To Raise or Not To Raise? Reading into Greenspan Hamletian Mind

Author: Nouriel Roubini  ·  August 29th, 2004  ·  91158http%3A%2F%2Fwww.economonitor.com%2Fnouriel%2F2004%2F08%2F29%2Fto-raise-or-not-to-raise-reading-into-greenspan-hamletian-mind%2FTo+Raise+or+Not+To+Raise%3F+Reading+into+Greenspan+Hamletian+Mind2004-08-29+13%3A29%3A35Nouriel+Roubinihttp%3A%2F%2Fwww.economonitor.com%2Fnouriel%2F2004%2F08%2F29%2Fto-raise-or-not-to-raise-reading-into-greenspan-hamletian-mind%2F › Share This Print

As Greenspan sips through long reams of obscure economic data (are cardboard production data a good leading indicator of economic activity?) while relaxing daily in his bathtub, he is pondering whether he should increase the Fed Funds rate at the September 21st FOMC meeting. Here is what he is mumbling in his mind, in between a bubble bath and endless wonky economic statistics:

“Well, the September 21st decision will be a real tough one, the last one before the elections! I thought that the economy was perking up; and then we hit this Q2 “soft patch”! But is it really a soft patch as we have been claiming in public or the beginning of a deeper deceleration of the U.S. and global economy? Japan is also slowing down (see the latest GDP, employment, housing spending and deflation figures) and figures from Europe are the usual mixed bag with overall softness and a sub-part Q2 growth of 2%. So, I am usally as kriptic in public as Delphi’s oracle but on this one I am a bit schizophrenic myself even in private. I haven’t really figured out what to do! I feel like Hamlet: to raise or not to raise?

Indeed, not only the Q2 numbers sucked (and the Q2 growth is now revised down to 2.8%, well below potential) but the July employment report was also as lousy as you can get, a pathetic 32 K new jobs. And, in spite of these supply siders claiming that the household survey is better than the payroll one, I know – and I have stated in public – that the payroll figures are a better measure of the trends in the labor market. The unemployment claims numbers are better but so noisy. July sales are up relative to the dismal June but that is in part a rebound; and durables – best measure of investment – are mostly flat (if you exclude the volatile transportation sector). And the housing market is also starting to soften, even if lately flattening of mortgage rates may help a little.

A few months ago I was accused of being behind the curve in terms of inflation and in terms of causing a big asset bubble with the Fed Funds at the abysmally low 1%; so, we started tightening as inflation perked up and labor markets were recovering. But we are now hit with a stagflationary oil shock, bad for inflation and bad for growth and employment. Some are already accusing me of missing the coming growth slowdown and engaging in wishful thinking when talking about a soft patch (and Steve Roach argued both ways, first telling me I was creating an asset bubble, now arguing the recovery is fragile). But this stagflationary shock gives me a real nasty dilemma: gotta tighten to control inflation; gotta stay on hold with rates if growth takes a real hit. In 2003, I did not worry about that oil price spike before the war (and kept the Fed Funds at rock bottom) as the economic recovery was still mushy, labor markets dismal and we still worried about deflation; but now that inflation and its expectations are picking up, labor markets firmed and growth more sustained, what should I do? Should I wait on rates on 9/21 until the flow of macro numbers gives us a better picture on whether it is a soft patch or a deeper recessionary quicksand? Markets like us to have a steady hand and not reverse ourselves every time a few confounding indicators come out: that is why we moved from 1.25% to 1.5% even after the lousy July employment numbers. And, over time, the Fed Funds has to get back to normal territory, i.e. 3-4%; it is still negative in real terms while we are well out of the recession.

But the hard question is how fast should we tighten? Should we pause in September? And would markets take it as a signal that we got it wrong on the economic recovery and the alleged “soft patch”? And will the Bushies get upset that we tighten right before the elections? Well, I am a lame duck Fed chair and gotta retire in 2006; so I care little about the Bushies now; but since I was blamed for the 1992 election loss of Dubya’s dad, I may want to be marginally cautious. I also prefer Bush to Kerry (even if Bush’s fiscal policy is totally reckless and the resulting current accout deficit will be eventually unsustainable). Also, some of the current soft patch may have to do with the electoral uncertainty: business is sitting on the fence on employment and investment decsision waiting to see who wins; they are sort of suspicious of Kerry even if he will rightly reverse Bush’s reckless fiscal policies. But the economy is always doing better – in terms of growth and stock market returns – under Democrats while almost all of our recessions have been under Republican administrations; so, what is this hiring and investment business hesitancy for? Kerry will be a mainstream centrist in economic policies just like Clinton, and I got along great with Bill!

Anyhow, at the Fed we are independent and proud of it; so, we should do what is right, not what is politically convenient or expedient. But, at the margin, if the data flow is mixed and ambiguous, it may be better to pause; the stock market will certainly not complain about that. But the Fed credibility depends on being perceived as independent; so, I will do what is right based on the facts.

Also, my gut feeling is that this is really a “soft patch” (at least I hope I am right) and we need to signal firmly that we will control inflation (even if inflationary expectations and actual inflation have stabilized in recent weeks in spite of the oil price spike) as we are sort of behind the curve. It is important to control inflation, both actual and expected before it gets out of hand. I also worry about asset bubbles and the risk of a systemic financial crisis – a’ la LTCM – in case rates are kept too low for too long and leverage and risky bets keep on creeping up among frenzied markets and investors that have totally forgotten about appropriate risk management. Also, tightening now allows me to ease in case there is a terrorist strike before the election, rather than being stuck in liquidity trap mode in that scenario. So, I would rather raise the Fed Funds rate rather than wait, everything else equal. But luckily, we will see the crucial employment numbers for August on September 3rd well before the September 21st FOMC decision. So, that will make it quite easy: if August employment is up less than 80K it will be better to wait and we will pause on the Fed Funds rate (unless all the other August indicators coming before 9/21 are real strong). If it is 150K or above we raise the Fed Funds rate for sure by 25bps. And if it is between 80K and 150K we will look – as we always do – at all the other macro indicators due between now and 9/21 before making a decision; this includes July the income and spending and inventories figures, the August ISM, consumer confidence, car/truck sales, PPI and CPI, retail sales, industrial production and capacity utilization and housing numbers. So, that is plenty of macro signals – on top of the employment numbers – to get a good sense of how Q3 has been going before we need to make a decision on 9/21.

Ok, decision taken on how to decide. I feel relieved. Let me get back to my relaxed bubble bath!”