Thursday, August 11, 2011
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.
Posted by Scott Grannis at 2:07 PM