February 28, 2016
Neil Irwin had an interesting piece on the Federal Reserve Board’s interest rate policy and its relationship to the stock market. The piece essentially argues that if the Fed were to make its interest rate decision based on economic data that it would hike rates at its next meeting. By contrast if it bases its decision on the stock market, it will leave rates where they are. It also argues that the Fed had acted to prop up the stock market in the 1997 following the East Asian financial crisis.
This is interesting analysis but there are some additional pieces that needed to be added to this puzzle. First, it is far from clear that the stock market was the main concern when Greenspan cut rates in 1997. There was a massive outflow of capital from developing countries following the East Asian financial crisis in the summer of that year.
At that time, many countries in the developing world had fixed their exchange rate to the dollar, as did Russia. This outflow of capital made it difficult for them to maintain the value of their currency. A reduction in interest rates by the Fed helped to alleviate some of the pressure on these currencies. (It didn’t work; most of them eventually devalued their currency against the dollar.)
Greenspan was also concerned about a stock bubble since the summer of 1996. (We know this from Fed minutes.) He decided not to act against the bubble, deciding it would be best to just let the bubble run its course. The recession that resulted from its eventual collapse in 2000–2002 gave us the longest period without net job growth since the Great Depression, at least until the 2008 recession.
Anyhow, while it is clear that Greenspan didn’t act against a stock bubble, it is a bit stronger claim to assert that he deliberately propped it up. It is also worth noting both that the price to trend earnings ratios were far higher in the 1990s (peaking at over 30 to 1) than what we are seeing at present. Furthermore, this was in a much higher interest rate environment, with interest rates on Treasury bonds in the 5.0–6.0 percent range, as opposed to 2.0 percent today. In other words, there was a clear case for a bubble in the late 1990s, which is not true today.
The other part of the analysis that is questionable is that the economic data point to a need to raise interest rates. Inflation by almost all measures remains well below the Fed’s 2.0 percent target. And, since the Fed has consistently undershot its target for the last six years it should be prepared to allow the inflation rate to rise somewhat above 2.0 percent for a period of time. (The modest uptick in core inflation is largely due to higher rents, the core CPI excluding shelter increased just 1.5 percent over the last 12 months.) On the wage side, while some measures show a slight acceleration in nominal wage growth, the Employment Cost Index shows a modest deceleration.
Other data show at best a mixed picture. GDP grew at just a 1.0 percent annual rate in the 4th quarter. The nominal value of new orders for capital goods is down by 0.5 percent from its year ago level (the drop is 4.4 percent if we exclude volatile airplane orders.) The trade deficit has been rising rapidly. Recent data on home sales and housing starts show a sharp drop. (These data are highly erratic.) Over the last three months consumption has grown at a 2.4 percent annual rate compared with the prior three months. This is a respectable pace, but not enough to sustain healthy growth in an economy with stagnant investment and rising trade deficit. Also, recent drops in consumer confidence (the current conditions measure) raise the prospect that consumption growth might slow in the months ahead.
In short, the economic data provide a pretty good case for leaving interest rates where they are or possibly even lowering them. After all, if there are no realistic fears of inflation, why shouldn’t the Fed put its foot on the accelerator? Millions of people will be denied jobs if the Fed unnecessarily restrains the economy.
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