Has the Fed cut rates without telling anyone

Greg Mankiw noticed that the Fed target is still 5.25%, however the effective rate in August was only 5.02%.

This is interesting, in NZ you could not do this as the Bank is willing to release any amount of money for a given interest rate (that is what our OCR target implies), the constraint in this case is money demand. In American they have a Federal Funds rate, which acts as there target rate. However, they also target a certain money supply level and use open market operations to get there.

Now you can’t arbitrarily choose the combination of the price (interest rate) and quantity of money in the market place, it depends on money demand. As a result, the Fed can only truly control one of these variables, as if they want to hit their target rate there is only one level of money supply that will allow it (given a strictly downward sloping money demand curve).

According to Mankiw, the Fed is pretty good at choosing the right amount of money supply so as to achieve the Federal Funds rate. By deviating from this they are loosening monetary policy, even if they haven’t said they have. The fact that the Fed has control of money supply as well as money demand allows them to be loosen monetary policy quickly without making the market feel like they are. However, it makes them less transparent, which in the long run is not a good thing.

OCR stays at 8.25%

The RBNZ left the OCR at 8.25%, a move that was completely expected.

They also released a monetary policy statement this month, which is what the markets were keeping an eye out for. The executive summary was pretty neutral, mentioning both global credit market uncertainty and the need to keep rates high to combat inflation. As a result, this gave little information to the market on whether the Bank was thinking about easing in March, June or September.

However, I think that the current MPS points towards loosening in the OCR late in 2008. For one, there forecast 90 day bill rate track remains high, only easing slightly into 2009. Furthermore, they forecast economic growth to March 2008 of 2.9%, significantly above other analysts forecasts. Also, they expect inflation expectations to stay near the top of the target band up until at least 2009 (falling to a low of 2.7%!).

I’m not sure how to interpret this. Does this mean that the Bank is prepared to tighten again as they are pricing in strong inflationary pressures? Or does it mean that the Bank is estimating a high track for GDP growth, so that when growth comes in lower (as it invariably will, given the lack of TOT movement in June), the Bank has a consistent reason to cut rates.

Even economists struggle with inflation

I have to admit that when I read this news story last night I was very angry. BERL seems determined to tell everyone that increasing interest rates increases the money supply, and a higher money supply leads to higher inflation. This would make sense, if money supply wasn’t INFINITE. But it is.

In NZ we have an OCR target, the RBNZ will provide an unlimited supply of money for a given target rate. By doing this the Reserve Bank sets the interest rate, and the quantity of money is determined by money demand not money supply.

Now, the amount of foreign capital available does have an impact on us. If our interest rates rise then additional foreign funds become available for firms and banks to borrow. The foreign funds are available for a rate higher than the previous interest rate (as they required a higher return to become available) but this rate is lower than the domestic rate. If our interest rate is far above the world rate, then a significant amount of capital becomes available at this rate.

The important thing to note here is that this capital will only be spent if there is demand for it. As a result, the fact that foreign capital wants to enter the country will limit the degree with which an increase in the OCR will lift interest rates, it won’t magically make people want to borrow and spend more money.

The problem NZ has faced is that the RBNZ has not been able to drive interest rates up as much or as quickly as they would have liked (I’ve heard a time lag of 18 months mentioned in some circles!). However, the reason inflation has risen strongly is that money demand has increased significantly since from 2003, and the RBNZ was unable (and at times relatively unwilling) to significantly drive up interest rates.

The OCR is still the right tool to use, however if our interest rates are too far above the world interest rates, the marginal effect of an increase in the OCR is very small. In cases like this some type of alternate instrument might be of use. However saying that the OCR increases the money supply is at best ignorant of New Zealand monetary policy, and at worst a desperate plea for attention from a set of economists.

Was Greenspan a big softy

Yves Smith think so. His argument is that, even though we didn’t fully appreciate it at the time, Greenspan really really cared about equity markets. He was scared of them, and he didn’t want to go out there and nail them as much as he should have. By being ‘hostage’ to the equity markets, Greenspan surrendered some of the Central Banks integrity. He gave up the hard arse, anti-inflationary image of the Central Bank that Paul Volcker had created.

I’m not sure I agree completely, I mean Greenspan did have the ability to keep inflation in the bag for 19 years. However, his unclear style of speaking and his refusal to target a clear level of inflation did create unnecessary uncertainty in the marketplace, and to some degree, may have damaged the inflation fighting power of the Federal Reserve.

A Reserve Bank governor needs to be a clear speaker, who finds the mere idea of inflation repugnant. That is why Don Brash did such a good job.

More immigration?

So, our labour market is looking extremely tight. According to the department of labour all nine of the main occupation classes are currently suffering from labour shortages, and these shortages are likely to continue into the medium term. So the country needs more workers, and it takes time to breed them, so why don’t we get them in from overseas?

The government seems concerned about letting people into the country as it might cause inflation. But if we are actually suffering from a chronic labour shortage, a few extra pairs of hands will surely help suppress inflationary pressures.

As long as the individuals we bring in are more productive than the average New Zealander everyone is better off. Whats the problem?

Outgrowing Inflation II

Rod Oram has had another crack at explaining why he thinks higher output will lead to lower inflation. His argument is, that higher output can help us reduce housing, labour, and business capacity constraints which are dogging the economy.

The first point seems to be his main one, that there are too few houses and so building more houses will reduce house prices . He has a point here, but not a strict point about inflation. House prices rising doesn’t mean inflation, it means that there has been an increase in the price of houses relative to other goods. However, house prices increases can drive inflation by making people feel wealthy, and thereby increasing their rate of general consumption. As a result, all that matters is the rate of growth (return) in house prices, which is driven by short-run demand factors (as supply takes time to adjust).

Now, growth won’t help increase house construction enough to drive house prices down, the constraints holding up house prices are structural. Councils refusing infill, the difficulty of getting consents to build property, these are the reasons that house construction activity has been sub-par. As a result, its not a matter of keeping interest rates low, it is more a matter of regulatory constraints.

His second point is that we need to increase labour skill training and capital to increase output. Yes that would increase output, however it is not current growth that drives investment, it is the expectation of future growth. As a result, the current goal of monetary policy of stabilising prices is the best way of driving efficient long-run investment (by reducing uncertainty).

The third point is that businesses need to innovate. Again this is a business decision, government policy is not trying to stifle innovation and so this doesn’t do anything to defend the idea that keeping interest rates down will reduce inflation.

Ultimately, I think in this second article he switched tack slightly, and discussed situations where we could grow, rather than attacking monetary policy as he did in the first article, which we wrote about. However, I don’t believe that he has shown that all things constant higher growth leads to lower unemployment, all he has done is changed some of the parameters (making people more productive etc).