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April 21, 2005

Landings, Hard and Soft: Part 3

Finally, we come to Brad Setser's take.  Actually, Brad and I have shared thoughts on this for a while now, and I have no quarrel with his opinion that the current situation is unsustainable.  So rather than repeat myself, I'll relay these thoughts from a speech given this morning by Sandra Pianalto, president of the Cleveland Fed. 

First, on the issue of fiscal deficits, yes, we take them seriously.

Let me turn now to the issue of whether large budget deficits may undermine central banks' success in maintaining low and stable inflation rates...

The current level of budget deficits certainly understates the magnitude of fiscal pressures. Both the United States and Europe face demographic changes where we see entitlement liabilities growing faster than the tax base available to support them. While these issues are not new, they are serious and should be addressed sooner rather than later...

That said,

However, there is no need for deficits to be inflationary.  The prospect of inflation arises only if the central bank ignores or, even worse, tries to resist any rise in real interest rates.  By doing so, the central bank would keep its policy rates too low and inadvertently ease monetary policy.   Of course, the real risk of an excessively stimulative monetary policy is that inflation expectations may eventually become unanchored.  History shows that once inflation expectations become unstable, more stringent policy actions might be required.

A central-bank commitment to price stability can avoid that outcome.  A central bank cannot always offset the effects of government deficits on economic growth and stability.  But the more credible the central bank's commitment to price stability, the less likely it is that an inflation premium will be built into market interest rates, and the less likely it is that rising inflation expectations will distort economic decisions.

And about those external balances?

Now I would like to discuss how monetary policy can best contribute to resolving the challenges brought by external account imbalances.  Substantial current account deficits developed in the 1980s, and these deficits now stand at record postwar levels as a share of GDP.  I think everyone agrees that these levels are unsustainable, and that a reversal is inevitable, even if the timing and pace of the adjustment are uncertain.

Some people envision a soft landing.  As we all know, a return to current account balance will ultimately require that U.S. households consume less and save more of their incomes.  Households could become concerned about having enough money for future consumption and step up their saving, even at today's interest rates.  The more commonly expected scenario, though, is that foreign savings coming into the United States could become less plentiful over time, driving up interest rates.  Then, households might be induced to save more and spend less.

If a substantial turnaround in U.S. current account deficits results in higher equilibrium real interest rates, the FOMC would most likely need to adjust its federal funds rate target accordingly to prevent a change in its policy stance.  It is also possible that a decline in the exchange value of the dollar could result in temporary upward pressure on the price level, due to rising import prices and the prices of import-competing goods.  The first responsibility of the central bank is to ensure that these price pressures do not feed into higher inflation expectations in the long run.  Once again, a clear commitment to price stability - in words and deeds - is the best contribution the central bank can make to the adjustment process toward more sustainable external account positions.

The soft-landing point of view is really just the expectation that the process of adjustment will be a smooth one. I believe that a gradual and orderly transition toward smaller current account deficits is the probable outcome.

What should the central bank be doing today?  Glad you asked.

How, then, should monetary policy deal with current account imbalances today?  I do not think that the FOMC should take preemptive measures to address these imbalances.  However, I do think that the Committee should continue to bring the federal funds rate target to a level that is consistent with maintaining price stability in the long run.  If we achieve that, then we will be in a position of strength to address whatever challenges arise.

Would you be surprised to hear that I completely agree?

UPDATE: Brad DeLong, Mark Thoma, the Prudent Investor, and William Polley take note (here, herehere, and here) of Chairman Greenspan's dissastisfaction with the current fiscal outlook, and his call to bring back the Budget Enforcement Act.

UPDATE 2: Concerning the Chairman's testimony, Max is not impressed.

April 21, 2005 in Federal Reserve and Monetary Policy , Trade Deficit | Permalink


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» Policy thought for the day from William J. Polley
Given all the talk about soft landings as well as Greenspan's dire warning on the deficit today, I thought this would be a good way to sum up my thoughts at the moment. Thanks to David Altig for the link.... [Read More]

Tracked on Apr 21, 2005 4:52:22 PM


>> "I think everyone agrees that these levels are unsustainable, and that a reversal is inevitable, even if the timing and pace of the adjustment are uncertain. "

I'd be interested in your thoughts on Bear Stearns' David Malpass's comments. He appears to be of the opinion that not "everyone agrees". From the WSJ a few weeks ago:

>> "With each hike in interest rates, those predicting a bad ending to the 40-month U.S. expansion look expectantly for consumer spending to flag. One of their main worries is the premise that we will run out of savings, especially if foreigners pull the plug or asset prices fall. The reality is that the U.S. has the world's biggest accumulation of savings and investments. The U.S. household sector, the world's largest net creditor, is favorably positioned for higher rates due to large liquid assets and the generally fixed-rate U.S. mortgage structure.

Of course, more saving would be better especially for those who haven't been able to save, and a reduction in the tax distortions that penalize liquid savings while favoring real estate would add to our growth prospects. However, the bigger harm is not that we expose ourselves to a collapse, but that we allow ourselves and foreigners to underestimate, even mock, our economic system. We apologize for our "low savings rate" and "dependence on foreigners," turn our foreign economic policy over to the International Monetary Fund's economic gurus, and contemplate consumption tax increases, forced saving, protectionism, and a weaker dollar (with the consequent increase in inflation). Instead, while working hard to improve our system, we should encourage others to emulate its freedom, flexibility and prosperity.

* * *
Not only are we not running out of household savings, it is growing fast both in terms of the annual additions and the cumulative buildup of American-owned savings. Household net worth, one good measure of savings, reached $48.5 trillion in 2004. Time deposits and savings accounts alone total a staggering $4.3 trillion, versus slow-growing credit-card debt of $800 billion. True, the U.S. is the world's biggest debtor, but it is building assets faster than debt. Even if household assets took a hard fall, the remaining net worth would still dwarf other countries'. On a per capita basis, counting mortgages but not houses, net financial assets total $89,800 in the U.S. versus $76,900 in No. 2 saver, Japan. Of course, some households don't have nearly this average, creating risks for them and burdens on others in the event of a downturn. This is an appropriate policy concern, but the macroeconomic issue is aggregate savings, of which the U.S. has an abundance. "

Posted by: mike | April 21, 2005 at 04:59 PM

Thanks for these posts. The last paragraph of her remarks is notable. It's good to keep reminding ourselves that anchored expectations are a primary role of policy today. And thanks for echoing the point in Hard landings I that underlying real rates must be allowed to vary with real shocks.

Speaking of Fed presidents, I've been reading the Fed publications widely since I first started blogging around six weeks ago (I'd never even read one before then), and I've been very impressed with the statements coming from the various bank presidents. Slight quarrels here and there, but they clearly get it.

If anyone is interested in infaltion targeting and transparancy and what that means, I read a very nice piece last night (and plan to post it in the near future) from Jeffrey Lacker at from the FRB Richmond. See http://www.rich.frb.org/news_and_speeches/presidents_speeches/index.cfm/id=70.

Posted by: Mark Thoma | April 21, 2005 at 05:18 PM

On the well-proven theory that the share markets anticipate the economic future with a 12 to 18 month headlead, the hard times are only coming. right now I am taking a look at the longterm budget proposals. initial impression: show me the savings!!!! a nice piece of good weather propaganda from the OMB (budget 5 million $ and not rising) is here
but the longer term outlook is based on unrealistic assumptions. will make a piece of weekend reading of the funny numbers, if it weren't for the serious implications for the US and the rest of the world.
BTW: how much is one billion dollars? 8.2 hours at the current rate the administration is spending it! (joke stolen from the web)

Posted by: Toni Straka | April 22, 2005 at 12:47 PM

>> On the well-proven theory that the share markets anticipate the economic future with a 12 to 18 month headlead, the hard times are only coming. <<

You're absolutely right. The markets have predicted 10 of the last 3 recessions!

Posted by: mike | April 22, 2005 at 03:38 PM

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