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April 27, 2005
Roach To Fed: J'Accuse! (III)
The Roach saga continues:
This whole story, in my view, remains balanced on the head of a pin of absurdly low real interest rates. And the Fed has certainly been pivotal in nurturing this low-interest-rate regime. In an extraordinary display of policy accommodation, the real federal funds rate is only now moving above the zero threshold after having spent three years in negative territory. Of course, a central bank has little choice to do otherwise if it has made a conscious decision to underwrite the Asset Economy.
In my view, Mr. Roach is making a classic mistake: Confusing a low federal funds rate with "an extraordinary display of policy accommodation." If I may, I will quote from myself:
A “neutral” monetary policy—one that avoids both inflationary and disinflationary pressures (as well as both artificial stimulus and unwarranted restraint on the pace of real economic activity)—requires that the funds rate target adjust to the evolving demand in credit markets as consumption, investment, and employment expand in anticipation of continued growth...
How far, and how fast, must the funds rate rise? What is neutral? It should be clear from this discussion that the answer is wholly dependent on economic developments well outside the scope of monetary policy. “Neutral” can only be defined relative to the state of the economy at a particular point in time. The economy of mid-2000 through mid-2003, characterized by distinct weakness in investment spending and employment growth, inevitably meant low real interest rates. Neutral in that situation meant a low—perhaps very low—funds rate to contain disinflationary pressures building in the economy.
Now, as the economy strengthens and investment and employment growth recover, the neutral setting of the funds rate is moving up. The distance it will go depends on myriad factors, most (if not all) of which will only be revealed in time (perhaps at a measured pace).
The suggestion that the low interest rates we have lived with over the past several years is proof of exceptionally stimulative policy is flat-out wrong. A corollary, of course, is that it is not generally possible to put a number on what "restrictive" is at any point in time. Hence, Roach predicts...
Given the excesses that now exist, it may even require a federal funds rate that needs to move into the restrictive zone -- possibly as high as 5.5%.
... and I, for one, would accept the proposition that 5.5% would be restrictive in the current environment. But I might also accept the proposition that something quite a bit lower than 5.5% would be restrictive. Or that if and when we get there, 5.5% will not be restrictive at all. After all, the funds rate was at 5.5% in the summer of 1997 when, according to Roach view of the world, policy was fueling the stock market bubble.
One more to go.
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