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April 27, 2005
Roach To Fed: J'Accuse! (II)
Stephen Roach continues:
I am not a believer in conspiracy theories. But the Fed’s behavior since the late 1990s is starting to change my mind. It all began with Alan Greenspan’s worries over “irrational exuberance” on December 5, 1996, when a surging Dow Jones Industrial Average closed at 6437. The subsequent Fed tightening in March 1997 was aimed not only at the asset bubble itself, but at the impacts such excessive appreciation in equity markets were having on the real economy -- consumers and businesses alike. It was a classic example of the Fed playing the role of the tough guy... Unfortunately, the tough guys weren’t so tough after all. Predictably, there was a huge outcry on Capitol Hill as the Fed took aim on the US stock market. But rather than stay the course as an independent central bank should, the Fed ran for cover in the face of political criticism...
Do you think maybe, just maybe, the fact that CPI inflation was actually falling throughout 1997 might have had something to do with it? Or that perhaps the Asian currency crisis that began in summer 1997, continuing into summer 1998, followed by the collapse of the Russian ruble, the Long-Term Capital Management meltdown, and the collapse of the Brazilian real might have played some role in the course of policy over that period?
The Committee certainly did. From the minutes of September 30, 1997 FOMC meeting:
... the risks to the economy appeared to be strongly tilted toward rising inflation whose emergence would in turn threaten the sustainability of the expansion. Several members emphasized in this regard that a tightening move could be most effective if it were implemented preemptively, before inflation had time to gather upward momentum and become embedded in financial asset prices and in business and consumer decisionmaking.
There were, nonetheless, a number of reasons for delaying a tightening of policy. The behavior of inflation had been unexpectedly benign for an extended period of time for reasons that were not fully understood. Forecasts of an upturn in inflation were therefore subject to a considerable degree of uncertainty, and the expansion of economic activity could still slow to a noninflationary pace. Members also commented that a policy tightening was not anticipated at this time and such an action might therefore have unintended adverse effects on financial markets. Members recognized that from the standpoint of the level of real short-term interest rates, monetary policy could already be deemed to be fairly restrictive.
By the next meeting, the Asian crisis was making its presence felt:
The current momentum of the expansion, together with broadly supportive financial conditions and favorable business and consumer sentiment, suggested that economic growth was likely to be well maintained, especially over the nearer term. As a consequence, the members agreed that there remained a clear risk of additional pressures on already tight resources and ultimately on prices that could well need to be curbed by tighter monetary policy. But the members also focused on two important influences that were injecting new uncertainties into this outlook. Turmoil in Asian financial markets and economies would tend to damp output and prices in the United States. To date, it appeared that the effects on the U.S. economy would be quite limited, but the ultimate extent of the adjustment in Asia was unknown, as was its spillover to global financial markets and to the economies of nations that were important U.S. trading partners.
By the July 1998 FOMC meeting, the Asian crisis was an explicit driver of the Committee's interest-rate decision:
[An] important reason for deferring any policy action was that a tightening move would involve the risk of outsized reactions and consequent destabilizing effects on financial markets in the growing number of countries abroad that were experiencing severe financial difficulties. It was not possible to anticipate precisely what those effects might be, but the risks seemed to be particularly high at this time. To be sure, U.S. monetary policy had to be set ultimately on the basis of the needs of the U.S. economy, but recognition had to be given to the feedback of developments abroad on the domestic economy. Those repercussions could be quite severe in the event of further sizable economic and financial disturbances in some of the nation's important trading partners. Many members concluded that because there did not seem to be any urgency to tighten current policy for domestic reasons, given the likelihood that inflation would remain subdued for a while, important weight should be given to potential reactions abroad.
As we now know, things did not soon improve, and the next moves would be to cut the funds rate (ironically just at the time that the benign inflation performance we had been enjoying was coming to an end).
Is it that unreasonable to accept that the FOMC might have been inclined to forgo raising the funds rate in 1997 because the 12-month CPI inflation was falling (from over 3% to under 2%)? Would Mr. Roach have us believe that restraining the supply of the world's reserve currency would have been the correct response to severe distress in global financial markets? Should a reasonable person attach him or herself to Oliver-Stonesque conspiracy theories instead of the straightforward explanations of the actual decisionmakers?
Yet more to come.
P.S. for the economists: Plug the inflation rate and almost any reasonable assumption of the output gap in 1997 into your favorite version of the Taylor rule. I think you'll find that, by this measure, monetary policy does not appear to be particularly "easy."
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