Laurence H. Meyer, Vice Chairman of Macroeconomic Advisers, spoke yesterday to the New York Association for Business Economics in a meeting co-sponsored by the Forecasters Club. He's a treat to listen to, as he speaks frankly and lucidly about the high stakes of current monetary policy. The room was packed, it being the day after the historic statement of the Federal Open Market Committee. Larry Meyer is an insider -- he called his memoirs about his six-plus years (1996-2002) as a Fed Governor A Term at the Fed: An Insider's View. Before joining the Fed Board he was professor of economics for 27 years at Washington University and in 1982 he founded a consulting firm where he works today.
Here are the highlights of his talk in Q&A format, put together from my notes at the lunch, with the caveat that I did not use a tape recorder or a Stenograph machine, and none of the charts in his talk is included. If a topic came up more than once I combined the comments and information. If you believe I missed something important, post a comment or email me and I will attempt to fix the problem ASAP.
Q1. How bad is the current credit and economic crisis?
A. The current crisis is very serious. It can be compared with other post-World War II U.S. recessions, but more realistically with Japan's post-1990 recession and the U.S. Great Depression.
The current crisis is more severe than any of the other postwar U.S. recessions. In fact it's equivalent to the sum of these recessions. Problems relating to the meltdown of the Savings & Loans were more confined to the industry than the current credit crisis. Other downturns were more short-lived than this one promises to be. The worst postwar recession was in 1981-82, when then-Fed Chairman Paul Volcker wrung out inflationary expectations with tight money and correspondingly high short-term interest rates.
Japan after 1990 faced a similar problem to the current crisis with its stock market and real estate boom and bust. The Bank of Japan did many of the right things - zero-interest-rate policy with quantitative easing, funding troubled assets, addressing deflationary trends. The problem is that it was too slow and its actions failed because they were too late.
The Great Depression was a time of serious asset deflation. It provides lessons what not to do. If the Fed has learned the right lessons we should be able to avoid a "lost decade" this time.
Q2. What is the Fed trying to do with its December 16 FOMC announcement?
A. Fed Chairman Bernanke has argued that any stimulus package should be Timely, Temporary, Targeted. For the current round, the emphasis has shifted slightly to more like Speedy, Significant, Sustained. The last three months suggest that a stimulus lasting just a couple of quarters is not going to be useful. In the environment following the Lehman failure, the economy may require more than two years of expansionary fiscal help. Here are the main FOMC actions:
1. Fed Funds Target at Zero Bound. The target fed funds rate will be below .25 percent, i..e, effectively at zero. The Fed is going to the "zero bound" (i.e., a nominal rate of 0 percent, below which a lender has to pay a borrower to take the money, which is unlikely to continue for long). Monetary policy has been effectively at zero for some time. It will be 0-.25 percent until probably 2010. If banks can borrow at 0 percent and lend at 10 percent, they will start lending. In January 2004, then-Governor Bernanke said: "Policymakers should act preemptively and aggressively to avoid facing the complications raised by the zero bound," and "There seems to be little reason for central banks to avoid bringing the policy rate close to zero if the economic situation so warrants."
2. Purchase of Private Securities. The Fed will purchase private securities to inject funds where needed, i.e., to lower risk spreads. This is different from the Bank of Japan's quantitative easing, which was based on the level of reserves and didn't target specific credit conditions such as unusually high risk premiums at the long end of the yield curve. The Fed is buying commercial paper. There is a question whether the Fed will buy corporate bonds and if so how it will decide to pick the firms whose bonds they buy.
3. Purchase of Longer-Term Treasurys. The Fed will purchase longer-term Treasury securities, not just T bills.
4. Long-Term Commitment toi Low Rates. The Fed expects a long and deep recession and therefore plans on long-term policy commitment to low rates.
The Fed's assets were at 2.3 trillion on December 10. Dallas Fed Governor Richard W. Fisher has predicted asset growth to $3 trillion in weeks. The assets are likely to grow to $4 trillion in a year. (For Fed assets go here and scroll down to H.4.1, Table 7. It shows that Fed assets rose nearly $1 trillion during the year as of December 10.)
Q3. How much fiscal stimulus is needed?
A.The fiscal multipliers are 1.5 for increased government spending, 1 for a tax cut and no effect for a tax rebate. So forget rebates and consider government spending to be the most effective approach.
The stimulus package for states and localities has been discussed as something in the $500 billion range. However, it doesn't make sense to spend that money on bridges to nowhere. It will take more than one year to spend the money effectively and efficiently. State and local spending projects will take time to develop and be approved. The projects could be roads and bridges, upgrades to the electrical grid, green-job projects, improved medical technology.
Q4. What is the outlook for monetary policy and financial markets in the near term?
A.With its December 16 statement, the FOMC could go on vacation for two years. But first they will monitor the management of the operations. There won't be much to discuss after a couple more meetings.
We can expect a deflationary environment for perhaps as long as two years. Only then do we need to worry about inflation. We are not in danger of hyperinflation. Not until 2010 is it likely GDP growth will be back above 5 percent. Not until 2012 will unemployment drop to a level that might contribute to inflation on the Phillips Curve (or NAIRU) model.
President-elect Obama's promised income tax cuts (for the middle class) are likely to be permanent. But by ten years from now America will have to face up to the country's growing liabilities and it will have to increase taxes.
Q5. How will we know if the Fed program is working?
A."We know why the economy will recover - we just don't know when." We will know:
- When credit conditions improve. In the meantime, fortunes are being made taking on over-priced risk. The yield on Baa bonds has turned down finally after shooting up following the mid-September failure of Lehman Brothers and the forced sale of Merrill Lynch. Banks willingness to lend plummeted after that date also. Prior to mid-September a series of reductions in the fed funds rate kept the Baa yield fairly stable. Bank traders aren't arbitraging between corporates and Treasurys because they don't have enough spare resources. So government, i.e., the Fed, needs to.
take action. This will mean a shifting of some risk from the private sector to the public sector.
- When long-term rates continue to fall. Spreads will be narrowing.
- When housing prices bottom out. Housing activity stabilized - "Not everyone can live with their parents." Those who couldn't hang onto their homes will be looking for rentals. Mortgage rates could go lower (banks asking 5 percent for a 30-year mortgage on December 16 were asking for 4.65 percent the next day).
- When equity prices rebound. Equities have fallen about 50 percent from their peaks. Recovery will register in a rise in equity indexes.
- When the fiscal stimulus Is getting spent. The projects at the federal, state and local government must get under way in an orderly process.
Q6. How will the Fed exit from the recovery plan?
A.First, if the recovery plan is working, the Fed will become decreasingly aggressive and eventually it will start reversing some of its actions, tightening credit and selling back debt it has purchased. The Fed could sell its own obligations to mop up liquidity. It may phase out some of the facilities it has opened - Fed assets used to include just six types of "facilities", and now they include twelve. In the asset-backed securities market, the Fed is picking non-recourse loans precisely because it will make for an easier exit. But such an exit is at least 18 months away.