Saturday, May 31, 2008

Making a Mountain out of a Molehill

Recent headlines suggest that the U.S. economy is spiraling into an abyss. The housing, financial, and manufacturing sectors are suffering greatly. However, ongoing recoveries in these sectors (some more than others) are fueling a new-found momentum in the U.S. economy. All of the sudden, things are not looking so bleak.

But were things ever so bleak? Just a month ago, headlines were saturated with talk of recession, but now many economists are claiming that we may just “skirt” a recession. Recent 5.0% unemployment and 0.9% growth certainly cannot be compared to 6.9% unemployment and -7.8% growth during the recession of 1980. Why the sudden change of energy? The Fed got it right this time.

Except for Volcker’s disinflation period (1981-1983), monetary policy has been either too little or too much.

Wrong (Figure 1): The Fed (led by William McChesney Martin, Jr.) started tightening at the end of the 60’s. The 1960’s was a decade of strong growth, fueled by a War and loose government spending. Inflation started creeping up, and the Fed began tightening – resulting in a loss of output, or a recession.

Wrong (Figure 1): The Fed (led by Arthur Burns) resumed tightening in the middle of the 70’s. During a period of a slowdown in productivity, where firms were producing less and less per hour, the Fed began to tighten in order to control inflation. Add an energy shock created by OPEC (Organization for Petroleum Exporting Countries), where the price of oil rose sharply, and a recession results. Unemployment hit 9%, and GDP fell by 3.4%. Economic theory says that the Fed was partly to blame for the recession

Right (Figure 1): The Fed (led by Paul Volcker) tightened in the early 80’s. Surging from another shock to the oil market, inflation hit double digits in 1981 (13.5%). Paul Volcker led a historical movement to reduce inflation in America, raising interest rates until inflation subsided by 1983 (3.2%). The result: 26 years of low inflation.

Wrong (Figure 2): The Fed (led by Alan Greenspan) loosened in the early 00’s. A terrorist attack on American soil, financial stress from a stock-market crash, and accounting scandals (Enron) caused a recession. Alan Greenspan lowered interest rates to combat economic hardship. Amid record-low inflation and unemployment, Greenspan continued to ease (lower the interest rate) until the interest rate hit 1% in 2004. Many argue that his excessive easing led to the housing bubble that led to a financial crisis starting in August 2008.

Right (Figure 2): The Fed (led by Ben Bernanke) loosened just enough…let’s hope. Recent Fed actions have been innovative and direct. Specifically, the Fed needed to target directly the financial stress caused initially by the housing bust and assets related to that sector, where the stress was unlikely to abate with standard Fed policy (simply lowering rates). In order to get cash to the banks and primary dealers (large investment banks), the Fed increased the number of monetary policy options from 3 to 6. The new options (TAF, TSLF, and primary dealer credit) targeted the financial crisis directly, and the financial markets have since shown signs of stabilization. However, at the same time, the Fed lowered interest rates (one of the 6 policies available) in order to help non-financial businesses, workers, and the rest of the economy along. The Fed target interest rate sits at 2%, and may be lowered just slightly in 2008, but then the Fed will likely raise it in order to avoid a run-up in inflation. The Fed created new policy options, and the interest rate did not get too low.

However, key risks remain. Gas prices are at record highs (3.99 per gallon as of 5/26/08) and food prices are rising. Only time will tell how record oil prices and recent monetary policy (the Fed) will affect future economic growth.

The media paints the picture of a mountainous recession, but it may simply be a mole hole of slow growth that we must conquer. The Fed is creative and seemingly cogent enough to get the economy through its current stress.

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