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How Bad Is the Bernanke Taper?

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Monday, 08 July 2013 15:34

Paul Krugman, among many others, has been denouncing the decision by Federal Reserve Board Chairman Ben Bernanke to discuss plans for backing away from the current pace of quantitative easing. While I agree completely with his logic, I am bit less concerned about the downside than he seems to be.

Krugman is certainly right that there is no reason to be talking of tapering right now. We are close to 9 million jobs below the trend level of employment. By the Congressional Budget Office's estimate we are still 6 percentage points below potential GDP, which corresponds to $1 trillion a year in lost output. Furthermore, inflation is low and falling. We would better off if it were somewhat higher since this would lower the real interest rate and reduce debt burdens. In this context, it is difficult to see any upside to talk of tapering.

And Krugman is also right about the market's strong reaction. The interest rate on both 10-year Treasury bonds and 30-year mortgages is up by more than a percentage point from the pre-taper talk levels. That is not helpful for the economy right now.

However, I am also not convinced that it is all that harmful. To my mind, the greatest benefit of low interest rates was the refinancing boom that it allowed. This freed up tens of billions of dollars for consumption. The refinancing process itself also generates economic activity in the form of legal fees, payments for appraisals and other costs (i.e. waste) associated with the refinancing process. Refinancing will quickly slow to a trickle with mortgage rates now over 4.5 percent.

But refinancing was always a self-limiting process. At some point everyone who could profitably refinance a mortgage at 3.5 percent will have done so. We surely must have been reaching this point so that refinancing would have slowed in the second half of 2013 and 2014 with or without the Fed taper.

Higher interest rates will also dampen the rise in housing prices. That is not a bad thing in my view. House prices are back at their trend levels in most parts of the country. In many areas they were growing at ridiculous rates (30-50 percent annually). If that had continued, we would have seen many local bubbles develop. If the rise in rates slows these price increases, that is good news in my book. A new bubble in Las Vegas or Phoenix would not move the national economy, but no one in their right mind could want to see another group of homeowners in these cities caught up again in a bubble, paying 20-30 percent above the trend price for their home.  

Perhaps the biggest negative effect of the Fed taper will be its impact on the value of the dollar. The dollar has risen around 5 percent from pre-taper levels against other major currencies. That will make U.S. goods less competitive and increase the trade deficit. Since trade is the fundamental imbalance in the U.S. economy right now, this is exactly the wrong way to go.

Long and short, this was a bad move by the Fed and pushes the economy in the wrong direction, but the impact will probably be limited. Consider the taper a mistake by Bernanke, but I wouldn't suggest he jump off a bridge over this one.

Comments (14)Add Comment
20 questions...ok 5
written by Jim, July 08, 2013 9:21
Dean, why has there been such an increase in real rates, not only in the US, but in bunds, gilts, even peripheral bonds, at a time inflation is nascent? Is Bernanke's decision more harmful to these European economies that are progressing more slowly than we are(scared we are winning!!)? Is the market predicting more inflation, or just a greater chance of short rates increasing sooner? Aren't both of these ideas deeply inconsistent with reality? Does this signal the Fed had more impact than the 30-80 bps most people believe or has the market overshot? I loved your piece on asset bubbles btw. Interestingly there is a huge dichotomy in valuations between large and small/mid cap stocks, near their postwar high in p/e differentials.
confusion over monetary base and money supply
written by pete, July 09, 2013 12:09
The dollar has plenty of room to fall if the money supply increases to reflect the increase in the base. This is what the inflationistas have been worried about. Ben could push this without buying mortgages, but it just ain't happening, yet. Low rates also induced hedge funds to buy real estate, not just refinancing. But the real issue is you want me to cut back on my consumption of cheap chianti and camembert, and that really stinks ;)
Inerest rates elsewhere
written by Dean, July 09, 2013 4:48
Jim makes a good point. The Bernanke taper has raised rates worldwide. It may have more impact elsewhere than the U.S. It certainly is not helpful in the euro zone, which badly needs anything resembling stimulus.
Politics of succession trumping economics?
written by WNY-WJ, July 09, 2013 10:25
Is it possible that the pivot to (expectationally) tighter policy has to do with the likely change in Fed leadership in early 2014? By pivoting to (expectationally) tighter forward guidance, monetary policy is arguably (expectationally) tighter, allowing a successor the option of later expectational easing... assuming that the Fed can stay the course thru the likely succession.

It is important to note that there is no change yet to Fed purchases associated with QE... just a lot of hot air.

More from this line of thinking here: http://wnywj.wordpress.com/201...nsparency/
But won't higher interest rates reduce viable investment?
written by Yoram Gat, July 09, 2013 1:49
My understanding of standard theory is that for an investment opportunity to be considered viable it has to provide RoI that is higher than prevailing interest rates. Thus, higher interest rates mean less investment.
The need for "Investment" vs *consumption*
written by A Populist, July 09, 2013 1:55
Dean,

I am puzzled by occasional statements from Krugman regarding the need for *investment*, such as this quote:

"...where else do we argue that demand curves (in this case the demand for investment) are vertical at low prices?"

My view, is that consumption is what is lacking. True, demand also consists of investment, but private investment responds to consumption (or anticipated consumption), either directly, or indirectly through the supply chain, and that private investment is done only for anticipated profit, so lower interest rates have their limits.

In our national discussion, it seems to me that using the word "investment", promotes confusion. When Austrians or supply-siders hear "we need more investment", they will nod their heads, assuming you are in agreement, that the problem with the economy is a supply-side issue.

Back in the 40's, 50's and 60's, it was understood (among the public - common wisdom) that increasing productivity meant that *consumption* must keep increasing, to keep everyone employed.

While Joe Public doesn't really understand economics, at least back then most had an intuitive idea that cutting wages and consumption slowed the economy.

Now, all the public hears, is that the wonderful investors and bankers are the ones responsible for prosperity, completely ignoring the role of consumption as a necessary part of the economy.

The idea of raising the minimum wage is not anywhere in our public discourse, nor is the word CONSUMPTION. Krugman seems to agree that the problem with the economy is a lack of demand, but even he cannot seem to bring himself to use the word *consumption*.

I know it may seem like a lost cause to get the public educated on economics, but it seems like we should not be afraid to use the word consumption, as it seems to be a concept that Joe Public can understand.

Using the words "lack of investment" to describe a lack of demand, I think leads to confusion.

With a public badly in need of understanding what is wrong with the economy, we need clarity.
You say Housing Bubble as if it were a bad thing.
written by Capt. J Parker, July 09, 2013 6:16
Gee Wiz. A stimulus junkie actually worried about reinflating a housing bubble! I knew there was a reason I keep reading this blog. Now, if only there was some discussion about the risks of a bloated monetary base given how easily rates can jump up. How bad a beating did the Fed's bond portfolio take from the 1% rate rise? Like pete says - the dollar has plenty of room to fall - and fall it will if the Fed finds itself lacking enough assets to sell when the time comes - and that time will eventually come.
@ Capt J Parker: Fall against what?
written by A Populist, July 09, 2013 6:34
Who wants *their* currency to become massively stronger and kill their export-related jobs, raise their hands!

How about you, Mr. Euro? How will Spain like that?

Any other takers?
Consumption
written by Jim, July 09, 2013 7:43
Isn't your POV that consumption is still too high as a % of disposable income so the real issue should be raising disposable income no? And that speaks to the point you made about the recent rise in equities having little impact on consumption because so few Americans own them, or the zandi housing wealth effect post where the savings rate should actually be higher. So then it's more of a question of how to increase disposable income and that goes with the minimum wage and the impact it would have on all of these low productivity retail, restaurant jobs being created but doesn't that also mean we need more inflation to create wage increases? How else do we get there? More investment in food stamps, snap, unemployment, teachers, firemen by the government I suppose.
Consumption
written by A Populist, July 09, 2013 9:06
@Jim

I can't speak for Dean, but I think a higher minimum wage should be a goal. Dean has said that many studies found that moderate increases in the minimum wage have a very small impact on employment.

I think that if you raise the minimum wage and create infrastructure jobs, that will help reduce SNAP EITC, and unemployment compensation. That would be a big political plus, as nobody wants to see people destitute (well, almost nobody), and nobody wants to see people freeloading (Contrary to silly caricatures of liberals). And, contrary to the picture that divisive hate radio types try to paint, most Americans generally don't want to *be* freeloaders - they just want a job.

I agree with Dean, that there is little room for most people to consume more. I would throw in the statistics on how much people have saved for retirement, which is terrifyingly inadequate. So, from my perspective, consumption has been higher than is sustainable at prevailing wages. If people had not been short changing their retirement savings to consume, and doing cash-out refis during the boom, the economy would have been slow for the last 15 years. At present wages, if people started to cut back consumption in order to save for retirement, I would expect to see the economy slow down further.

I don't know how you can avoid concluding that low wages and increased productivity have created a secular shortfall in demand, and a surplus of labor, that no one is doing anything to correct.
who is falling where....
written by pete, July 09, 2013 9:49
competitive debasing of currency is a tricky thing. internally there are transfers, as we have seen, from poor to rich, and from lenders to borrowers, when there is unanticipated inflation. i.e., banking crisis and lousy income distribution. internationally of course there is no change, if the euro and dollar both fall (in terms of goods and services) then there will be no change in the exchange rate. Yet this seems to be somehow the prescription, everybody should inflate. So that is just the internal thing...lower the real wage rate, and screw the lenders.
@apopulist
written by Jim, July 10, 2013 12:06
I agree with that I am just trying to figure out how we raise disposable income outside of the minimum wage and more government support. I don't think we want a return to a 110% consumption to disposable income. Daniel Gros wrote a good article about how the fed supports states more in the form of banking guarantees than social support in arguing for a European banking union. It just occurred to me when Dean cited the toobigtoo fail subsidy what utter bs that entire concept is. That can't help labor get their share of the pie back.
@apopulist "increased productivity"
written by Jim, July 10, 2013 12:11
That part however is very wrong.

http://ftalphaville.ft.com/2013/07/08/1559732/us-productivity-growth-back-to-form/
...
written by A Populist, July 10, 2013 2:06
@Jim:

I read the linked article. Regarding the drop off in productivity *growth* I agree with this comment:

"ReportTom_ | July 8 9:44pm | Permalink
The recent drop in productivity growth seems pretty obviously related to the preponderance of low-value adding jobs among new hires."

However, even though productivity *growth* has slowed, productivity in absolute terms continues to increase (growth is still positive). Even a very small annual increase in output per man-hour, compounds over time. Unless cumulative growth in consumption keeps pace with cumulative growth in productivity, hours worked must decline.

Also, the more scarce a resource, the greater efficiency the economy will make of that resource. So, if labor becomes more scarce, productivity growth will resume.

As it is, we are wasting resources on marginal productivity jobs. Also, the fear of being thrown into the maw of minimum wage wasteland distorts flexibility in the labor market. Who would dare to leave a safe job for even a very attractive alternative, when the price of failure could be an unlivable minimum wage, or permanent unemployment?

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.

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