Worst Case Scenarios: Why the Fed Tends to Overtighten
Forget, for the moment, the specifics of the May 10 Fed Minutes. Instead, consider the decision making process the FOMC goes through.
When making complex decisions with serious ramifications, it is useful to understand what is at risk if you are wrong. That one factor impacts various outcomes dramatically.
Its a given that the future is unknowable. The complexity of the economy, random events, unexpected interactions, dumb luck -- force all forecasters to recognize the inherent possibility, and indeed, high likelihood of error. Typically, that recognition colors policy making. (Consider recent examples where expectancy analysis was ignored in the policy making process -- with dire results).
Once you get through that process of error expectancy, then play out the various decision tree possibilities: The results are why the Fed tendency to overtighten is all but a fait accompli.
And, we like it that way.
Why? What is the worst case scenario if the Fed Overtightens? The economy slows, maybe we even have a recession. Not to make light of what is always a painful situation, but -- so what? Recessions are a normal part of the business cycle. The U.S. economy is flexible, multi-faceted and resilient enough that a mild recession -- or even a strong one -- is a minor inconvenience in the grand economic scheme of things.
Consider: A recession reprices overvalued assets; It creates a cathartic cleansing that forces efficiencies where there were none before. It removes excesses that have developed.
Has the U.S. ever not bounced back from a recession? Of course not. Over the next century, we will have a dozen or more recessions, and an equal number of recoveries.
But consider the alternative error: What happens if Inflation is no longer contained -- if it gets away from them?
That is a far, far worse outcome than a recession. I am old enough to remember the nightmare of the 1970s. I have no desire to live through THAT again (and I'm not referring to Disco, Bell bottoms or Nixon). It was FUGLY:
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1970s Inflation: Worse than Disco
Source: Economagic
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Once inflation is no longer contained, it becomes a runaway wildfire. The Fed -- indeed, central bankers everywhere -- find it difficult to play catch-up. Inflation is self-reinforcing -- it forces everyone in the system to raise prices, pass along increases, demand higher wages. It feeds upon itself.
The response? The Fed goes Volcker (now, a verb) on the economy: They force an even more severe recession. The medicine to recover from this is a brutal, economic chemotherapy. It can take a decade to recover from uncontained inflation -- or the cure.
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That's the dilemma confronting the Fed. What is the worst case scenario if they are wrong and overtighten? We get some unpleasantness -- but nothing fatal. No one likes recessions, but they are a natural part of the business cycle. (We don't care for death either, but its a part of life). After the Recession, comes the Recovery.
This is why the Fed tends to overtighten. We always -- ALWAYS -- rebound from a recession. Relatively quickly, also. But 1970s-style inflation is a spectre that haunts the dreams of all economists -- especially those who sit on the Fed.
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Given this choice of potential negative outcomes, what would you do?
Thursday, June 01, 2006 | 07:20 AM | Permalink
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Comments
"Inflation is self-reinforcing -- it forces everyone in the system to raise prices, pass along increases, demand higher wages. It feeds upon itself."
You've just reinforced my stance that inflation is not only a monetary issue, but also a psychological issue, which is why we get a steady stream of open mouth committee members giving speeches about how tough the Fed is going to be on inflation, as if telling the average joe this b.s. will make him feel better about his rising costs, excluding those things that are rising in price.
It's all crap anyway as the Fed is the creator of inflation. Break out your W.I.N. button, Barry.
Posted by: Uncle Jack | Jun 1, 2006 7:40:29 AM
Great comment! Why CNBC spends its time cheering the possibility of a pause is beyond me. Are they that nieve as to think this will be good for equities if inflation gets out of control? Nothing could be worse.
Posted by: bsteve | Jun 1, 2006 8:12:32 AM
Well Said. Seriously.
Posted by: DG | Jun 1, 2006 8:15:15 AM
If the Fed wants to force a recession and higher unemployment, could they lay off Fed bankers and Fed economists this time to make their numbers instead of impacting the lives of real people?
Posted by: Fred | Jun 1, 2006 8:22:19 AM
Barry,
I agree with everything you say except for how severe a recession could be.......imbalances (budget and current account), potential dollar crisis, financial leverage, complacency (under-pricing of risky assets), taken together with baby boomers cashing out of equities does not point to a benign recession we can snap out of quickly, but something more severe and longstanding if the fed overtightens or the risk psychology changes.
Posted by: pjfny | Jun 1, 2006 8:23:03 AM
Yes. Just ask the Japanese about the "quick" bounce back recovery from extreme excesses in stocks and real estate...
Posted by: Ned | Jun 1, 2006 8:44:11 AM
no one complained when they took the FF rate to 1%, created negative real interest rates and drove an asset and commodity bubble. it's a double standard.
the Fed is living a fools paradise if they think they can engineer a soft landing. i find it very interesting that they have changed their tune in respect to market driven indicators such as the dollar and the TIPS b/e spread. that is a responese to the disrespect the market is showing the Bernanke Fed. i've said it before they are damned if they do/damned if they don't. markets are much smarter and more effective than a board of bureaucrats and they are now in control. sorry Ben, you have already become irrelevant.
Posted by: vf | Jun 1, 2006 8:53:36 AM
inflation may haunt those who sat on the Fed, but I'm not sure inflation is what keeps those who sit on the Fed up at night.
Posted by: dave | Jun 1, 2006 9:02:06 AM
I cannot understand how so many economists base their fears of inflation on a potential repeat of the late 70s early 80s cycle. There are SO many differences between now and then that make a repeat VERY unlikely. Inflation fears, while logical at some level, are way overblown.
The market is forcing the Fed to look back and not forward to the inevitable slowdown already beginning. The effects of the last 200+ basis points of tightening are yet to be felt and the Fed is being forced to raise rates that will soonnhave to be cut.
Posted by: ben | Jun 1, 2006 9:10:39 AM
wouldn't it be better for the government to raise taxes, and cut expenditures?
Posted by: big Al | Jun 1, 2006 9:33:25 AM
The choice isn't recession versus no recession; Its Mild recession versus Severe recession . . .
Posted by: Barry Ritholtz | Jun 1, 2006 9:33:51 AM
Barry,
Except that this time we will have a synchronized worldwide recession. This will cause the worldwide real estate bubble to burst. Real estate bubble is the worse kind of bubble (well, with the exception of the tullip bubble) to have because it is non productive asset compared to telecom and internet bubble that we had in 2000. Just ask the Japanese. So while I believe that we will eventually recovery from it, it may take a long time, years and perhaps even decades.
Posted by: Dennis Chan | Jun 1, 2006 9:36:39 AM
I agree that recessions are a normal part of cycles but the problem is that not very many people set themselves up for them! That's directly related to the Greenspan put.
And if one believes in the Greesnpan put, wouldn't one have to believe that, to overshoot, the Fed would have to lift rates past where Greenspan started in the first place? And since equilibrium rules over the long term, the US might just be forced to bring it back to those levels... Inflation might just do the job for them if the Fed doesn't. The Fed might try to save the economy but time will show that outside forces will show how useless the Fed is. It can control the market rate for a while until the uimlances get so huge that a tidal wave washes up the shore.
Asset bubbles overflow into the price of goods. Over time people will take their profits and spend them. The only way out of inflation is for the asset bubble to burst. And that's not palatable either.
I still don't believe the US will implode but I do think it will go through some tough times like the UK did. And they might need their own Thatcher but that's after debt to GDP reaches huge leveks. But Bush seems to be doing a good job of accelerating the process!
Posted by: D. | Jun 1, 2006 9:39:34 AM
Another important difference: labor has been eliminated as a political and economic force. There is no demand for higher wages because employees are afraid -- of losing their jobs, of losing their houses, of losing the war, of losing their lives. How fear changes the equation is an interesting question, particularly when it comes to inflation.
Posted by: MDR | Jun 1, 2006 9:41:57 AM
Destroying the value of the currency (inflation?) is the way politicians raise taxes on the stupid (foolishly trusting of the talking heads?) and those too poor and underpaid to own many assets that could rise in value. We are also leaving out the political element of Bernake's position (which is the main reason the Fed does what it does IMHO). He wouldn't want a recession BEFORE the next election or the folks that appointed him will be mighty ticked off. Jimmy Carter (another "sweater" guy?) got badly Volkered. Right?
Posted by: Ned | Jun 1, 2006 10:16:06 AM
It's funny how the "we cant have a recession now because it would be terrible" meme is being put up as a counter to Barry's point.
Doesn't that imply that we ahould have had one earlier when it would not have been so bad? Doesn't that support Barry's argument? That we should take the medicine early on?
How would it be better if we take the medicine later?
Posted by: drab | Jun 1, 2006 10:26:40 AM
FRB will always do what it can to support Republican chances. and they're doing that right now, in letting "pause" talk proliferate in the face of obvious inflation. question is, when will they write off Republican chances for this Nov and start to focus on taking the bad medicine now to ensure recovery and upswing 2 yrs from now for brother Jeb. i think the evidence in commodities and emerging markets is that the tightening is on
Posted by: scorpio | Jun 1, 2006 10:30:46 AM
Dear Barry, The only positive thing for the Bush admin to crow about has been the economy. I agree a mild recession is consistent with the natural cycle. What concerns me is the possible manipulation by the Bush admin to make the economy continue to look good into the next election and the resulting long term effects. Its not good to fool with mother nature and natural processes. Dave
Posted by: dave | Jun 1, 2006 11:11:50 AM
Them thar industrial commodities look to be dumping a big turd. Three limit downs in a few weeks? Asian business execs have turned negative on the economic outlook. Oh, but not CNBC. DOH! Anyone care to guess the last time gasoline supply was this high? 1996. Know when oil supply was this high? Oil was at $10 bucks. Natural gas stocks? Fifty percent above the five year average. But, Wall Street tells us supply is tight because of China and India? And, we are running out of oil. (I actually wish we were for innovation.) Oh yeah baby. China has supposedly been growing at 10% a year from 20 years............and oil was $10 just before the tech bubble popped. It has nothing to do with China demand. Well, maybe $30 dollars of the move did. Just like copper and just like zinc and lead and platinum and paladium and on and on and on.
If Iran and the US have some type of agreement which eases this supposed "risk" premium which is really the Wall Street greed premium as they jam up oil prices, we will likely see them drop a turd too. Especially if global growth craters. We'll have enough excess oil to take a bath in. But.........I do expect oil to hold reasonable pricing instead of dropping to $5. People love this running out of oil story too much.
Guess what the locust hedgies will likely do now? Well, that is if they are smart enough to not buy copper on the dips. Look down on their chart and it says buy tech for the mid cycle bull run ala 1995. So, we'll likely get a tech rally soon as they plow out of commodities. I expect more psycho behavior before it is all said and done. The locusts will continue their foraging till they crash and burn.
Ok, one final comment. A conspiracy theory. Some healthy paranioa. lol. What if, post 9-11, the Bush administration met with Wall Street and/or business leaders. Let's say a strategy was devised. Spur innovation for energy independence. How would that happen? Drive oil through the roof and you'll make profits doing it. We, the administration, will support you by squawking that it is global demand and threatening the oil companies. And, doing so will start cranking up the American innovation machine. And, we will continue to support you, financially if required, to keep the price high. Plausible? If I were Bush, that is what I would have done. lol.
Posted by: B | Jun 1, 2006 11:18:24 AM
Barry, Great points, kind of mostly. Peter Bernstein writes brilliantly about how you handle a low probability event that, if it came to pass, would have devastating consequences, and it’s a very interesting question. The kind of mostly part of my response is sort of twofold. First, the Fed, in its Greenspan era arrogance, pushed the idea, at least implicitly, that its brilliant management of the economy had basically superannuated the business cycle, that recessions were a thing of the past. Always struck me as shades of “The market has reached a permanent high plateau” (Richard Fischer, paraphrased, in August or thereabouts of 1929), pride goething before a fall. But certainly the idea developed that recessions were bad things to be avoided at all costs. In my opinion that’s a large factor behind the paltry nature of the recovery we’ve had, that we didn’t let the corrective part of a recession, in which over- and mal-investment gets washed out and bad debts written down and balance sheets cleaned up (happened on the corporate level, but not at the consumer level) and demand gets rebuilt (it never slowed down), play out.
The other mostly sort of is all the attention paid to deflationary scares a couple of years ago. I thought it was all bogus, frankly, but the Fed research papers about what to do at the zero bound, (and isn’t that when Bernanke picked up his Helicopter Ben moniker?) and the lessons of Japan, all had to do with the thought that deflation was a more dangerous force, once in play, than inflation. So I’m not sure I agree with you—remember also that Bernanke’s big academic work was on the Depression, which he viewed as caused by Fed errors, errors in tightening too much. I”ve got a paper somewhere from a Grant’s conference that was delivered by Edward Chancellor on this subject—sounds like I should dig it out and read it again. If I find it, I’ll get you a copy.
In any event, certainly the stagflation view, which seems a not low-probability outcome, would suggest both too much tightening (which in my mind may already have occurred—that is to say, we may be past the point of no return on a recession) and too little tightening, which is to say, inflation’s ugly head is already reared and looking around.
Posted by: Scott Frew | Jun 1, 2006 11:36:19 AM
With the FOMC talking about a possible 50b.p. move last meeting , do we still believe that the Fed and Bernanke are dovish ?
Posted by: DM2 | Jun 1, 2006 11:42:16 AM
I agree with the people who note that the present situation is hardly analagous to the 70's.
By 1971 the nation had realized that it was caught fighting an unwinnable war in Indochina. By 1975 the last soldier was gone.
At present the US is trapped in Iraq with absolutely no way out. The current trajectory is an expansion of the Middle East War, certainly not limiting our involvement.
As the sole superpower we require the rest of the world to have confidence in the longevity of our economy, and especially our currency.
Now the US is in a terrible situation. Each interest rate hike further threatens stability by risking a collapse in the housing market.
As you identify, if they don't "take the medicine now," we are risking escalating inflation and potentially hyperinflation due to a runaway money supply.
I encourge you, Barry, to focus more on "The Big Picture" in your expository travails. None of these economic phenomena are occuring in a vacuum.
The fact that dollar holders in China, Russia, and the Middle East are getting jittery about the prospects for their investments is closely tied to our renegade foreign policy.
The refusal to acknowledge the problem with running up national debt year after year is the same refusal to acknowledge that Iraq is not going to be a "democracy," and the only solution is to withdraw immediately.
Posted by: sell_the_dow | Jun 1, 2006 12:27:49 PM
My take is that if the FED overtighten there will be a severe recession, but if they let inflation get away, it will probably be much worse, ie possibly a global depression. With modern global communications and liquidity, markets are more in sync than ever, and investor fear and greed are now more globally aligned. Dramatic, mabe, but underneath, wasn't the last depression basically caused by a massive credit bubble, just like we have today?
I am also wondering if inflation is already here, it's just that so many indicators seem to be 'adjusted' or just don't show it (i.e. how can house prices skyrocket and yet there is no inflation!).
Another example. If there was no notable inflation in the UK, why are the Lecturers demanding a 23% pay rise over the next 3 years. That's about 7.5% a year! They are currently offered 13.1% over the next three years. Once employers start to give in to such demands, well we all know what happens...
Posted by: Greg | Jun 1, 2006 12:40:11 PM
I understand that inflation is bad for those who lend money. However the current situation is bad for wage earners. Our wages have been stagnant / declining. I recall that in the 70's in real terms, after inflation, wages were rising. As a wage earner, why should I hate inflation?
Posted by: camille roy | Jun 1, 2006 1:23:16 PM
The deregulation of industry (that began with Reagan and Thatcher) that promotes price competition, the decline of the influence of unionized labor, and the global labor arbitrage created by free trade and globalization will likely prevent a recurrence of 1970's style consumer price inflation. Asset price inflation is a different monster.
Consequently, I'd take the other side of your trade. I think the consequences of overshooting could be far greater than just a mild recession. Between inflation and deflation, deflation is the greater evil. That's because inflation can be cured with tough policy decisions. But with deflation, you can't compel people to take on credit. Japan is still trying after almost 20 years.
Posted by: S | Jun 1, 2006 2:00:47 PM
