A Question For Fed Chairman Bernanke
July 21, 2009
Chairman Bernanke used its House testimony today to lay out conditions that would compel the Fed to tighten monetary policy, a diminishing output gap, better labor market conditions, and evidence either of rising expected inflation or rising actual inflation. By framing the answer in conditional terms, analysts did not get a quantitative answer on the timing of the first rate increase and how rate increases will dovetail with the re-absorption of excess liquidity. Market participants have been obsessing over the likely timing of the first rate hike, and Bernanke has gone to great lengths in a Wall Street Journal Op-Ed article today, his formal statement to Congress and his follow-up testimony to indicate that the date will be later rather than sooner. The top priority now is to ensure that tightening is not done prematurely.
The first rate hike’s timing is no more than an opening move and a rather insignificant one from a base of 0-0.25%. My question to the Chairman is different, namely whether the Fed prepared to lift rates in increments of more than 25 basis points on multiple occasions. Put differently, I would like to know how aggressively monetary officials expect that it will be possible to tighten policy without jeopardizing a nascent upturn. Nobody can be sure of the answer now, but this is a question that will be crucial before the time to act arrives.
In the era of transparency, the Fed’s Modus Operandi has evolved toward a more cautious path over its last four significant tightening cycles.
- The Fed funds target was lifted by 325 basis points to 9-3/4% between March 1988 and February 1989, a time when the stance could change as readily between meetings as at them. There were two rate hikes undertaken in three separate months — May 1988, June 1988, and February 1989 — each time by a total of 50 basis points. The target rate also went up 3/8ths of a percentage point in December 1988.
- The Fed funds target was doubled from 3% to 6% within a 12-month period to end-January 1995. After beginning with three 25-basis points increases, the third being implemented between meetings, the magnitude of the moves was escalated with a sequence of two 50-basis point hikes, a 75-bp advance, and a final 50-bp increase.
- In 10-1/2 months between late June 1998 and mid-May 1999, the Fed implemented six rate hikes, each right after a scheduled meeting. The first five moves were by 25 bps, and the final one was a move of 50 bps, bringing the funds target to 6.5% from 4.75% prior to the first of those moves.
- All 17 moves undertaken between mid-2004 and mid-2006 were made at scheduled meetings, and each one was a predictable 25 basis points in size. The target rate climbed from 1.0% to 5.0%. That tightening continues to draw great criticism usually about its late start. The Fed didn’t begin until after seven quarters of positive growth averaging more than 4.0% per annum, and policymakers ignored asset price inflation while keeping the target pinned previously at 1.0%. I find even more fault in the self-imposed 25-bp limit on each move. A central bank that meets just eight times a year has simply got to be more flexible in getting from point A to a very distant ultimate destination.
Other central banks used to be less inhibited about raising target interest rates in larger-sized increments, although some too have gravitated to using a low, presumably safe, gear. Between June 1988 and May 1989, the Bank of England target rate went up 750 basis points, including 200 bp in the first month, 100 bps in July 1988, 150 bp in August 1988, 100 bps in November 1988 and 100 bps in May 1989. But almost a decade later, a seven-step 150-basis point tightening from October 1996 to June 1998 consisted entirely of 25-bp increments.
In lifting its refinancing rate from 2.5% to 4.75% between November 1999 and October 2000, the ECB began with a move of 50 bps, followed with three 25-bps increases, then another 50-bp jump before a final two moves of 25 bps each. But the second ECB tightening cycle from 2.0% in December 2005 to 4.25% in July 2008 consisted of nine increases of 25 basis points each.
The most useful information for future Fed policy may come from the Bank of Japan’s experience. From a 2.5% starting level, that bank’s discount rate was boosted by 75 basis points in May 1989, 50 bps in October 1989, 50 bps in December 1989, 100 bps in March 1990, and 75 bps in August 1990. Five increases, none by less than 50 basis points, covered a space of 350 basis points in 15 months. That worked out to 23.3 basis points per month, not dramatically greater than the 16.7 basis point pace of the Fed in its 2004-6 tightening. But whereas the Fed moved in small, predictable increments that were too small to sharply impact the decisions of investors, businessmen or consumers, the Bank of Japan, which allowed overnight money rates to climb above 8%, put Japan through a wringer from which it never recovered. Japanese real GDP had expanded 4.0% per annum in the fifteen years to 1Q92. Potential growth has been so weak since that time in contrast that the central bank’s overnight target rate has been 0.5% or less since September 1995.
A subsequent attempt to tighten Japanese monetary policy revealed an extraordinary intolerance of that economy to the slightest braking of monetary support. Officials ended five years of quantitative easing in the spring of 2006 after a period in which real GDP had expanded 2.0% per annum over 4-1/4 years. A rate hike from zero to 0.25% was implemented in July 2006, and a second one of that size was engineered in February 2001. Officials had every intention of doing the second move earlier and of following up both with several more increases, but the economy fluttered and ran eventually into the global recession.
The Japanese and U.S. economies each suffered financial market breakdowns with severe downward ramifications on real activity and demand. Each system fell into a liquidity trap, forcing officials eventually to turn to quantitative tools for stimulating growth. Japan delayed in this decision much longer than the United States, but it remains uncertain if that different initial reaction will separate the U.S. final result from Japan’s experience. Fed officials have acknowledged that tightening next time ought to be more aggressive than last time, which means moving at times in increments of greater than 25 basis points. That may not be possible, if the U.S. economy cannot tolerate the slightest application of monetary restraint. Of course if that happens, the present-day inflationary worries of investors will prove misguided. But if the Fed doesn’t at least try to learn the tolerance of the U.S. economy to restraint, markets will never know the economy’s vulnerability to inflation and will assume an unwillingness or inability of central bankers to walk the talk.
Copyright Larry Greenberg 2009. All rights reserved. No secondary distribution without express permission.
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