Memo to Fed: Cut Rates, then Reform Policy

The US economy is showing signs of a potentially rapid deceleration. In particular, there is accumulating evidence that the housing sector slowdown may be becoming a meltdown. In many areas house prices are falling, house sales are down nationally, and mortgage delinquencies and foreclosures are rising - especially in the sub-prime market. This has caused tremors in broader financial markets. The only good news is employment and wages continue growing, but labor markets conditions are also widely viewed as a lagging indicator.

Now that the Fed has acknowledged economic conditions have turned mixed and the housing sector is still struggling, the next step should be to start lowering interest rates. Additionally, the Fed must come to grips with the problem of debt-financed asset inflation, which lies behind the current housing bust. That calls for deeper policy reform.

An important element of the case for lower interest rates is the fact that the tightening effects of earlier rate increases continue building because of the long lags with which monetary policy works. Consequently, conditions are still tightening despite the fact the Fed has been on hold since June 2006.

One lag concerns adjustable rate mortgages whose interest rates are adjusted annually. That means rates on these mortgages have been rising throughout the year despite the Fed’s rate pause, and they will continue rising for borrowers whose rates are scheduled to be reset in the next three months. A similar mechanism holds for mortgages with initial low teaser rates and mortgages with one-time reset clauses that trigger after a fixed period.

Meantime, the spillover effects from the housing sector’s problems are growing. Increased delinquencies and defaults have caused belated tightening of credit standards, which promises to make mortgages more expensive and difficult to obtain. That will reduce the number of homebuyers and also make re-financing more difficult.

Increased defaults also mean more foreclosures, which will further lower home prices. Currently, this impact is concentrated in lower priced homes served by the sub-prime market. However, price reductions can be expected to ripple into contiguous parts of the market, making re-financing more difficult for those owners and even causing additional defaults.

Lastly, declining home prices and tightening credit standards will diminish mortgage equity extraction, as is already happening. Since such cash outs have been an important factor supporting robust consumer spending, this augurs weaker future spending.

In addition to lowering interest rates, the Fed must also address two problems calling for deeper policy change. First, Chairman Bernanke’s close identification with inflation targeting has created something of a bind. Though the Fed has no official inflation target, it has allowed market opinion to settle on the idea of an implicit two percent target. With inflation stubbornly stuck above two percent, this means a rate reduction could dent the Fed’s credibility.

This confirms former Chairman Greenspan’s view that inflation targeting would adversely limit the Fed’s flexibility and discretion. The clear implication is that inflation targeting is a bad idea, and the Bernanke Fed should now distance itself from that idea by abandoning chatter about inflation targeting.

A second problem is that a rate reduction could trigger renewed debt-financed asset inflation, which highlights a major dilemma. If the Fed pushes rates too high in its attempt to choke off wider inflationary effects of asset inflation, it risks triggering a credit crunch and defaults as is now happening. Conversely, if it does not push rates high enough it risks triggering accelerated inflation as agents borrow more in anticipation of rising prices. This implies a knife-edge situation, with the economy being held hostage by asset speculation.

One solution is quantitative regulation extending the system of margin requirements to asset classes such as mortgages. This would enable the Fed to vary the cost of those assets without changing interest rates, thereby damping speculation without imposing collateral damage on the rest of economy.

As a graduate student, Chairman Bernanke wrote about how the Great Depression was fostered by a cascade of bank failures that rippled through the financial system. It would be ironic if he were now to preside over his own financial crisis. Moving promptly to lower rates and enacting policy reform that gives the Fed new tools for controlling asset inflation seems a good way to lessen that likelihood.

This article was originally posted on Tuesday 20 March. Paragraph two was amended on Thursday 22 March to take account of the Federal Reserve’s decision to leave interest rates unchanged but to alter its policy statement.

Copyright Thomas I. Palley

3 Responses to “Memo to Fed: Cut Rates, then Reform Policy”

  1. calmo Says:

    Well crafted Memo to Fed. And us too.
    Surely getting late in the day to take the “dangerous inflation” signal from the CPI stats seriously.
    Given the troublesome lags in the “tightening” that even the Fed did not fully understand (”the conundrum”) and the possibility that a wider scale military adventure could change the economic picture, I wonder if the lowering of rates is a tad hasty (and possibly wreckless , putting the Fed’s reputation on line unnecessarily, if “the lags” take over again and the appearance is “nothing happened”.)
    The “policy reform that gives the Fed new tools for controlling asset inflation” sound wonderful and I think we should divert some of those 2500 accountants busy with Fannie’s books to this worthwhile cause.

  2. Caravaggio Says:

    It’s nice to read a well written article every now and then, but I’m not sure about the prescription of cutting rates and abandoning the perceived inflation target. I would argue for more transparency and further codification of the inflation targeting objective in to the Fed’s mandate. Otherwise, I see scope for a dangerous continuation of the perception of a ‘Fed put’, which is surely damaging over the long-run. Also, I’m not sure about what the Fed is thinking about the sub-prime fall-out - perhaps we will find out tomorrow - but I see a good possibility that the event will prove a relatively contained affair.

  3. calmo Says:

    What might get contained: the delinquencies from subprime and Alt A/ Jumbo. The process, not event, occurs over the duration of the loans in question, several more quarters.
    What doesn’t get contained is the displacement of these workers to other sectors of the economy not dependent on housing. The BLS picture so far shows that some of those “professional services” jobs taking up the slack in residential construction and manufacturing losses are RE jobs. I imagine this is typical of some of the other services and don’t expect these numbers to prevail.
    What doesn’t get contained unless there is a New Thing, is the fall in house prices, back into some alignment with wages. The record of smaller housing booms in the past shows this takes years.