Kansas City Federal Reserve Bank President Thomas Hoenig made some interesting remarks in Santa Fe, New Mexico, about the long-term risks that are created when money and credit are easy for too long, keeping rates near zero (like now in the United States).
He also talked about when financial imbalances put macroeconomic and financial instability at risk.
Hoenig has dissented at the past two Federal Open Market Committee meetings, arguing that the FOMC should not promise to keep rates low for an “extended period.”
When we accept the premise that the United States is slowly, but definitively, moving toward recovery, why should the Fed run the risk of raising interest rates too late and putting the economy in significant long-term danger?
Hoenig expects U.S. GDP to grow at 3 percent in 2010.
Labor markets now seem to have stabilized, along with the unemployment rate.
Consumer spending is improving and is expected to increase at 3 percent during the first quarter, which is critical because consumer spending accounts for about 70 percent of GDP.
The manufacturing sector is following consumer spending and production higher and has increased 8 percent since hitting bottom last summer. Business spending on equipment and software also seems to be picking up.
The weaker links remain residential and non-residential construction, where private investment in non-residential building has fallen at an annualized rate of 25 percent in the last three months and is expected to fall further in the foreseeable future.
Hoenig expects inflation to remain low for the next year or two.
No doubt, the current state of the U.S. economy still warrants an accommodative Fed monetary policy. But there are justified concerns about the possibility of a buildup of financial imbalances that will create long-term risks.
Nobody disagrees that low interest rates stimulate sensitive factors of the economy, but we also must admit that low interest rates distort the allocation of resources in the economy.
During the last decade, we have seen too many resources channeled into financial market activities and real estate construction (residential and non-residential).
Today, we see a Federal Reserve System balance sheet that is more than twice its size of two years ago.
The actual Fed policy statement suggests that rates will remain at near zero for at least six more months, encouraging investors to place bets relying on the continuation of the extended easy monetary policy.
These low rates also will help create financial imbalances for all investors, private as well as institutional, who are searching for yields. That will drive them to invest in less-liquid assets using short-term sources of funds, which is extremely hazardous as history and logic have taught us.
If the Fed doesn’t revise its monetary policy (even only to a very small extent) sooner rather than later, we will be in bubble-land … once again. And that bubble will inevitably pop … once again.
Maybe Fed officials (with the exception of Hoenig) are confident that the long-term risks of financial imbalances caused by an extended easy monetary policy are quite small and that any risks that occur will be handled quickly and efficiently.
I have my doubts that they will be able to reverse the consequences once the economy goes beyond recovery and far into expansion.
OK, I agree. That time won’t be tomorrow but sometime in the future.
So we shouldn’t worry too much.
I sincerely hope the Fed officials are correct.
Otherwise, we will have to battle greater inflation, significant credit and market imbalances and probably another financial crisis that would probably have the economic effect of an eight-plus earthquake.
Yes, I know.
We still don’t have to worry.
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