Thursday, February 18, 2010

Revisionist history about interest rates in the 2000s, and the effect of gasoline on the US economy

Yes, the Fed held down interest rates too low for too long in the 2000s. Hindsight, however, is 20/20, and people were more aware of this possibility than you'd think.
Bill Miller's October 2005 investor letter (found here: cites oil and interest rates as constraints on the US economy. Without the benefit of seeing what happened between October 2005 and February 2010, he could not link them properly. But in hindsight, we can. 
On oil, he points out "the experience of dramatically higher gasoline prices and the prospect of paying much more for heating oil this winter have kept investors worrying about the impact on consumption spending" and says that "we have good evidence that $70 oil or higher puts global growth in jeopardy" based on the evidence already accrued (remember, this was before the true froth in the oil bubble). He believes that the incredible constraint that high oil prices play in the world economy will serve as an effective governor on oil prices, because at that point, the marginal cost per barrel of production was about $40. His projection that oil wouldn't go higher was wrong, but taking his observations a tiny step further, the fact that oil kept rising so much meant that the economy could never seriously heat up in the presence of low rates, so we had to keep interest rates lower than we should have. We can look back and understand that these low rates offset an economy constrained by oil prices, but facilitated a housing bubble.
In fact, his commentary indicates that the Fed was perfectly aware of "froth" in the real estate markets and was having trouble getting real estate speculators to stop. We were aware about the possibility of a housing bubble in October 2005, we were moving to stop it, and intervention wasn't working. He attributes it to investor psychology - probably part of the problem, it usually is - but it's also likely that he underestimates just how badly high oil prices affect the US economy and how badly high oil prices affect long term bond investor psychology and how much we need to lower interest rates to offset this. (note: a high trade deficit weakens the dollar and causes higher oil prices, so this ties in with what I've been writing about, also)
Bill Miller isn't perfect - certainly he was wrong in his projection that ceasing short term rate increases would increase medium and long rates and contain the housing bubble (at that point, it wasn't quite as destructive as it got a couple years later), because he doesn't attribute it properly to energy prices. However, people, including Alan Greenspan, were aware of the problems we faced in real estate and were indeed trying to contain them.
This suggests that as long as our cars use gasoline, we're not going to have the easiest time avoiding crises and competing internationally through economic growth, even if government policy can stay out of the way.
Quotes below on the Fed:

"The Fed has raised the funds rate 11 times and is poised to go to 12 on November 1. It has done so to remove the policy accommodation put in place to counter the bursting of the tech bubble and the ensuing economic weakness emanating from the aftermath of Sept 11, the junk bond collapse, and the corporate scandals. It has also explicitly expressed concern about "froth" in the residential real estate market, and one way to inhibit that is to raise the cost of financing. It has succeeded at the short end, but failed at the long end, resulting in Chairman Greenspan's  "conundrum" of why it is that intermediate and long rates have not risen as they "ought" when the Fed is moving short rates higher...

[Stopping rate increases, resulting in a] rising market will also likely solve Mr Greenspan's conundrum. A pause, or even the signal of a future pause, in the rate increases will awaken the bond vigilantes from their Rip Van Winkle slumbers as they begin to fret about inflation. Falling bond prices will also shake loose those who think bonds have little risk, since they have done so well for so long, and that stocks are risky since they have done poorly. If stocks start to rise, their perceived riskiness will fall, and money will be attracted to equities and away from bonds. The resulting rise in intermediate and long rates will feed back into mortgage rates, slowing if not halting the speculative activity in real estate. That money will likewise move to stocks. Thus the solution to the conundrum is a paradox: to get rates to rise, stop raising rates...

Among the old leaders, the homebuilders stand out, trading at 5 or 6x earnings due the incessant drumbeat about a housing bubble. That industry would benefit greatly from better capital discipline via share repurchase, and some merger and acquisition activity."

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