Prometheus 6

This should start you thinking about the medium-term future.

Rates to Rise as Economy Expands, Greenspan Says
By EDMUND L. ANDREWS

WASHINGTON, April 21 — Alan Greenspan, the chairman of the Federal Reserve, sent investors an implicit message today: don't get ahead of yourselves.

One day after after Mr. Greenspan unnerved the financial markets by declaring that the threat of deflation has disappeared, the Fed chairman strongly hinted that rising productivity and low inflation would allow the central bank to keep interest rates at rock-bottom levels a bit longer.

"The crucial difference between now and in the past is the extraordinary acceleration of productivity," Mr. Greenspan told members of the Joint Economic Committee of the Congress. "That means that price pressures are not anywhere near where they would have been in the past."

He did acknowledge that the economy had "entered a period of more vigorous expansion" and that rates would eventually have to rise.

Testifying before Congress for a second day, Mr. Greenspan again demonstrated his ability to keep his options open by projecting ambiguity without actually contradicting himself.

But the bottom line of his remarks today were consistent with a theme echoed in official Fed statements and remarks by other senior Fed officials. The message is that the economic growth appears robust and job creation is likely to accelerate, but that the central bank can afford to retain its policy of cheap money because the economy still has a considerable amount of "slack" in it.

Investors have been skeptical of that message and are increasingly convinced that faster growth will force the Fed to raise rates as early as this summer in order to head off inflation.

Why? Brad DeLong , discussing "Global Economic Prospects: Bright for 2004 but with Questions Thereafter" :

Greenspan is confident that raising interest rates and thus raising the unemployment rate during the bubble of the late 1990s would have been the wrong policy, and that aggressively lowering interest rates after the bubble was the right policy. Lowering interest rates cushioned falls in bond prices. Lowering interest rates made use of bond financing for investment more attractive. Lowering interest rates boosted bond and real estate prices, induced households to refinance, and so provided a powerful spur to consumption spending that largely offset the post-bubble fall in investment spending. In Greenspan's view, the aggressive lowering of interest rates was exactly the right thing to do in the aftermath of the bubble to shift spending from investment to consumption and so to keep the economy not far from full employment.

Mussa says: not so fast. Very low interest rates, coupled with assurances from high Federal Reserve officials that interest rates will stay very low for substantial periods of time, produce a situation in which the prices of long-duration assets--long-term bonds, growth stocks, and real estate--climb very high. What goes up may come down, and may come down rapidly. And should some class of asset prices come down rapidly and should it turn out that many debtors in the economy go bankrupt because their assets have lost value, serious financial crisis will result. The price of using exceptionally easy money to keep the collapse of the dot-com bubble from turning into a depression has been the creation of a three-fold vulnerability:

• If the assets the prices of which collapse when interest rates start to rise are emerging-market debt, then the memories of the 1990s and increasing risk will induce large-scale capital flight from the periphery to the core--an echo of the East Asian financial crises of 1997-1998.
• If the assets the prices of which threaten collapse when interest rates start to rise are domestic bond and real estate holdings that have been pushed to unsustainable levels by positive-feedback "bubble" buying, then the "monetary authority would... confront the grim choice of trying to keep an unsustainable asset price bubble alive or trying to combat the collapse of such a bubble without a great deal of room for monetary easing" to keep real estate and bond prices from falling far and fast.
• "If monetary policy is tightened too much too soon" (presumably because of fears of positive-feedback "bubble" buying), the result may be a credit crunch and a recession--with no guarantee that a reversal of the monetary policy tightening will undue the effects of the credit crunch.

I do not believe that many economists would say that Mussa's fears about the potential macroeconomic vulnerabilities created by the low interest-rate policy the Federal Reserve has pursued since the end of the dot-com bubble are unreasonable. (Few, however, carry their alarm to the degree that Stephen Roach of Morgan Stanley does.) And Mussa expresses them in a coherent language--one in which sustained rises in asset prices induce positive-feedback trading that "bubbles" prices above fundamentals, one in which what goes up comes down rapidly, one in which large sudden falls in asset prices produce chains of bankruptcy and raise risk and default premia enough to threaten to cause deep recessions. The language has echoes of the great Charles P. Kindleberger's (1978) Manias, Panics, and Crashes (New York: Basic Books), and of earlier writings about the consequences of excessive money-printing: "inflation, revulsion, and discredit."