Wednesday, January 19, 2011

Angel Wings, three mumus, sweat pants, and Monetary Policy in 2011

When do you throw the angel wings away? My Dad threw me into Venetian Pool and told me to start swimming or I would sink to the bottom of the pool like a box of two week old Twinkies. Actually the water in the children’s pool at Coral Gables’ most unique swimming hole was only about two feet deep so my Dad wasn’t as callous as my sentence alluded.  Other parents purchased angel wings for their darlings. The angel wings hold the child on top of the water as they learn techniques of swimming – like moving your arms and legs in a manner that keep you on top of the water. They are a great idea. Once the kid masters the basic idea of swimming without fear of drowning, she can dispense with the wings and get on with trying to beat Mark Spitz’s records. The challenge comes with the more timid kids who are never quite sure their parents weren’t hiding in one of Venetian Pool’s dark and romantic caves making out. These kids were reluctant to give up the security of their angel wings and clearly jeopardized their ability to swim the English Channel. Their parents were faced with a dilemma. If we take the wings away our kid will NEVER learn to swim. If we don’t take the wings away our kid will NEVER learn to swim.

Martin Wolf and Ben Bernanke think that we are all reluctant kids who need our binkies or was that angel wings? Anyway M&B have been arguing of late that it is much too soon to start withdrawing monetary stimulus from the US and European economies. So I ask the question – will withdrawing stimulus now prevent us from ever swimming the English Channel? Or for you non-swimmers, will withdrawing monetary stimulus now mean that the economy will not recover? Or….tada…..will not withdrawing now imply the economy will not recover?

I think a clear and public plan to begin to withdraw the monetary stimulus is necessary right now. Waiting is foolish and will cost us. The reason is simple and relates to the angel wing example. Waiting creates self-defeating habits that are VERY difficult to reverse. Worse yet, reversing the policy too late creates unnecessary hardships. Okay – so let me dive into the deep end and splash around a bit. Sorry. I promise to not discuss angel wings one more time. But if you have never seen Venetian Pool in Coral Gables you REALLY have to see it.

M&B are like caring parents for more than 600 million people. They see an economy in the midst of a recovery, albeit one with less than hoped for employment increases. They see the risks surrounding another economic slowdown and do not want to contribute to an even longer and weaker recovery. Who can fault them for that? I guess I can or I wouldn’t be sitting here typing on a perfectly good day. It seems to me that postponing the inevitable puts central banks into a very bad position. Here is why. First, most of us know that the US economy will move closer to full capacity. At that time the Fed and ECB will need to generate more normal interest rates well above 0.25%.

Second, based on M&B’s unwillingness to raise the policy rate and tighten money after 6 quarters into a recovery, this raises the question as to when they will. Saying NO today means they are raising uncertainty for all of us. We know it is going to come but when? That matters to a lot of people.

Third, while we know it is prudent to raise rates at some point, how do we know they won’t raise them after inflation and inflation expectations have already firmed? Is it possible that we could be another 4-6 quarters down the road and still have a higher than desired unemployment rate yet inflation already starting to boil?  Will M&B continue to stall then? What exactly will it take to get them to remove the stimulus?  

Fourth, if inflation gets ingrained and rises above the Fed’s target this will surely cause longer-term interest rates to skyrocket. Even if the Fed stalls for a while longer – long-term rates will rise with or without a tighter Fed policy. This spike in interest rates without policy will be bad for the economy and the unemployment rate. If inflation jumps again and the Fed is finally impelled to reverse engines and raise interest rates—this could cause long-term rates to rise even higher. Remember 1979/80? Ugh.

But M&B promise to withdraw the stimulus right when it is needed. At the perfect moment when the economy is strong enough and inflation has not yet become ingrained in expectations, they will magically start the withdrawal. They want to do it this way to minimize the risk of hurting the economy with tight money. That is one risk. But what I am suggesting is that they are not considering the other side of the risk equation. History shows us that economic and political forces make it very difficult to identify the perfect time and that central banks often wait too late.  There is no such thing as just-in-time monetary policy and arriving too late has been shown to have disastrous effects.

 It is sort of like postponing a diet. You need to start right after Thanksgiving but you wait until after Christmas. Then you postpone to after New Year’s. But that would ruin your enjoyment of the bowl games. Okay – so you finally start the diet after the Super Bowl. At that point you need to lose a ton of weight plus you need to buy three mumus, four sets of sweat pants, and a small tent.  

10 comments:

  1. Of course the Austrians have a different perspective. They fear the boom more than the bust. One reason is at some point you have to deal with the aftermath of buying North of 2.5 trillion dollars of Doritos for the Super Bowl party on top of everything you spent for the New Years blow out, Christmas morn, and the trip to Grand Mothers for Thanksgiving; for like the last 20 years, most of which was on a credit card you still have not paid off.

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  2. Hi Larry, I like your post and can only hope that one day my daughter can spend an afternoon at the Venetian Pool in Coral Gables.

    Here's a simple question from a layman to an economist. I know that lowering interest rates is a benefit to consumers, as it encourages people to borrow and invest in homes, cars, etc. But what benefit is bestowed on central banks (and the economy in general) by raising interest rates?

    Is it a supply-side theory that when banks generate more revenue through lending, the economy will be better off?

    Or is it rather: when interest rates rise, people borrow less (and spend less) with an aim of keeping inflation in check?

    Or is it something else altogether?

    Thanks,
    Kirk

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  3. Dear Kirk,

    While the stubborn behavior of the unemployment rate is our concern, we have done a lot to create more spending and employment with lower interest rates and government stimulus spending. The question for us today and tomorrow is how to make the best progress on unemployment as the economy recovers. History gives us plenty of examples of monetary policy that stayed too long and too late -- and ended up hurting unemployment gains as it engendered higher interest rates and high inflation. It is a subtle and touchy game. Getting it just right is what matters. Right now we are in a situation where too much money waiting in the wings is a growing risk. Supply-side theory has to do with focusing on factors that determine firm's motivations to produce goods and hire workers -- and less to do with demand. Supply-side policy attempts to directly impact the motivations of firms....and less the spending desires of households. I hope that answers your questions. If not, try again!

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  4. Just keep watching the price of a barrel of oil climb and the attending price increase in our food, clothes, Bubblicious, etc., and tell me how any Fed action will stop inflation.

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  5. Crash,

    Good point. Monetary policy is supposed to be a broad macro tool. As such it has nothing to do with food, oil, or the prices of JD. The Fed is supposed to be focused on macro inflation -- a time when the average price of goods and services in rising -- because the prices of many or most goods and services are rising faster than around 2 percent in a sustained way. We have no perfect proxies for macro inflation. Some people use the moving average of the percentage change in the PCE deflator less food and energy.

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  6. Lar – your commentary regarding M&B’s knowing when to rescind $$$ reminds me of investment advisors’ standard recommendation\strategy to “not time the market” – because no one can know. Our fine administration and its economic advisors began clueless – spent $800 T without significant results – and remain clueless. Timothy and Ben (and now Martin?) are confident QE2 will not ignite inflation despite rising prices of gold gold, black gold, commodities, wine, beer, potato chips at my local grocery, screw drivers at Home Depot – and oh yeah, gasoline. Cluelessness abounds aplenty. By the time they et al realize inflation has already consumed our collective lunches we will have been bending over, grasping ankles, and receiving the benefits of their wisdom. Better to focus on cutting federal spending and the debt – and reign in excess $$$. Now that Jeff Immelt will be jump starting jobs we won’t have to worry about excess $$$ needed for job creation. Let QE2 die a dignified death.

    RE: the Venetian Pool. You didn’t mention the “times well spent” in its caves.

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  7. Charlie,

    I did infer a little something when I discussed Mom and Dad in the caves making out! I have a feeling that Congress and the Fed are going to arrive on the scene a little too late. Even the attention to government debt is starting to wane. Little will be done to attend to the excess stimulus until after the bond vigilantes have their claws firmly implanted in our necks. Remember when Nixon put in Wage and Price Controls? Even after the vigilantes are after us, I fear that our goofy leaders will try to resort to some novel (=stupid) approach rather than turn off the appropriate spigots of spending. I would sell my US assets and buy others if I only knew of a country that had some decent leaders....

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  8. Larry,
    How 'bout you, Charlie, and me go form our own country. I'll be president, and you two can fight it out for what ever is left. I know of a small, semi-dry island in the middle of the Okefenokee.

    The big news from the impending State of the Onion address...other than everybody making kissy face...is a call for more stimuli from the feds. Wow! I thought the definition of insanity was to keep doing the same thing over and over even though it didn't work before. Hasn't anybody learned that Keynes is dead...in more ways than one?

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  9. Crash,

    Sounds like fun -- if possible I would like to be Secretary of Moonshine.

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  10. http://www.heritage.org/Research/Reports/2005/03/The-Impact-of-Government-Spending-on-Economic-Growth

    An excellent paper for old and mentally infirm geezers...like me.

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