TCS Daily

Can Greenspan Steer?

By Arnold Kling - August 26, 2002 12:00 AM

At the beach where we vacation every summer, my daughters like to ride the bumper cars at an amusement park called Funland. One thing I notice is how weak is the link between the steering wheel and the direction of the car. Often, it seems that while the girls are spinning the wheel frenetically, the change in heading that they purchase is slight.

This flimsy steering mechanism strikes me as an apt metaphor for monetary policy. Federal Reserve Chairman Alan Greenspan can spin his steering wheel (the Federal Funds rate), but the correlation between those actions and the direction of interest rates in general is weak and inconsistent.

Consider which of the following statements best characterizes the recent trend in interest rates.

(a) Interest rates have been unchanged since December of 2001, the last time the Federal Reserve cut its key rate.

(b) Interest rates have fallen sharply in the past three months and are significantly below last December's levels.

As any consumer with a mortgage or any corporate treasurer managing her company's debt knows, the correct answer is (b). Only people who are fixated on Greenspan and the Fed would answer (a).

Economists Paul Krugman and Brad DeLong are Fed-fixated. In a recent New York Times column, Krugman wrote that,

"The U.S. economy's 'potential output' - what it could produce at full employment - has lately been growing at about 3.5 percent per year, thanks to the productivity surge that began in the mid-1990s. But according to the revised figures released a couple of weeks ago, actual growth has fallen short of potential for seven of the last eight quarters... And yet the Fed chose not to cut rates on Tuesday. Why?"

DeLong, writing in the Financial Times, agreed that.

"the Federal Reserve's failure to cut interest rates so far this spring and summer is very puzzling. If 1.75 percent was the appropriate interest rate last winter, when stock indices were 20 percent higher than they are today, it is hard to see how 1.75 percent can be the appropriate interest rate today. If 1.75 percent was the appropriate interest rate last winter, before the shock of revelations about corporate accounting began to drive a larger wedge of uncertain size between the terms on which the government can borrow and the terms on which private businesses can raise capital, than 1.75 percent is unlikely to be the appropriate interest rate today."

Output Gap

Krugman and DeLong make an important point that is not widely understood, which is that economic performance should be measured relative to potential growth. There is an unfortunate tendency, in the press and even among professional economists, to write as if the benchmark for economic growth is zero. This means that only negative growth constitutes a recession, and it implies that growth of one or two percent per year is acceptable.

Given Krugman's estimate that potential GDP is increasing at a rate of 3.5 percent per year, any shortfall relative to that in economic growth represents under-performance. What DeLong and Krugman recommend using as an indicator is the output gap, the difference between actual and potential GDP. According to DeLong, that measure currently stands at four percent.

It is particularly important to set the correct growth benchmark in an economy where potential output has been super-charged by Moore's Law. Because of Moore's Law, DeLong forecasts accelerated growth in productivity. That means that Krugman's estimate of 3.5 percent annual growth in potential GDP may be conservative.

Taking into account the effect of Moore's Law on potential growth, actual economic performance in the past two years has been dismal. Krugman's admonishment to "mind the gap" is well founded. To close the gap in one year, the economy would have to grow by 7.5 percent (3.5 percent potential growth plus 4 percent to close the gap). We certainly should not settle for growth of 2 or 3 percent when Moore's Law is in effect.

Who Needs the Fed?

With the economy slumping, DeLong and Krugman say that we need the Fed to lower interest rates. Where their argument loses force is when we examine what is happening in the bond markets. We already have lower interest rates!

As DeLong's Macroeconomics textbook says (p. 271), "The interest rate that is relevant for determining investment spending is a long-term interest rate." The ten-year Treasury rate, which rose to 5.21 percent in April and 5.16 percent in May, has fallen below 4.30 percent recently. This is a dramatic decline, which among other things has fueled a drop in mortgage interest rates.

The drop in long-term rates does not reflect fears of deflation. In fact, Morgan Stanley's Richard Berner and David Greenlaw see little change in the market's expectations for inflation. They point out that "The yield on the 3% 10-year TIP [Treasury security indexed for inflation] that was auctioned a month ago has fallen sharply, by 50 basis points, or roughly the same decline as that in comparable 10-year notes."

Since May, the real or inflation-adjusted interest rate, as measured by the yield on TIPs, has fallen from over 3.5 percent to 3 percent. The long-term real interest rate has declined by 20 percent!

One of DeLong's concerns is that the drop in Treasuries could simply reflect a flight from corporate bonds into safer securities. In that case, the drop in Treasury yields would not be matched by a reduction in private-sector borrowing costs. However, corporate bond rates also have declined. The average interest rate on Corporate bonds rated Baa by Moody's has fallen from 8.09 percent in May to 7.52 percent recently.

In short, looking at the unchanged Federal Funds rate gives a false picture of how interest rates have behaved recently. While Greenspan and company stood pat, the bond market dramatically lowered the cost of borrowing in the ways that matter most to consumers and businesses.

Bond Market Vigilantes

Over a decade ago, Wall Street economist Edward Yardeni coined the term "bond market vigilantes" to describe the phenomenon of private investors exercising interest rate policy independently of the Fed. At the time, he noted a tendency for long-term interest rates to rise whenever investors caught a whiff of inflation, regardless of what the Fed might have been doing at the time.

When the Fed last cut interest rates, in December of 2001, the bond market vigilantes were not buying it. The ten-year rate actually was higher in December and January than it was in November. The bond market vigilantes were implicated in April when the ten-year rate rose again.

Thus, the verdict on last December's rate cut would be that it was ineffectual. On the other hand, this summer, key interest rates plunged without any action on the part of the Fed. The Fed's ability to steer interest rates is looking a lot like a child's ability to steer the bumper cars at Funland.

In our large, sophisticated financial markets, the Fed is only one player, and its significance may be less than is commonly assumed. Even if they spun their steering wheel much harder, it is doubtful that they could get market rates to turn any more in the desired direction.



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