Thursday, August 11, 2011

More thoughts on the FOMC's new policy

The Fed's decision earlier this week to announce that its target interest rate would remain "exceptionally low" for at least two years was not only unprecedented in the annals of central banking, but would have been previously inconceivable. So the impact and import of the announcement has taken a few days to sink in. Today's disastrous 30-yr T-bond auction provided the first evidence that the world does not like what it sees. 30-yr yields jumped almost 20 bps on the auction results, and the 10-30 spread has reached its widest for the year, now only 15 bps shy of the all-time high reached last November on the eve of the launch of QE2.

The Fed's extreme and unprecedented efforts to provide monetary stimulus to the economy are undoubtedly contributing to the market's deep sense of unease, with Europe being the biggest source of concern for the moment (more on that in a subsequent post). What is disconcerting is that this new twist to Fed policy is also contributing to rising inflation expectations, even as the economy struggles. Is aggressive monetary stimulus really necessary? Worth the risk of igniting higher inflation? Will it work, or will it just create more bubbles and distortions?

QE2 didn't have any immediate effect on the economy or on the money supply, because banks decided to hold on to the extra reserves the Fed dumped into the banking system, but it probably helped weaken the dollar. But now, the promise of two years or more of super-low funding costs will almost certainly galvanize the banking industry and the institutional investment community. Banks stand to make handsome profits with an outsized and semi-permanent gap between their funding costs and their loan portfolio, and they can even make hay by buying Treasury notes and bonds, since the Fed is basically guaranteeing that the yield curve will be positively sloped for at least two years. Institutional investors can borrow at rates only slightly higher than the funds rate, and use the proceeds to leverage themselves into a variety of attractive situations—anything that promises to yield more than 1% or so.

The Fed is encouraging everyone to take on more risk by borrowing, leveraging up, moving out the yield curve, or shifting money from relatively riskless CDs to riskier bonds, stocks or commodities, and I have to believe that they will be successful. Not many will want to look this gift horse in the mouth. Sooner or later we should see faster growth in the money supply, a weaker dollar, stronger commodity prices, higher real estate prices, higher stock prices, and—of course—higher inflation. Whether we will see a stronger economy is the real question.

In a sense, the Fed is gambling that the promise of cheap money will trump the concerns that have kept markets and businesses depressed: fears of rising tax and regulatory burdens, of another real estate collapse, of a sovereign default or two, and of a Eurozone banking collapse. By weakening the demand for money, this gambit should at the very least result in faster nominal GDP growth by increasing the velocity of the existing money supply; it's the composition of that faster growth (i.e., how much is real and how much is inflation) that is the unknown at this point. There will be less hoarding of money, more risk-taking, and more lending and borrowing. But will the money be directed to productive, job-producing activities, or just to consumption and speculative activities?

I'm willing to bet that we will see at least some pickup in growth, if for no other reason than I think that at least some of the increased risk-taking the follows from this new policy will prove productive.


Dr William J McKibbin said...

Scott, I too am still digesting this latest move by the Fed -- my initial take is that by holding rates at zero through 2013, the economy will benefit -- however, the Fed seems to be sacrificing themselves institutionally to accomplish this -- what does the Fed know that I do not (?) -- I tend to believe that we are in for the arrival of new currency regimes in the form of commodities-based paper -- we'll see -- again, I am still pondering all of this -- I enjoy your blog by the way...

Public Library said...

The assumption is people will stop 'hoarding' like it was circa 2004-2007. Problem is, the situation is completely different.

Personal balance sheets are stretched, job optimism tepid at best, and having just been burned makes it highly unlikely people will follow suit.

Additionally, people will need to save more to offset the financial repression. The Fed is pushing the US off the cliff IMHO.

You need to ride the wave and get out before the bottom really falls out during the next crisis. 2008 was a signal, not the real thing...

John O said...

Yes the spread is favorable to banks and reits right now but isn't the underlying problem that no one has more than 10% to put down, and banks and lenders are not going to lend 90% to a semi or un-qualified borrower? How does this unwind.
Here's another idea. Cheaper for the govt to bulldoze 3 million unoccupied homes and take them out of inventory, that might stimulate the market a bit.

Benjamin said...

Actually, Bernanke-san is doing nothing. Rates would be low in any event. Inflation is dead, and there is nowhere to invest money. Capital gluts-ville.

Usually, low interest rates discourage capital formation, but not now. We hit zero and people keep saving, globally.

Instead of feeble dithering, the Fed should move to steady QE3 and targeted nominal GDP.

And investors may or may not expect inflation. Yields are so low it is hard to know what anyone thinks. Inflation is so low, that measuring it with the CPI is like trying use a inch ruler to measure millimeters.

Some very conservative economists would argue we are in deflation now as the CPI overstates inflation (well, they used to argue that, but then Obama become president).

The right-wing has developed an unproductive obsession with minute rates of inflation, and a perverted fetish or even worship off gold and other symbols of wealth, such as the perceived value of currency. Some right-wingers speak of "debased" currencies and cultures. Next we will be setting up gay brothels in the White House.

Real wealth comes from innovation, business investment, management and labor. Support those activities and forget about choking the economy through tight money.

Is the Fed tight now? Oddly enough, yes. They hit zero-bound, when they would like to go to, say, minue 3 percent interest rates. But they can't. That place does not exist.

That is why we need QE3.

It is a strange period in financial history. The hoary bromides of the left-wing (more fiscal stimulus) and the right-wing (gold or tight money) do not work.

What works is using Milton Friedman's policies for Japan.

We are getting Japanned more and more every day. Consider out S&P 500, below 1999 levels. Consider our falling property markets. Consider our less than one percent CPI inflation rate for the last three years.

Bernanke-san, please come home from Japan.

Fullcarry said...


The FOMC statement actually said the following:

"The Committee currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013."

That is a forecast, not a commitment. That distinction is quite important, no?

Scott Grannis said...

Fullcarry: yes, the Fed did make its "promise" conditional, but its prior commitment to an "extended period" was also conditional and commonly understood to be one year. Adding "at least through mid-2013" is quite specific and at the very least must imply a longer period of lower rates than their former promise. Bottom line, they are trying very hard to encourage people to borrow and spend money.

The Roller said...

Good point, Fullcarry.

The board of governors at the Fed could double the FFR from .25% to .50, and still hold to their statement of "exceptionally low levels, at least through mid-2013".

Look for massive amounts of continuing takeovers in an environment such as this.

ronrasch said...

With a weak dollar American is for sale at a discount. Also, with Obamacare, excessive regulation, high energy prices, and high corporate taxes, business will likely not want to risk capital. Also, there is inflation in energy and food prices that hit the poor throughout the world the hardest. Great post by the way Scott.

brodero said...

3 years after the May 1980 consumer sentiment low..the S&P 500
was up 45%

brodero said...

Look out AGG the bond etf has
yield to maturity of 1.69%...with
a duration of 4.20