Tuesday, March 13, 2012

How much longer will the Fed worry about the economy?


February retail sales were much stronger than expected, and as this chart shows, they have been rising strongly for the past three years. Over the past year, sales are up 6.5% in nominal terms, and about 4% in real terms. I think this is strong evidence that the economy is no longer fragile and in need of super-accommodative monetary policy. But when will the Fed finally wake up to this reality? It could be sooner than most folks think.


2-yr Treasury yields (shown in the chart above) are effectively the market's best guess for what the Fed funds rate is going to average over the next two years. From the lows of last September, when the world thought that the Eurozone sovereign debt crisis was sure to plunge the global economy into another deep recession, 2-yr Treasury yields are up almost 20 bps. That equates to almost two Fed tightenings over the next 2 years; not all that much, but this is evidence that the bond market is beginning to realize that the funds rate is not going to be pegged at 0.25% for the next 2 years as the Fed has been promising.


The long end of the Treasury curve is also beginning to have doubts about just how much more the Fed needs to do to pump up the economy. 30-yr yields are up about 50 bps from their all-time lows of early last October. If the market became convinced that the economy was in a sustainable expansion, yields would be much higher still—at least 4%. If anything is fragile it's not the economy, it's the health of the Treasury market, which is still trading at very low yields that only make sense if the economy is at real risk. 

5 comments:

brodero said...

Year over year retail sales ex gasoline at 6%....very strong

Dr William J McKibbin said...

The price of US monetary stability will be a California default -- once California defaults, the Fed is in for clear sailing -- otherwise, all bets are off for monetary stability...

Donny Baseball said...

William-
I predict that California will do the unthinkable to stave off default. No, not roll back the welfare state, I'm referring to drilling for oil. California still has vast energy reserves and the jobs and tax dollars that result from exploiting those resources is the ONLY thing that can save the Golden State now. (And most of the drilling will take place in icky parts of the state that coastal elites don't have too see anyway.) When lawmakers make the bloated public sector a deal - it's drill or you're all fired and we won't pay your pension - the public will take the deal and drill.

William said...

I read on Bloomberg yesterday US banks are buying "Treasuries" at a faster pace than they did in 2011. I guess that they must take the FED at its word.

Donny Baseball said...

Even at these low rates, banks are getting a net interest margin on the T-bills of roughly 175 bps, which is right in line with historical NIMs. As long as cost of funds is low, they will buy Treasuries, but there will be the temptation to goose NIMs as the economy improves and as inflation becomes more visible, banks will demand more yield. That Bloomberg article was accurately describing a situation that is entirely temporary. Just the bond trading in the last few days is enough to impact the NIM that this article refers to. Banks are NOT on board permanently for paltry T-bill yields.