Policy Dilemmas For Next Week’s Fed Meeting

Krishna Guha in his assessment in the Financial Times this morning of the key policy issues facing Ben Bernanke and his team at next weeks Federal Reserve meeting had this to say:

“Meanwhile, the Fed is likely to reiterate that it expects to keep rates near zero for an “extended period”, challenging market expectations of early tightening.”

Which struck me as interesting, since in an article which I wrote for yesterday’s (Sunday) edition (offline and in Spanish) of La Vanguardia newspaper (English text below) I said the following:

Investors are, on Krugmans view, simply erroneously positioning themselves in the face of what they now feel is inevitable. This view is erroneous he argues, since the road to full blown recovery is likely to be longer and harder than market participants are currently envisioning, and the only way to really get interest rates back under control would be for Bernanke to commit himself to holding down short term interest rates for a lengthy and indefinite period of time.

This is what is called keeping yourself just nicely ahead of the curve I think. The article which follows is basically a journalistic rewrite of this post (which appeared on Afoe last week). It does have the advantage of being considerably more digestible for the non specialist than the Afoe original

Expect The Best And Prepare For The Worst

Readers of the English language financial press are pretty much agog at the moment before the sight of two of the Anglo Saxon world’s best known contemporary intellectuals having a very public and very bitter argument right before their very eyes. And the topic of their feud? The size of the US fiscal deficit, and whether running it is deadly, tolerable, or simply a good thing.

There have, of course, been numberous high profile economic disputes before (the one between the then IMF Chief Economist Ken Rogoff and Nobel Economist Joeseph Stiglitz immediately comes to mind ), but the latest imbroglio between Harvard historian Niall Fegurson and the world’s newest addition to the list of Nobel Laureates, Princeton economist and New York Times columnist Paul Krugman, looks set to break all previous records, at least in terms of audience ratings.

In essence Professor Ferguson advances three arguments: first, he maintains that the recent sharp rise in long term US Treasury bond interest rates is a sure sign that the market is “trembling” in the face of the huge bond issuance that is set to arrive from just over the horizon; second, such large fiscal deficits are both unnecessary and counterproductive; and, finally, he suggests, there is every reason to fear they will have a strong inflationary impact.

Krugman, for his part, fears the threat is deflation not inflation, argues that such large fiscal deficits are necessary, and even desireable in current circumstances, as the private sector pays down its debt, and suggests that the rise in longer term interest rates is due not to inflation fear, but rather to the expectation that Ben Bernanke will raise short term interest rates sooner, rather than later, to avoid just such an outcome.

What both participants are agreed on is the evident fact that yields on 10 year US treasuries have been rising sharply recently – the hit a high of 3.91 percent on June 8. There was a time when this would have been considered pretty low. But the financial crisis has changed all that: at the end of last year, the 10-year bond yield was languishing at 2.06 percent, so long-term rates have risen 167 basis points in the space of five months. In relative terms, that’s a jump of 81 percent.

At the heart of the problem is what appears to be some sort of negative feedback loop, since investor expectation that inflationary pressures accompanying an economic recovery will lead the Federal Reserve to raise short term rates could well end up delaying the very recovery they so hope for.

The Federal Reserve has been working overtime, and against the tide, to try calm markets and bring rates down again. The irony here is the basic reason the Federal Reserve started buying Treasury debt in the first place was to lower mortgage rates to revive the moribund housing market. And that was starting to work, but now rising interest rates rise are pushing mortgage rates back up again, in a way which is likely to delay the much needed rebound in the housing market, derailing the broader economic recovery in the process.

Unsurprisingly results from Freddie Mac’s Primary Mortgage Market Survey, released at the start of June, showed a jump in the 30-year fixed mortgage rate to an average of 5.29% for the week ending June 4, compared with an average rate of 4.91% the week before. That was the highest rate recorded since the week ending Dec. 11, 2008. With Treasury yields rising even higher over the last week, the 30-year mortgage rate is most probably somewhere around the 5.50% at this point.

Investors are reacting, not because they fear that the United States is about to become a new Zimbabwe, but precisely because they know it won’t. Investors know perfectly well how Ben Bernanke and his colleagues over at the Federal Reserve will react to a situation where inflation is perceived as rising above their target range – they will start to raise short term interest rates, and it is this expectation of future increases in short term rates which ironically cause longer term interest rates to rise.

Expectations are rising fast that the US central bank will increase its target rate for overnight loans between banks before the end of the year. According to futures contracts traded on the Chicago Board of Trade investors now assign a 66 percent probability to a rate increase by the November policy meeting, compared with only 24 percent a week or so ago.

So far from investors demanding enhanced premiums for holding US assets due to their fear of impending inflation, what we are witnessing here is a kind of see-saw (stop-go) process, whereby bad economic data leads investors to anticipate interest rates being held low in the US for some considerable time to come, raising risk sentiment and sending funds scurrying off in search of the sort of yields which are to be found in riskier emerging market assets (the so called “carry trade”), driving the greenback down to ever lower levels. Positive economic news, on the other hand makes borrowing in US dollars inherently riskier, sends investors into headlong to retreat, and the dollar cruising back up again. All of which is very counterproductive, since given the knife edge character of the current US “recovery” all it does is slow the recovery down (since the cheaper dollar is good for US exports) while piling on the deflationary pressure.

Investors are, on Krugmans view, simply erroneously positioning themselves in the face of what they now feel is inevitable. This view is erroneous he argues, since the road to full blown recovery is likely to be longer and harder than market participants are currently envisioning, and the only way to really get interest rates back under control would be for Bernanke to commit himself to holding down short term interest rates for a lengthy and indefinite period of time.

One thing is certain, this completely new situation is forcing investors to form opinions about topics which had previously been confined to the obscure and arcane realms of theoretical economics. The net result is a sharp increase in market volatility, and a high level of uncertainty about even the shortest of short term scenarios. Naturally this does not make for a comfortable life for market participants. As Jim Bianco, president of the Chicago-based Bianco Research says, “The Fed wants to operate in predictable ways. They are also trying to not just look arbitrary, which makes people think ‘I can’t ever go to the bathroom because there could be a press release that the Fed changed this or that.’ That’s been a real concern: ‘Wow, I just went to the bathroom and lost $2 million dollars.’”

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About Edward Hugh

Edward 'the bonobo is a Catalan economist of British extraction. After being born, brought-up and educated in the United Kingdom, Edward subsequently settled in Barcelona where he has now lived for over 15 years. As a consequence Edward considers himself to be "Catalan by adoption". He has also to some extent been "adopted by Catalonia", since throughout the current economic crisis he has been a constant voice on TV, radio and in the press arguing in favor of the need for some kind of internal devaluation if Spain wants to stay inside the Euro. By inclination he is a macro economist, but his obsession with trying to understand the economic impact of demographic changes has often taken him far from home, off and away from the more tranquil and placid pastures of the dismal science, into the bracken and thicket of demography, anthropology, biology, sociology and systems theory. All of which has lead him to ask himself whether Thomas Wolfe was not in fact right when he asserted that the fact of the matter is "you can never go home again".