Monday, 16 August 2010

2003 rate oddity

Kansas City Fed President Thomas Hoenig argues the FOMC is making a mistake by not raising interests rates. He worries the Fed is making the same error it made in 2003, keeping interest rates too low for too long and encouraging asset price bubbles. Andrew Sentance has made similar claims in the UK.

Macro Maestro doesn't find this argument too compelling, for several reasons. First, temporary factors - particularly falling import prices- temporarily depressed inflation in 2003. Investors and policymakers  misunderstood these trends and assumed they would continue, triggering a deflation hoax. Even if inflation was about to turn negative, it would have been a relatively benign type of deflation. The situation now is more disturbing - huge negative output gaps in the West are forcing inflation lower and this trend seems likely to continue. Moreover, the private sector is still deleveraging, trying to rebuild its balance sheets and pay back debt. Falling consumer prices, which would raise the real value of existing debts, would be far from benign.

Second, even if central banks are currently inflating asset prices, this is not being matched by rising indebtedness. Bursting asset-price bubbles usually only have important real economy consequences if they encourage debt growth. (When prices subsequently decline they make these debts unsustainable - this is why house-price bubbles are usually more devastating than stock-market bubbles.)

So, Macro Maestro believes central banks are right to hold off policy tightening for now. At least until the main downside risks have gone. Sure, growth has only slowed in line with many economists' forecasts earlier in the year but we should wait till we can be sure there is nothing sinister behind this slowdown..

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