China's short-term economic destiny hinges on the health of the American
economy. Of the roughly RMB 20 trillion of value that China will produce
this year, more than ten percent will be exports to the United States. The
United States is the importer of last resort for the Chinese economy: a
sharp fall in demand from America for China's products would stand a very
good chance of sending the Chinese economy into recession. Neither the
Japanese nor Western European governments would allow their imports from
China to rise enough to make up for a substantial fall in demand from the
United States. And the other countries of the world are not rich enough to
be reliable as large-scale sources of demand for exports from China. Thus
China's current export-led development strategy relies, for its short-term
success, on strong demand from America--which requires that America avoid
major recession.
Now, however, for the first time in three years, the possibility of a
major recession in America is on the table.
The United States has a market economy, yes. There are substantial islands
of social democracy within that market economy--total government spending
at all levels of government is roughly one-third of total income, perhaps
one-tenth of the prices in the economy are heavily regulated by government
agencies, and the antitrust authorities act to curb (or attempt to induce
lower prices by threatening to act to curb) monopolies. Yet few would
dispute that the United States has, overwhelmingly, a market economy.
Yet there is an important island of central planning within this market
economy. One of the most key prices in the economy is set by a board of
bureaucrats: the Federal Reserve determines short-term interest rates.
Thus the terms on which businesses and households calculate the relative
price of time and waiting--of producing and consuming next year rather
than this year--is not trusted to the market.
Every month and a half or so, the Federal Reserve's Open Market Committee
meets in Washington. It is a meeting that nearly everyone (except
professional monetary economists) would find mind-numbingly dull. After
the meeting, the Open Market Committee directs the Federal Reserve Bank in
New York to buy or sell short-term Treasury bonds to set the overnight
interest rate on bank reserves. In the case of the last meeting, the Open
Market Committee directed the Federal Reserve Bank of New York to keep the
interest rate on overnight bank reserves at 5.25% per year. Traders
seeking advantage thereupon kept the three-month interest rate on Treasury
bills--short-term bonds--at the same 5.25% per year.
The Open Market Committee decided that this key price--the interest
rate--didn't need to be raised or lowered to be consistent with price
stability and with maximum employment, purchasing power and growth. This
is the first time in two years (and 18 meetings -- the meetings are held
every month and a half) that the FOMC has not raised interest rates, which
have climbed 4.25 percentage points since the spring of 2004.
From one perspective these FOMC decisions are trivial and tiny. As a
result of this phone call, the trading desk at the Federal Reserve Bank
will buy or sell a few extra billion dollars in bonds, far less than $100
worth for each person in the United States. Banks and other financial
institutions will have a little more or less cash, and a little fewer or
more bonds, but the proportion of cash and bonds in their portfolios will
change by what seem to be insignificant amounts.
Yet such relatively small actions by the Federal Reserve's FOMC affect
every single bond price and interest rate in the entire world. Traders on
Wall Street are now revising their expectations about the future path of
interest rates.
When the FOMC raises interest rates, as many expected would happen
Tuesday, corporations tend to borrow a little bit less than they would
have otherwise, spend a little bit less on new factories and equipment,
and so hire fewer people. Construction companies borrow a little bit less,
spend a little bit less building houses, and so hire fewer people. The
slightly higher interest rates lead a few households to decide not to take
out that home equity loan after all. Those households spend less, so the
businesses that supply what they buy hire fewer people.
The chain of decisions triggered by raising interest rates is costly.
Unemployment would be a little bit higher if the FOMC had raised interest
rates today: By November 2007 there would probably be an extra 250,000
Americans unemployed. That's why the FOMC didn't do it. That's why the
FOMC stood pat and kept bond prices and interest rates constant Tuesday.
But raising interest rates would have had benefits as well. Lower demand
lowers inflation. Because the FOMC didn't raise interest rates this time,
by November 2007 inflation will probably be higher by about 0.1 percent
per year. If you believe -- as the FOMC does, with a faith so strong that
St. Paul would marvel at it -- that the economy works much better if
prices are roughly stable, with lower average unemployment and faster
growth, then that creep-up of inflation is not something that should be
allowed to continue indefinitely.
Every economist in the world wishes Federal Reserve chairman Ben Bernanke
and his team at the FOMC well. We all hope that he makes the right
decisions, even when we disagree with him. We would prefer that his
decisions be right and our judgments be wrong rather than his decisions be
wrong and our judgments be right. But we all have our views, and so the
FOMC's meetings every month and a half are surrounded by a chorus of
commentary from economists, each of them saying what he or she thinks the
FOMC should do.
For the Federal Reserve is trying to hit the sweet spot. It would be bad
if inflationary pressures returned to the levels they were in the 1970s,
and growth slowed as people became confused about which prices were rising
because goods were in short supply and which prices were rising simply
because the Federal Reserve had pumped too much cash into the economy by
keeping bond prices too high and interest rates too low. It would be bad
if the Federal Reserve pushed bond prices too low and interest rates too
high and then discovered that it had pushed unemployment higher as well.
Some think that the FOMC has already raised interest rates too high. They
see an economy in which the principal danger is not that inflationary
pressures are gathering but that spending is already falling. Dean Baker
of the Center for Economic and Policy Research notices rapid increases in
credit-card debt outstanding in May and June, and fears that this is a
sign that past FOMC interest rate increases are already shutting down the
home-equity ATM, and that households that can no longer borrow
attractively against home equity are maxing out their credit cards. If
that's true, they will be forced to cut back on the consumer spending that
has fueled so much of the current business cycle expansion. The economy is
still growing now, but Baker and others think that's because a lot of the
consequences of the past two years of interest rate increases have not yet
had their full effect. These increases are still "in the pipeline," and
come November 2007, according to this point of view, we will all be glad
that that the FOMC did not raise interest rates Tuesday.
On the other side, Marty Feldstein of Harvard, president of the National
Bureau of Economic Research, and former chairman of the President's
Council of Economic Advisors under Ronald Reagan, believes that the
Federal Reserve must "convince the markets that inflation will be
contained" as successfully under the stewardship of Bernanke as it was
under Alan Greenspan, and as a result the FOMC "must show that it is
willing to take the risk of tightening [interest rates] too much." But
John Berry (who used to make the Washington Post's coverage of the Federal
Reserve the most sophisticated of all daily newspapers before he jumped to
Bloomberg) judges that the markets expect a pause, and that there will not
"be much of a backlash from analysts wringing their hands about Fed
Chairman Ben S. Bernanke being 'soft on inflation' or about the loss of
Fed credibility as an inflation fighter. After all, a pause would be just
that."
Feldstein recognizes that uncertainty is immense, and that he could well
be wrong in his judgment that inflationary pressures are the major risk to
be guarded against: "The consequences of the past [two years' worth of]
interest rate hikes are difficult to predict ... [a] fall in house prices;
residential construction plummet[ing] …; lower housing wealth; [a] sharp
fall in mortgage refinancing, bringing down consumer spending,
expenditures on equipment and software slow[ing] sharply … A much sharper
slowdown than the central tendency forecasts is certainly possible."
This uncertainty is the reason that the FOMC is feeling its way month by
month, moving interest rates in small, bite-sized quarter-percent
increments, and warning everyone that it does not know what it is going to
do next. The FOMC calls its decisions "data dependent," and the committee
members know the stakes and risk and the magnitude of uncertainty as well
as anyone.
From one perspective this looks like witchcraft: a group of people in a
room pulling and pushing metaphorical levers when they are not sure how
strongly these levers are attached to anything.
From another perspective this is a triumph of technocratic central
planning. Trained professionals are trying their best to socially engineer
a healthy and productive economy. They're thinking and making decisions at
a level of detail and sophistication that not one person in a thousand can
follow, and yet those decisions have a powerful impact on all of us.
And it is not only the short-term economic destiny of the United States
that hinges on whether the FOMC has gotten it right. The short-term
destiny of China, and of the rest of the world, hinges on the FOMC's
getting it right as well.
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