Monday, September 10, 2007

Hawk No More

I tend to agree with KNZN's assertion that what is need is fast decisive action by the FED. Even as late as this spring I was a hawk, calling for increases in the funds rate by 25 -50 basis points. Now I am reversing course, looking for a 50 basis point cut now and a bias towards at least 25 more basis points if the September employment data is as bad as I expect.

Isn't this the kind of schizophrenic action that bankers are supposed to avoid?

The traditional approach says yes, but I am coming to believe that slow steady tightening with a tendency towards over-tightening and then dramatic easing might be the way to go.

Why?

Because the response pattern from monetary policy is humped shaped. We get real effects first, inflationary effects later. Moreover, the damage from recession is that people lose their jobs and can't pay their bill immediately. The damage from inflation occurs because the long term trend of prices becomes less certain.


Pumping loads liquidity into the economy as it tilts into recession has the potential to stop what is happening now and prevent the acute crises that comes from joblessness. On the contrary controlling the evolution of prices should be a much more gradual process that convinces financial entities that, whatever happens today, the value of long money is protected.

From a slightly nerdier prospective, the suboptimality of a recession occurs because liquidity constrains the equation of marginal cost and benefit. The suboptimality of inflation occurs because uncertainty drives a wedge between marginal cost and benefit. Setting the modal response towards over tightening combined with spikes of easing provides slack when constraints bind while keeping expected values in the target range.

6 comments:

Anonymous said...

I think the Fed cuts Fed Funds by 25bp and Discount Rate another 25 bp ... they'll be deliberate and patient .... futures point to 25 bp more by November meeting and 25bp more by February meeting

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