Paul Krugman, among many others, has been denouncing the decision by Federal Reserve Board Chairman Ben Bernanke to discuss plans for backing away from the current pace of quantitative easing. While I agree completely with his logic, I am bit less concerned about the downside than he seems to be.
Krugman is certainly right that there is no reason to be talking of tapering right now. We are close to 9 million jobs below the trend level of employment. By the Congressional Budget Office's estimate we are still 6 percentage points below potential GDP, which corresponds to $1 trillion a year in lost output. Furthermore, inflation is low and falling. We would better off if it were somewhat higher since this would lower the real interest rate and reduce debt burdens. In this context, it is difficult to see any upside to talk of tapering.
And Krugman is also right about the market's strong reaction. The interest rate on both 10-year Treasury bonds and 30-year mortgages is up by more than a percentage point from the pre-taper talk levels. That is not helpful for the economy right now.
However, I am also not convinced that it is all that harmful. To my mind, the greatest benefit of low interest rates was the refinancing boom that it allowed. This freed up tens of billions of dollars for consumption. The refinancing process itself also generates economic activity in the form of legal fees, payments for appraisals and other costs (i.e. waste) associated with the refinancing process. Refinancing will quickly slow to a trickle with mortgage rates now over 4.5 percent.
But refinancing was always a self-limiting process. At some point everyone who could profitably refinance a mortgage at 3.5 percent will have done so. We surely must have been reaching this point so that refinancing would have slowed in the second half of 2013 and 2014 with or without the Fed taper.
Higher interest rates will also dampen the rise in housing prices. That is not a bad thing in my view. House prices are back at their trend levels in most parts of the country. In many areas they were growing at ridiculous rates (30-50 percent annually). If that had continued, we would have seen many local bubbles develop. If the rise in rates slows these price increases, that is good news in my book. A new bubble in Las Vegas or Phoenix would not move the national economy, but no one in their right mind could want to see another group of homeowners in these cities caught up again in a bubble, paying 20-30 percent above the trend price for their home.
Perhaps the biggest negative effect of the Fed taper will be its impact on the value of the dollar. The dollar has risen around 5 percent from pre-taper levels against other major currencies. That will make U.S. goods less competitive and increase the trade deficit. Since trade is the fundamental imbalance in the U.S. economy right now, this is exactly the wrong way to go.
Long and short, this was a bad move by the Fed and pushes the economy in the wrong direction, but the impact will probably be limited. Consider the taper a mistake by Bernanke, but I wouldn't suggest he jump off a bridge over this one.