Memo To: Fed Governors
From: Jude Wanniski
Re: Just Be Patient
Yes, practically every Fed watcher in Creation predicts that you will vote tomorrow to raise the federal funds rate by a quarter point, to 1.25% from 1%, where you have kept it for the last year. The argument on why you will do this is you had to bring the overnight rate to its lowest point in 56 years in order to get the economy out of its deflationary funk, and now that it is growing you have to raise the rate to keep the economy from growing too fast. All the major newspapers have endorsed a rate hike and President Bush has indicated he has no objections, but there are a few of us still around who believe economic growth in itself will snuff out any inflationary impulses that may be in the air, and slower economic growth fostered by higher interest rates may have the opposite effect. In this morning's Washington Times, James Galbraith and I have an op-ed we co-authored expressing these reservations. We did so having discovered during an exchange of e-mails that while he is a Keynesian and I am a supply-sider, we came to the same conclusion, i.e., that in your meetings today and tomorrow, you should hold your horses. In our view, the patient will cure himself by leaving the overnight rate where it is, with longer-term rates rising naturally in response to the expanding economy.
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Rate hike reservations
By James Galbraith/Jude Wanniski
Published June 29, 2004 Washington Times Commentary
One of us is the First Supply Sider. The other is the Last Keynesian. One is Republican; the other Democrat. One helped invent Reaganomics; the other spent four years trying to stop it.
Yet we agree on one thing. Alan Greenspan should not raise interest rates now or in the near future.
To begin, there is no evidence of a monetary inflation. If that were happening, gold prices would go up. But the price of gold has fallen $35 since it touched $430 earlier this year.
And while growth has returned, the economy remains far from full employment. We have enjoyed just a few decent months of job creation. A million jobs in three months is good news. But we remain about 1.3 million jobs below the actual level of payroll employment four years ago. We're still about 5 million jobs short of what we should have, given population and labor force growth since then.
Economists once argued inflation would not only rise, but also accelerate in a destructive spiral leading to hyperinflation -- if the unemployment rate fell below a threshold level called the Non-Accelerating Inflation Rate of Unemployment, or NAIRU.
But where was that threshold? Six percent, as many argued 10 years ago? Five and a half? Five? We ran the experiment in the late 1990s, with unemployment below 4 1/2 percent for 2 1/2 years. Inflation numbers didn't budge. If the NAIRU exists -- which we doubt -- it isn't anywhere close to today's 5.6 percent unemployment rate.
Price pressures exist. Chairman Greenspan was rightly concerned when gold, oil and commodities were all heading higher together. Yet the Fed took the path of patience at that time. Now with real recovery and rapidly rising business profits, liquidity may flow away from commodities toward investment. That would calm rather than roil commodity prices, while financing businesses at low interest rates. With a little more patience from the doctor, in other words, the patient might cure himself.
And oil prices may come down soon, if the Organization of Petroleum Exporting Countries acts as promised. But if they do not come down, that will be due to changing world energy markets and insecurity associated with the Iraq war -- not monetary inflation.
There also are large increases in health-care costs. They have nothing to do with monetary inflation, nor with tight labor markets or rising wages. A better security policy, a better energy policy, and a better health care system would help. High interest rates are not a good substitute for these measures.
What will happen when interest rates rise? We don't know. But there are several good reasons to worry.
• First, in the wake of the refinancing boom, banks and other financial institutions are chock-full of mortgage-backed securities with fixed and low yields. Rising interest rates will hit their value pretty hard. They could precipitate a sharp fall in their price, as well as in bank stocks, the bond market and equities more generally. To what end? No useful purpose would be served.
• Second, American households remain heavily indebted. They will not be squeezed immediately by high rates, because many have converted their debts into fixed-rate mortgages (wisely so, despite Chairman Greenspan's recent advice to convert to ARMs.) But they will be hit by sticker shock on their next house or car, and we can expect a slowdown in those sectors (indeed, in housing it may be under way already). No useful purpose would be served by this either.
• Third, higher interest rates probably will appreciate the dollar. This will help Americans who are consumers of foreign goods. But it hurts Americans who produce goods for foreign markets. And if all commodity prices fall (as they will), other asset prices also will tend to fall -- including the stock market.
In the end, where does this deflationary course of action lead? Toward another slowdown, even a recession, with millions of jobs lost and full recovery delayed. That, through history, is the only way high interest rates fight inflation. We don't doubt the eventual effectiveness of this strategy. We question, rather, whether it is sane.
On monetary policy, one of us favors the Gold Standard. The other is nostalgic for Bretton Woods. We agree, though, there is nothing wrong with a federal funds rate of 1 percent, and a yield curve rising to around 5 percent on long-term bonds, when we are below full employment and with at most a slowly creeping rise in consumer prices. That was the case in the late 1950s, the last time the yield curve looked like it does now.
Short-term political pressures in the late 1950s pushed the Fed away from an ideal set of interest rates. America's problems cannot be solved by raising the overnight funds rate. The Fed would surprise the market by leaving rates alone this week, but it would more likely than not be a pleasant surprise.
James Galbraith is professor at the Lyndon Baines Johnson School of Public Affairs, the University of Texas at Austin, and senior scholar at the Levy Economics Institute. Jude Wanniski is President of Polyconomics, Inc., Parsippany, N.J.
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