As crude oil prices recently approached $68 a barrel, a Wall Street Journal writer concluded that “inflation fears got an added jolt this week as oil prices rose to a three-year high.”
Two other Wall Street Journal writers added that “If crude continues to move higher, it could begin to stifle economic growth.” They suggest that “higher consumer prices for gasoline and other energy products act like a tax, while pushing inflation higher and increasing pressure on the Federal Reserve to raise interest rates more aggressively.”
Such anxieties about $70 oil are obviously overwrought. Crude prices were usually above $100 from March 2011 to September 2014, yet nobody was then fretting about inflation fears forcing the Fed to raise the fed funds rate.
But this does raise two very important issues: First, the importance of soaring oil prices in the recession of 2008-2009. Second, the way the Federal Reserve has overreacted to surging oil prices by pushing up interest rates before and during oil-shock recessions and (in 2008) leaning against their fall after the recession was well under way.
In May 2009, economist James Hamilton of U.C. San Diego testified before the Joint Economic Committee. He noted that, “Big increases in the price of oil that were associated with events such as the 1973-74 embargo by the Organization of Arab Petroleum Exporting Countries, the Iranian Revolution in 1978, the Iran-Iraq War in 1980, and the First Persian Gulf War in 1990 were each followed by global economic recessions. The price of oil doubled between June 2007 and June 2008, a bigger price increase than in any of those four earlier episodes.”
Like every postwar recession except 1960, the “Great Recession” of 2008-09 was preceded by a spike in the price of crude oil. West Texas crude soared from $54 at the start of 2007 to $145 by mid-July 2018. Yet U.S. reporters and economists still write as though the Great Recession had nothing to do with a global energy shock but was instead a “financial crisis” that began with the collapse of an investment bank (Lehman Brothers) on September 15, 2008. This is a stubborn myth.
In reality, the inability of unemployed homeowners to pay their mortgage bills, and the failure of investments tied to those mortgages, were secondary complications of a global energy shock which cut industrial production in Canada and Europe in 2017 before that happened in the U.S. By the end of 2008, the contraction of real GDP “was twice as deep in Germany and Britain [as it was in the U.S.] and much worse in Japan and Sweden.”
Because energy is a key part of the cost of doing business, higher energy costs made production and distribution less profitable and thereby shrunk the global economy’s supply. Yet even as late as June 2008, as crude prices soared above $140, The New York Times and Washington Post were hysterical about illusory inflation – not recession.
Did the Fed also mistake a temporary oil price spike for a sustained rise in the overall trend of inflation? I believe it did that in 2008 and even more obviously in prior incidents of a sudden surge in oil prices.
The big oil price spikes (and recessions) between 1973 and 1980 that Hamilton mentioned were clearly matched by huge spikes in the Fed-controlled interest rate on federal funds. Oil prices and the fed funds rate were also rising before the 1991 and 2001 recessions. When crude rose from $34 to $74 from May 2004 to June 2006, the fed funds rate rose from 1 percent to 5.25 percent. Once recessions were well underway the Fed always began to bring interest rates back down, but always (including 2008) too slowly.
On January 2, 2008, The Financial Times published my article, “Why I am Not Using the-R-Word This Time.” Citing James Hamilton, I wrote that “if the emphasis on oil prices in Prof Hamilton’s 1983 study is correct, the US economy is likely to slip into recession because of higher energy costs alone, regardless of what the Fed does. If Mr. Bernanke’s 1997 study is right, timely reductions in the Fed funds rate should avert such a recession.” Once he became Fed chairman, unfortunately, Bernanke did not aggressively cut the funds rate in a timely manner – but instead tried hard to prop rates up. As Cato’s George Selgin documented, “Between December 2007 and September 2008, the Fed sold over $300 billion in Treasury securities, withdrawing a like amount of reserves from the banking system, or just enough to make up for reserves it created through its emergency lending,” One result was to keep the fed funds rate above 2 percent until September when oil prices finally fell. In October the Fed also began paying interest on bank reserves (above 1 percent until mid-December) to discourage bank lending.
Although an oil price of around $70 is only half as high as the peak in 2008, and lower than it was just a few years ago, we do have a lot of experience with sudden increases in oil prices that always ended in recession. And we have a lot of experience with the Fed acting as though they were not focused on “core” inflation at all (i.e., excluding energy) but were unduly influenced by the misleading and ephemeral impact of oil price gyrations on headline inflation numbers.
So, the Wall Street Journal's recent warning that “If crude continues to move higher, it could begin to stifle economic growth” would be likely only if crude moved a lot higher. And the warning that a higher oil price must put “pressure on the Federal Reserve to raise interest rates more aggressively” would be likely only if the Fed has still not learned anything from one of its biggest and most frequently repeated mistakes.
For some years, hot money flowed in, adding massively to China’s foreign reserve stockpile. Speculators borrowed cheaply in U.S. dollars and bought yuan-denominated assets in anticipation of an ever-appreciating yuan. Well, this carry trade has shifted into reverse, with $91 billion in net outflows in the last quarter of 2014. And with that, the ever-appreciating yuan story has come to a close, too. Indeed, the yuan has lost 1.8% against the greenback since the New Year.
A clear picture of the drag that the hot money outflows are putting on China is shown by inspecting the annual growth rate in the People’s Republic of China’s net foreign assets. With the reserve of the carry trade, the slowdown in net foreign assets growth has been pronounced.
This, in turn, has reduced the foreign asset component of the growth in China’s money supply, putting a squeeze on the economy’s fuel supply. Indeed, China’s money growth rate has fallen well below its trend rate since mid-2012.
In an attempt to reverse the slump in China’s money supply growth, the People’s Bank has just reduced its benchmark interest rates for the second time in three months. A wise move.
If there’s anything we ought to have learned from the recent boom and bust, it's that a Fed commitment to keep interest rates low for any considerable length of time, like the one Greenspan’s Fed made in 2003, is extremely unwise.
The problem isn’t simply that interest rates should be higher, or that the Fed should have a different plan for how it will adjust them in the future. It’s that the Fed shouldn’t be making promises about future interest rates at all, because it can’t predict whether a rate chosen today will be consistent with stability in six months, or in one month, or even in a week.
Instead of making promises about future interest rates, the Fed should promise to change its interest rate target whenever doing so will serve to maintain a reasonable level of nominal spending or nominal gross domestic product, which is the best way to avoid causing either a boom or a bust.
Given all the attention that the Federal Reserve has garnered for its monetary “stimulus” programs, it’s perplexing to many that the U.S. has been mired in a credit crunch. After all, conventional wisdom tells us that the Fed’s policies, which have lowered interest rates to almost zero, should have stimulated the creation of credit. This has not been the case, and I’m not surprised.
As it turns out, the Fed’s “stimulus” policies are actually exacerbating the credit crunch. Since credit is a source of working capital for businesses, a credit crunch acts like a supply constraint on the economy. This has been the case particularly for smaller firms in the U.S. economy, known as small and medium enterprises (“SMEs”).
To understand the problem, we must delve into the plumbing of the financial system, specifically the loan markets. Retail bank lending involves making risky forward commitments, such as extending a line of credit to a corporate client, for example. The willingness of a bank to make such forward commitments depends, to a large extent, on a well-functioning interbank market – a market operating with positive interest rates and without counterparty risks.
With the availability of such a market, banks can lend to their clients with confidence because they can cover their commitments by bidding for funds in the wholesale interbank market.
At present, however, the interbank lending market is not functioning as it should. Indeed, one of the major problems facing the interbank market is the so-called zero-interest-rate trap. In a world in which the risk-free Fed funds rate is close to zero, there is virtually no yield be found on the interbank market.
In consequence, banks with excess reserves are reluctant to part with them for virtually no yield in the interbank market. As a result, thanks to the Fed’s zero-interest-rate policies, the interbank market has dried up (see the accompanying chart).
Without the security provided by a reliable interbank lending market, banks have been unwilling to scale up or even retain their forward loan commitments. This was verified in a recent article in Central Banking Journal by Stanford Economist Prof. Ronald McKinnon – appropriately titled “Fed 'stimulus' chokes indirect finance to SMEs.” The result, as Prof. McKinnon puts it, has been “constipation in domestic financial intermediation” – in other words, a credit crunch.
When banks put the brakes on lending, it is small and medium enterprises that are the hardest hit. Whereas large corporate firms can raise funds directly from the market, SMEs are often primarily reliant on bank lending for working capital. The current drought in the interbank market, and associated credit crunch, has thus left many SMEs without a consistent source of funding.
As it turns out, these “small” businesses make up a big chunk of the U.S. economy – 49.2% of private sector employment and 46% of private-sector GDP. Indeed, the untold story is that the zero-interest-rate trap has left SMEs in a financial straightjacket.
In short, the Fed’s zero interest-rate policy has exacerbated a credit crunch that has been holding back the economy. The only way out of this trap is for the Fed to abandon the conventional wisdom that zero-interest-rates stimulate the creation of credit. Suppose the Fed were to raise the Fed funds rate to, say, two percent. This would loosen the screws on interbank lending, and credit would begin to flow more readily to small and medium enterprises.
One of the direct results of the Federal Reserve's zero interest rate policies has been a massive reduction in interest income going to households. Since 2008, household interest income has fallen by about $400 billion annually. That's $400 billion each year that families have not had to spend.
Now of course you can also argue that families interest expenses have also fallen, and that would be true, but that just serves to illustrate that much of monetary policy is not about creating wealth, but re-distributing it. Since interest payments are one's person expense and another's income, Fed driven changes in the interest rate should not increase household income in the aggregate.
As interest income/expense is not the only item on the household balance sheet, the Fed does try to make us feel richer via changes in asset prices. The problem, however, is that the change in many asset prices can also have little more than distributional effects. If owners feel richer because their house prices have gone up, or not fallen as much as they would have otherwise, then renters are poorer as they need to save more to by the same house. The same holds for commodity prices. Monetary driven increases in the price of food might be great for farmers, or speculators, but it makes households poorer by the same amount it increases the wealth of commodity holders. If the Fed truly wished to help our economy get back to "normal" then it would allow the free choices of individual borrowers and savers to determine the interest rate. It would also end its implicit practice of picking winners and losers in our economy. Unlike Fed driven changes in asset prices and interest payments, voluntary exchange between savers and borrowers increases the welfare of all parties involved.
I almost hesitate to suggest that anyone actually read Alan Blinder's defense of Keynesian economics in today's Wall Street Journal, except that the piece lays out clearly in my mind why Blinder is so wrong. The only part you really need to read is:
In sum, you may view any particular public-spending program as wasteful, inefficient, leading to "big government" or objectionable on some other grounds. But if it's not financed with higher taxes, and if it doesn't drive up interest rates, it's hard to see how it can destroy jobs.
So in Blinder's world, deficits are explicitly not future taxes, despite what I believe is a fairly strong consensus among economists that some form of Ricardian equivalence holds (see John Seater's literature review and conclusion, "despite its nearly certain invalidity as a literal description of the role of public debt in the economy, Ricardian equivalence holds as a close approximation."). Perhaps Blinder is blind to the fact that deficits are so much a part of the public debate today because households absolutely see those deficits as future taxes.
I also think Blinder misses that fact that crowding out can occur without raising interest rates. As Cato scholar Steve Hanke points out, the Fed's current policies have basically killed the interbank lending market, which has encouraged banks to load up on Treasuries and Agencies, rather than lend to the productive elements of the economy. While I sadly don't expect most mainstream macroeconomists to focus on the link between the banking sector and the macroeconomy, Blinder has no excuse; he served on the Fed board.
As I have argued elsewhere, banks are indeed lending, but to the government, not the private sector. The simplistic notion that crowding out can only occur via higher interest rates, as if price is ever the only margin along which a decision is made, has done serious harm to macroeconomics. But then if macroeconomists actually understood the mechanics of financial markets, then we might not be in this mess in the first place.
The new Brazilian government of President Dilma Rousseff has announced spending cuts of 50 billion reais (approximately $30 billion) this year. This amounts to approximately 1.3% of the country’s estimated GDP for 2011. Despite good intentions, that is still a very timid effort in curbing the size of government in Brazil: Total government spending (including state and local levels) runs at almost 40% of GDP.
Perhaps the timidity of the proposal is explained by the fact that curbing the size of government is not the motivation for the spending cuts. Nor is it to avoid a looming fiscal crisis. Brazil’s estimated budget deficit for 2010 was 2.3% of GDP; not good, but still a far cry from the fiscal woes of Europe or the U.S.
Dilma’s reason for cutting spending lies in the helplessness of Brazil’s Central Bank in containing the rise of the real without harming the economy. The real has appreciated against the dollar by 38% in the last two years (thanks in large part to Ben Bernanke's policies at the Fed). Efforts to contain this appreciation by intervening in the foreign exchange market and building up reserves led to a rise in inflation, which closed at 5.9% last year. The Central Bank has raised interest rates in order to curb inflation, but at 11.25% they are already too high and constitute a heavy burden on Brazil’s productive sector. Moreover, high interest rates are a magnet for foreign money seeking high returns, which drives up the value of the real even further.
Cutting government spending wouldn’t seem like the favored policy alternative of a left-wing technocrat such as Dilma Rousseff. However, it is the best way to bring down interest rates and control inflation under the present circumstances. It remains to be seen if the cuts do the trick, but they are certainly a positive sign from Brazil’s new president.