Economic Insights from Fed President Hoenig

Kansas City Fed President Thomas Hoenig is a lone dissenter at the Federal Open Market Committee (FOMC)—the central bank’s main policymaking body.

At the June FOMC meeting, for the fourth time in a row, he dissented to the Fed’s statement that economic conditions “are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” The aim of this phrasing is to pull down long-term interest rates (such as rates on bonds) and thereby stimulate the economy.

Mr Hoening, however, is of another opinion, as reported in the statement following the June meeting of the FOMC:

“continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted because it could lead to a build-up of future imbalances and increase risks to longer-run macroeconomic and financial stability, while limiting the Committee’s flexibility to begin raising rates modestly.”

As he said earlier this year, he does not believe the “extended period” language is warranted any longer and his main concern is that low interest rates will lead to a build-up of financial imbalances that could pose future risks. He already sees such imbalances building up in bond markets.

In light of the financial crisis, there is a wider recognition among economists of the dangers of low interest rates for extended periods of time. Hoenig points to “long run risks that are created when money and credit are easy for too long, when interest rates are near zero, and when financial imbalances risk macroeconomic and financial instability.” Thus he emphasizes the widespread economic distortions created by easy money:

“There is no question that low interest rates stimulate the interest-sensitive sectors of the economy and can, if held there too long, distort the allocation of resources in the economy. Artificially low interest rates tend to promote consumer spending over saving and, over time, systematically affect investment decisions and the relative cost and aollocation of capital within the economy.”

Such a view of the impact of easy money on the economy is in line with the “Austrian” view of boom and bust, as described in a previous commentary.

Hoenig applies this framework to the financial imbalances that led up to the current crisis; too many resources were chanelled into the financial sector and construction, in large part caused by the Fed’s monetary policy:

“Exceptionally low rates, while perhaps not the single cause, played an important role in creating the conditions leading to our recent crisis.”

Where Hoenig misses the mark, though, is in assessing the current state of the economy. If he had expanded upon his semi-Austrian insights into economic distortions, especially the widespread misallocation of resources that take place in a low-interest environment, he would have seen that the U.S. curently finds itself in a structural crisis in which resources need to shift back to more sustainable uses. Thus his assessment of the strength of the U.S. recovery seems misplaced.

In a more recent speech, to his credit, Hoenig points to sectors of the economy that will be struggling for some time to come, notably the construction industry. The temporary boost from federal homebuyer tax credits are petering out as these programs have been terminated.

Recently released numbers from the departments of housing (HUD) and commerce shows that the sales of new homes in the U.S. has fallen by 32.7 percent from April to May. The major reason for this fall was the expiration of the $8,000 first-time homebuyer tax credit at the end of April.

Hoenig expects that “given the overhang of unsold homes, building acitivity will remain subdued through most of this year or longer.” However, he still does not think the adverse developments in the housing and construction sector will derail the recovery.

Moreover, he cites the donwside risks to economic recovery from the European crisis, which has increased uncertainty and led to “a renewed aversion to risk,” causing investors to flee into safer assets such as U.S. Treasuries.

Hoenig thinks the European debt crisis will have a limited impact on U.S. growth rates, which could turn out to be a too optimistic assessment of the fragilities still seen in global financial markets. However, he rightfully stresses how this episode “illustrates the longer run danger of running persistent budget deficits”—a danger that should soon be addressed in the U.S.

Earlier this year, he warned that the Treasury could come “knocking on the central bank’s door”, asking it to print money to fund the public purse.

“One option for dealing with a fiscal imbalance is for the central bank to succumb to political pressure and monetize the debt. As deficits and debt levels within a country rise relative to national income, interest rates tend to rise as well. In this instance the central bank is often pressured to keep rates low and encouraged or required to assist the markets in facilitating the government’s funding needs. If the central bank succumbs to this pressure, its balance sheet will expand, bank reserves will grow, and inevitably the money supply will increase. This process often appears benign at first, but if it goes on unchecked, the outcome is almost always higher levels of inflation and ultimately a loss of confidence in the value of the currency and the economy.”