Substantial lengths of time often pass between when an economic policy change occurs and that change actually affects the economy. Unfortunately, such lags are not widely understood. This was sharply evident one morning this week.
I received an e-mail from an articulate reader reacting to a recent column about the hard choices faced by Federal Reserve policymakers. “Since the rate can be adjusted several times a year at a small percentage,” he wrote, “why not just wait and act as inflation is observed?”
That is a darned good question. My answer is that changes in the money supply seldom have any but superficial effects before nine months or so have passed. In some cases, two years can lapse before all the effects are felt. I sent that reply then clicked on an Internet news site. A wire service story about Fed Chairman Alan Greenspan’s expected testimony before Congress asserted, “New signs emerged that higher interest rates were taking a toll on the pace of activity.”
The story went on to note that June new housing starts had dropped by 8.5 percent, according to the Commerce Department. I chuckled. If a decision announced on the last day of June was responsible for cutting housing starts over the preceding 29 days, then what economists call “lags” in monetary policy not only are short, but actually negative, causing changes even before a decision is made.
One might reply that households decided against building based on expectations that the Fed would start constricting monetary growth. This is a fair response. Introductory economics emphasized the importance of expectations in all sorts of consumer decisions. Stock and commodity markets rise or fall every day on expectations of what will occur as much as they do on actual events.
On the other hand, fewer new housing permits actually pulled in June probably reflects households that considered building but got cold feed in May or even April. yes, much media discussion back then about how the Fed was going to raise rates sooner or later might have caused the chill. Thus, one could still tenuously claim some link of causation between the announcement of a quarter of a percent rise in short-term rates on June 30 and permit applications earlier that month.
One might make a rather different case, however.
The Fed controls money growth. The money supply, together with many market factors, determines interest rates.
The Fed has the greatest influence on short-term rates, but that influence dwindles as the term of the loan grows. A small cut or increase in overnight rates by the Fed has little effect on 15- and 30-year mortgages.
Monthly data on 30-year conventional mortgages, tabulated by Fannie Mae, show that mortgage rates bottomed out in June 2003, at 5.23 percent. They began to rise, and in June 2004, averaged 6.29 percent.
If the Fed sets interest rates and has not increased rates in four years, why did mortgage rates increase by a full percentage point in 12 months? The answer is that people who consider lending money for 30 years don’t just look at current conditions.
Expectations of what will happen over the entire life of the loan come into play. It is foolish to lend money for 30 years at a low interest rate if inflation could rise and turn those mortgages into money-losing instruments rather than moneymakers.
That is precisely what wiped out the savings and loan sector. S&Ls accepted short-term deposits and made long-term fixed rate loans. inflation burgeoned in the 1970s and the interest S&Ls took in was less than annual increases in the consumer price index. Every month, the effective value of the mortgages shrank.
When changes in depository regulations wiped out what little advantage the thrifts had in attracting household deposits, the whole sector effectively was doomed. This lesson of the dangers of lending long-term at fixed rates is well understood in financial markets. So, as the Fed continued expanding the money supply to keep short-term rates extremely low over the past year, that very inaction motivated lenders to pull back from writing mortgages at the rates of mid-2003.
Yes, one can make the naive case that Fed announcement at the end of June somehow discouraged building activity earlier in the month. One can make a much stronger case, however that mortgage rates rose–and thus housing starts fell–because of Fed inaction.
Mortgage and long-term bond markets fear inflation the way Dracula feared the daylight and the cross. If the Fed refrained from raising short-term rates at all, it would not halt the rise in mortgage costs. It would rather accelerate such rises because lenders would say, “Here we go again: the Fed is asleep at the switch just like 30 years ago.”
Chairman Greenspan was entirely correct in his assertion to Congress that the U.S. economy is basically health and growing. The Fed can tighten substantially from current low rates without strangling the baby in its crib.
He may be entirely correct that increases can take place at a “measured” pace as new information about output, price levels and employment emerges.
But he and the 13 other Ph.D. economists who sit around the big table at the Federal Open Market Committee meetings also know that the true effects of actions they take often don’t show up for a year or more, regardless of some reporter’s belief that effects are instantaneous.
© 2004 Edward Lotterman
Chanarambie Consulting, Inc.