With There Ever Be Another "Tight Money" Recession?

[MediumTex]

In the early 1980s Paul Volcker's Fed raised interest rates repeatedly in the face of an economy that was already very weak in the hopes of taming the inflation that had been ravaging the economy for a decade.  This policy apparently stopped the runaway inflation, but it also tipped the economy back into recession after it had just come out of recession.  At the time, Volcker was fiercely criticized for these moves.

As far as I know, this was the only example of what Harry Browne called a "tight money" recession (i.e., a recession in which the Fed tightens the money supply as the economy tips into recession) in modern times.  

Does anyone think that the Fed would ever do something like this again?  I tend to think that it wouldn't.  I'm actually sort of surprised that it ever even happened once.

[craigr]

It will happen. But only after the US goes through another 10 years of bad inflation and finger pointing blaming everyone and everything but the guys at the printing press.

[Ad Orientem]

It will happen. But only after the US goes through another 10 years of bad inflation and finger pointing blaming everyone and everything but the guys at the printing press.

I agree.  Interest rates are lower now than they ever were in the 1960's and 70's and the base money supply has tripled in the last few years.  Ben Bernanke has done things that Arthur Burns could not even dream of.  We have massive currency inflation right now.  Price inflation is to my mind inevitable.  The only question is when.  And while no one in Washington will admit it, they desperately want high inflation.  It is the only way they are going to be able to get a handle on the national debt without doing things that will piss of most of the electorate.

At some point the inflation will get out of hand and or people will say enough and then there will be the very painful medicine.  But I think we are many years from that point.

[stone]

I'm not even sure that the Fed could induce tight money now even if they wanted. There is so much more government debt outstanding now than in 1981. Volker induced high interest rates by selling enough treasuries to mop up  base money so that the liquidity requirements of the banking system were pinched. The banking system is now awash with a glut of bank reserves thanks to QE etc. Even if all of the QE was reversed, I'm not sure it would reel in enough bank reserves to raise interest rates much above inflation. The Fed can pay interest on reserves that banks store at the Fed but it doesn't have a source of funding to pay for much of that. Whatever way interest rates might be raised, it would still leave the issue of what a colossal cost paying that interest would be for a $15T government debt. Paying that interest would entail a massive deficit, increasing the size of the headache.

A Volker style rate hike might be conceivable after the real value of the outstanding government debt had been pared down greatly by negative real rates and or taxation.

[moda0306]

I would consider "tight money" today to be if fiscal deficits are lowered to below our trade deficit, and our s-t treasuries yield positive real return of 1% or more.

This isn't very scientific, but has more to do with 1) what wil put fiat assets in domestic checking accounts, and 2) what will induce people to keep it there risk free.

I could see in a couple more years our fiscal deficit shrinking back below our trade deficit, and possibly yields being a bit higher in real terms than they were for most of the last couple years.

This fits with my belief that fiscal policy drives money much more than monetary policy does.  I don't consider QE to be of much consequence.   Fiat purchasing power is fiat purchsing power, whether it's held in a checking or savings account.

[moda0306]

Ps, looking at our massive trade deficits over fiscal deficits from 1997-2008 combined with the fed raising rates through the mid 2000's (much more the former than the latter), I would possibly classify aspects of our current recession as a "tight-money recession," using my own non-monetarist definition, of course.

[stone]

moda, surely what it was supposed to mean was high real short term treasury rates such that all other asset classes were dumped in order to hold short term treasuries. We are VERY far from that now surely.

[stone]

Brazil had just such a year in 2011. Cash beat inflation and the other three PP assets for them in 2011. I think looking at the contrast between their government debt and inflation etc situation and that in places such as the USA, UK and Japan helps to clarify all of this.

[moda0306]

Stone,

I understand... I was just pointing out that we might want to open our minds a bit to what could realistically be called "tight money" in terms of its recession-causing ability.  High-powered base money seems to have dwindled down way too far by 2008 in terms of its domestically held ratio to potential GDP.

Just a quick question... How "real" were the interest rates in 1981?  Best as I can guesstimate, 18% nominal with 12% inflation brings them to 6% real.

Just curious.

To the ACTUAL question of a REAL tight money recession, I don't think we will for a long time... but of course if you accidentally or on-purpose elect an Austrian fed chairman I think it's a possibility... That's one area I think the PP'ers should pay very, very close attention to when the time arises.

[stone]

moda, can you describe operationally how the hypothetical new Austrian minded Fed would go about raising short term treasury rates much above inflation? I just can't see how it would be done without first massively cutting down the value of the stock of government debt. It is not just about being minded to do it. It is also about having the means to do it.

[moda0306]

Doesn't the fed hold a massive amount of the debt?

Simplly sell that debt out into the open markets...

The fed can also do other things such as raise reserve requirements to asinine levels and choke off the fed window...

Couldn't that tighten private credit like crazy?

[Lone Wolf]

Does anyone think that the Fed would ever do something like this again?  I tend to think that it wouldn't.  I'm actually sort of surprised that it ever even happened once.

If the Fed was facing high, persistent inflation and a real threat to the dollar, I could certainly see the Fed raising rates sharply to keep things from spinning out of control.

Politically, this is very unpleasant (witness the criticism of Volcker and the sharp hit on Reagan's popularity at that time.)  On the other hand, this policy had one big thing going for it -- effectiveness.  The inflation was successfully arrested and we entered the greatest bull market in US history.

[stone]

moda,  my guess is that if the fed sold off its entire stock of assets, it wouldn't come close to reeling in enough bank reserves to induce "tight money". From what I can see the Fed has unlimited capacity to spew out bank reserves but limited capacity to reel them back in. Who is going to be paying top dollar for MBS from the fed in a rising interest rate environment? Much the same could be said about LTT that the Fed
now holds thanks to operation twist. Also high interest rates equate to spewing out more money to bond holders that they will then use to bid for treasuries driving interest rates back down again. I really think that the "large government debt = low real interest rates" result is very hard to kick against under the sovereign fiat system (of course with a Euro or gold standard system it is the opposite).

I also don't see how reserve requirements would do the trick. Reserve requirements are in relation to the size of deposits that the bank holds for customers. In the UK and Canada there is ZERO reserve requirement currently.  I wittered on about that on the other thread that D1984 had about this:
http://gyroscopicinvesting.com/forum/ht ... p?t=15.165

banks would probably just charge customers significantly for making deposits if reserve requirement were increased so much. You would probably just make the process of bank credit creation unprofitable and so speed up private sector deleveraging and shrink the banking sector. The difference between treasury rates and the rates at which you could get a loan would widen a lot. So customers would be charged 2% for the service of having a deposit, they would be charged 15% for taking out a loan and short term treasuries would yield negative 2%. It still wouldn't make anyone want to hold bank reserves. Basically to get short term treasury rates up people have to want to hold bank reserves more than they want to hold short term treasuries.

I'm happy to be told I'm wrong about all of this but it isn't clear to me now how I'm wrong.

[moda0306]

stone,

It could very well be very difficult.. I'm having a bit of trouble reversing QE on a massive scale in my head.  I guess the fact that I don't think it does much at all to our money in forward should mean I don't have problems with it in reverse, but I haven't thought it all through yet.  I'm not one to think the "natural rate" to borrow money to the gov't these days is anywhere near 6%, and everything south of that is manipulation.

Further, the MMT/MMR observation that treasury interest actually increases the money supply confuse the issue a bit... yes, more base fiat assets are entering the private sector, but they are doing so at the expense of saving money with the treasury, and not having them "work" in the economy creating productivity and/or inflation... so at least in the short-term it would appear to be anti-inflationary.

[stone]

moda, under our system, the natural rate of interest is zero. The fed has to work at it to induce an above zero let alone an above inflation rate.  In 1981, there was very little government debt so the fed was quite capable of inducing tight money. I suspect it can't now. From now on I guess increasing commodity prices will be what puts the breaks on any business cycle not Fed induced interest rates. Wasn't that what happened in 2010 when a recovery started spluttering into life only to be quashed by high commodity prices?

[moda0306]

stone,

I tend to agree with you that under our system our natural rate is zero, but since I didn't want to break this thing into another giant MMT/MMR thread I wasn't going to boldly go where no Austrian has allowed a thread to go before.

For the record, Gumby and I are officially in the clear here.... stone did it!

To be fair, I could see some kind of CPI-tracking treasury security to represent the "natural rate," more out of fairness to those savers who are losing out to inflation.

That said, a risk-free security that bears REAL interest was never to be seen pre-1971, and from 1981 on for decades we gave savers exactly that... ST instruments that returned higher than inflation after taxes.

[stone]

moda, I wasn't meaning from a "fairness" point of view, I was simply meaning from an operational point of view. What happens when the keyboard strokes are made sort of thing.

[bswift]

The answer to the OP's question is definitely yes.  Easiest question in the world.  Whenever there is an outcome with no time limit, safe to say yes, it will happen. 

I can't follow all the highfalutin discussion of zero being the natural rate of interest.  But if the Fed raised the real Fed Funds rate to 0% right now, we would be in a hellacious recession faster than you can say Alan Greenspan.  With the level of debts across the economy so much higher than in 1981, it wouldn't take 6% real rates to have the same crushing effect.  How sensitive we are to rates is directly proportional to our net indebtedness. 

I don't expect broad-based inflation anytime soon, so I doubt very much the Fed will raise rates, not even in 2014.  I expect we will go back into recession with rates still effectively at zero, and then we will really have troubles.

[MachineGhost]

Does anyone think that the Fed would ever do something like this again?  I tend to think that it wouldn't.  I'm actually sort of surprised that it ever even happened once.

Very easily.  Greenspan did it in 1993/1994.  All it will take is a heterodox theory and enough proponents of such on the Board. 

MG

[MachineGhost]

To be fair, I could see some kind of CPI-tracking treasury security to represent the "natural rate," more out of fairness to those savers who are losing out to inflation.

MMT rears its ugly head again.

The natural rate of interest is whatever rate is necessary to attract capital flows to productive use in a country or its economy.  That is not zero unless real rates are negative.

Someone correct me if I'm wrong.

MG

[moda0306]

MG,

It would seem to me that Greenspan's raising of interest rates in 1993 and 1994 had a lot more to do with coming out of the recession of the early '90's than trying specifically cause a recession to stop runaway inflation.

[moda0306]

MG,

We're not talking about the natural rate of a currency user (a corporation or homeowner), we're talking about the currency issuer.... the entity that through taxation and creating an envoronment of economic prosperity does not need to issue debt to spend.  The US gov't doesn't need to "attract capital."

The natural rate for an entity that doesn't need to borrow is zero... it's simple monetary wealth storage at that point.

[MachineGhost]

It would seem to me that Greenspan's raising of interest rates in 1993 and 1994 had a lot more to do with coming out of the recession of the early '90's than trying specifically cause a recession to stop runaway inflation.

Greenspan raised rates in 1993/1994 under the old fixed exchange rate theory that higher interest rates would attract capital flows to the economy, thus putting an end to the recession.  Greenspan believed there would be no negative consequences.

My wider point was that it is relatively easy to raise short term rates.  Certainly, it would be necessary after a prototypical decade of letting double digit inflation rates persist to "break the back of inflation", but there are other cirumstances where it can and has be done also.  Real rates merely need to rise (or fear of) to be deflationary, the underlying rational is secondary.

I believe Hussman has calculated that the Fed would have to take back half of the outstanding bank reserves just to allow the short term rate to go up to .25% or so without triggering inflation or a tight money recession.  Can Bernanke pull it off?

MG

[moda0306]

MG,

If you look at GDP and unemployment during the early/mid 90's....

http://www.tradingeconomics.com/united- ... gdp-growth

http://www.google.com/publicdata/explor ... l=en&dl=en

http://www.treasury.gov/resource-center ... &year=1994

... you'll see that it appears that the recession looked like it was being climbed out of just fine by the time the treasury started raising rates in early 1994.  Unemployment had been tracking down solidly for a while, and was at 5.9% about when rates started to rise, and GDP growth seemd pretty solid from '92-'94.

Maybe you're right, and that was his line of thinking, but it appears to me that it looks like this would be about the time that the fed would raise rates for purposes that they usually do... because recovery/growth was solidly underway, and the need for easing was no longer apparent.

[MachineGhost]

... you'll see that it appears that the recession looked like it was being climbed out of just fine by the time the treasury started raising rates in early 1994.  Unemployment had been tracking down solidly for a while, and was at 5.9% about when rates started to rise, and GDP growth seemd pretty solid from '92-'94.

Maybe you're right, and that was his line of thinking, but it appears to me that it looks like this would be about the time that the fed would raise rates for purposes that they usually do... because recovery/growth was solidly underway, and the need for easing was no longer apparent.

I agree, so my recollection of why Greenspan raised rates is wrong.  I like yours better.

MG