Tuesday, January 18, 2011
This chart illustrates some enduring truths about monetary policy, Treasury yields, and the health of the economy, so it's worth revisiting from time to time. Right now it's sending a strong message: monetary policy is very accommodative, and poses virtually no risk to the economy. This unfortunately undermines at least some of the rationale behind the Fed's quantitative easing strategy (i.e., the economy needs help). Moreover, it also suggests that easy money today could be setting us up for rising inflation tomorrow, and that in turn could lead to another round of monetary tightening and the recession that would likely follow—though it could take several years for the unpleasant implications of this chart to surface.
The blue line represents the real Federal funds rate, using the PCE Core deflator as a measure of inflation (that being also the Fed's preferred inflation measure). The real funds rate is arguably the best measure of how "tight" or "loose" monetary policy is: a high real rate discourages borrowing by making it very expensive, while a low real rate encourages borrowing by making it cheap. When borrowing becomes intolerably expensive, the public's demand for money rises (rising money demand being the opposite of rising demand for borrowed money), and eventually collides with the Fed's efforts to make money scarce (by tightening monetary conditions). An effective shortage of money thus develops that typically results in a recession.
Based on this chart, one could argue that every post-war recession was caused by tight money. And in almost every case of very tight money, there was also a pronounced rise in inflation which created the need for monetary tightening. The late 1990s was the notable exception, since the Fed tightened aggressively even though the PCE Core rate of inflation never exceeded 2% from mid-1997 through mid-2001, gold and commodity prices fell, and the dollar rose.
The red line reflects the difference between the yield on 10-yr Treasuries and the yield on 1-yr Treasuries, what's known as the slope of the yield curve. Bond market math tells us that the yield on 10-yr Treasuries is the market's best guess as to the average of the Federal funds rate over the next 10 years. Investors in aggregate are necessarily ambivalent between keeping money in cash for the next 10 years or buying a 10-yr Treasury bond today—both strategies are expected to yield the same total return over time, because a steep yield curve means that the market expects the yield on cash to rise over time as the Fed tightens policy.
The fact that the red and blue lines move inversely most of the time confirms that the slope of the yield curve is a good indicator of how easy or how tight monetary policy is. When the Fed is very easy, the yield curve is usually very steep, because the bond market anticipates that the Fed will eventually have to raise rates significantly. Similarly, when the Fed is very tight, the yield curve becomes either flat or inverted, which is the bond market's way of saying that tight money today will be followed by easier money tomorrow. In short, monetary policy can't remain at extremes of tightness or looseness forever, and the slope of the yield curve is the bond market's way of saying how obviously easy or tight monetary policy is at any point in time.
So, when the blue line is very high (i.e., when the Fed is very tight) and the red line is very low (i.e., when the yield curve is flat or inverted) that almost always signals a recession ahead, because it means that money is becoming exceedingly scarce. Conversely, as is the case today, a low red line and a high blue line are typically indicators of a business cycle that is still in its early stages, and money is in relatively abundant supply. The unusually weak level of the dollar today confirms that dollars are relatively plentiful, and the high level of gold and commodity prices says the same thing.
The bad news here is that the Fed is likely repeating the errors of the 1970s, when monetary policy was on a roller-coaster ride and money was at times very cheap. Very cheap money in the 1970s helped fuel inflation, and today's cheap money is likely to do the same.
The good news is that deflation risk is non-existent; the economy is not starved for money; and there is every reason to expect the economy to continue to expand for the foreseeable future. Plus, there is still time for the Fed to reverse course before inflation becomes too high or too ingrained.
Posted by Scott Grannis at 2:16 PM