, he understands that the inflationary forces in commodities and money supply are not temporary.

What about Greenspan's argument that the past few years have allowed households to refinance their debts and put themselves in a better position? It has some merit. If we look at these three charts: the household debt service ratio (of disposible personal income), the household financial obligation ratio (of disposible personal income), and the renter financial obligation ratio (of disposible personal income) we can see some things right away (Economagic series).

The first thing that we can see is that it is indeed true that the past few years of lower interest rates has stabilized the debt service ratio of disposible personal income for households. It has stabilized at about 13% or about 1% more than the long term average. However more starkly the total financial obligation of households is stabilized at 31%, a stark contrast to the early nineties when the ratio was less than 25%. So as a percentage of disposible income, households are weighed down more heavily than they were 15 years ago. The fact that this hasn't been some sort of inevitable trend can be seen by examining the renter financial obligation ratio. It has remained more or less steady at about 15.50% with some oscillations about the long term rate.

What we can conclude from this is that households are significantly more debt burdened than they were a decade ago, and that the flatness of the debt service ratio of disposible personal income has not prevented the steepness of that climb toward more debt. So lower interest rates have not repaired the balance sheets of households. While they don't have cash flow problems thanks to the flatness of the debt service curve, they certainly have taken on more financial obligations by a significant degree. That these obligations are associated with being a property owner can be be shown because the renter financial obligation ratio to disposible personal income has remained almost flat with some oscillations about the long term trend rate.

Another interesting conclusion is that the American public did not generally use the period of low interest rates in order to repair their balance sheets. Instead they maintained essentially the same debt service levels and only paid off some of their debts. The overall financial obligations outstanding only declined a small amount from its peak, from 33% to 31%, hardly a massive repairing of balance sheets that Greenspan claimed. This is the traditional definition of moral hazard btw. Sometimes by giving people a break, they just use it to dig themselves into a deeper pit.

I'm afraid that these numbers do not support Greenspan's argument. With a rise in short term interest rates, we could expect households to have to pay more debt service and their higher rates than the past financial obligation ratio is bound to make such higher interest rates more painful. Whether or not that is a systemic risk remains to be seen, but certainly it is a systematic risk. The pain will be broad and widespread, and no amount of disingenuous by Greenspan can wish that away.


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