The Interest Rate Threat of Unwinding the Stimulus
Carlos M. Pelaez
The comparison of the current credit/crisis and global recession with the Great Depression of the 1930s is misleading. Comprehensive review of the vast literature on the Great Depression reveals a contraction of output and employment that was immeasurably stronger than the world contraction in 2008-2009 (Pelaez and Pelaez, Regulation of Banks and Finance, 197-217). The decline in real or price adjusted GDP in 1930-1933 accumulated to 26.7 percent and 45.5 percent in current dollars or without adjusting by price changes (Pelaez and Pelaez, Financial Regulation after the Global Recession, 151). The cumulative decline of inflation adjusted GDP of the United States during the current recession in the last two quarters of 2008 and first two quarters of 2009 was 4.7 percent. GDP increased in the third quarter of 2009. The proper comparison for fruitful policy analysis is with the contraction of the early 1980s. Table 1 shows the annual rate of growth and fed funds rate in contraction quarters during the current recession and during the early 1980s. The objective of policy is not repeating the depression regulation of the 1930s but rather finding lessons in the 1980s. Cole and Ohanion have shown that the US economy did not recover to full employment in the 1930s because of government policy (cited in Pelaez and Pelaez, Regulation of Banks and Finance, 215-7). The key lesson is that the growth rate in the expansion must be similar to that in the 1980s shown in the third column of Table 1. The economy expanded during five consecutive quarters at annual real rates ranging from 7.1 percent in the second quarter of 1984 (QII84) to 9.3 percent in the second quarter of 1983 (QII83), which were more than twice that of trend around 3.5 percent. Those high rates of growth are required in the next quarters to create again the jobs lost during the contraction.

Table 1 Annual Rate of Real GDP and Fed Funds Rate Percent per Year
Current Fed Funds 1980s Fed Funds 1980s Fed Funds
Recession Rate Recession Rate Expansion Rate
QIII08 -2.7 1.81 QII81 -3.2 19.10 QIV82 0.3 8.95
QIV08 -5.4 0.16 QIII81 4.9 15.87 QI83 5.1 8.77
QI09 -6.4 0.18 QIV81 -4.9 12.37 QII83 9.3 8.98
QII09 -0.7 0.21 QI82 -6.4 14.68 QIII83 8.1 9.45
QII82 2.2 14.15 QIV83 8.5 9.47
QIII82-1.5 10.31 QI84 8.0 9.91
QII84 7.1 11.06
Source: BEA, Department of Commerce, Board of Governors Federal Reserve System.

There is a critical difference in the current environment. Interest rates declined sharply in the 1980s from a high of 19.10 percent for the fed funds rate in June 1981 to 8.95 percent in December 1982, remaining between 8.95 and 11.06 percent after the expansion phase (see Table 1). The opposite trend will occur during the current expansion phase because the feds funds rate is fixed by the Fed at 0-0.25 percent and must and will increase sharply in the months and years ahead. The zero interest rate may be considered a government regulatory failure. The problem with fiscal and monetary stimulus is the pain of the unwinding. If the stimulus is not unwound or increased the economy may contract in the future again during a tough debt crisis.
There are two issues relevant to the analysis of the stimulus: its size and the simultaneous unwinding of fiscal and monetary policy. First, the size of the stimulus can be explained by the origin of the credit/dollar crisis and global recession. The credit crisis originated in four excessive types of stimuli in 2001-4 (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, and Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4): (1) the interruption of auctions of the 30-year Treasury in 2001-2005 that caused purchases of mortgage-backed securities (MBS) equivalent to a reduction in mortgage rates; (2) the reduction of the fed funds rate by the Fed to 1 percent and its maintenance at that level between June 2003 and June 2004 with the announced intention of even lowering the rate if required; (3) the housing subsidy of $221 billion per year; and (3) the purchase or guarantee of $1.6 trillion of nonprime MBS by Fannie Mae and Freddie Mac. The combined stimuli mispriced risk, causing excessive risk and leverage as the public attempted to obtain higher returns on savings. Investors reduced liquidity in the hunt for higher returns and lenders relaxed credit standards acquiring bad loans. Consumers borrowed excessively at the artificially low interest rates relative to their capacity to repay. The rise in prices of stocks and real estate created a false feeling of permanent increases in wealth, mispricing risk for lenders, borrowers, government and nearly all economic agents. Country risk is beginning to feel stress in the growing number of excessively indebted countries in the group known as PIGS (Portugal, Italy, Greece and Spain). The Fed increased interest rates from 1 percent in June 2004 to 5.25 percent by June 2006. The reset of mortgage interest rates and principal caused default of mortgage loans and declining real estate prices. The default of underlying mortgages caused losses in structured products such as MBS, collateralized debt obligations (CDO) and credit default swaps (CDS) (Pelaez and Pelaez, Financial Regulation after the Global Recession, 50-1, Regulation of Banks and Finance, 59-60, Globalization and the State Vol. I, 89-92, Globalization and the State Vol. II, 198-9, Government Intervention in Globalization, 62-3, International Financial Architecture, 144-9). Some financial institutions and investors began to suffer losses, causing reductions of capital that triggered increases in perception of risk of counterparty financing. Initial monetary policy consisted of reductions in fed funds rates by open market operations touching the “zero bound” of 0-0.25 percent in December 2008 and revival of the rediscount window. Research by Bloomberg finds that the US government and the Fed “spent, lent or committed $12.8 trillion” by March 2009 which was about the entire economic activity or GDP in 2008 (www.bloomberg.com cited in Pelaez and Pelaez, Regulation of Banks and Finance, 224). The amount disbursed or lent by March 2009 was about $4.2 trillion.
Second, the volume of unwinding includes major positions in securities by the Fed, Fannie and Freddie. The Fed used about 11 facilities of monetary policy during the crisis (Pelaez and Pelaez, Financial Regulation after the Global Recession, Table 6.3, 160-1). The Fed engaged in the policy of “quantitative easing” (Pelaez and Pelaez, Regulation of Banks and Finance, 224, The Global Recession Risk, 83-107). When the policy rate or fed funds rate is near the “zero bound” the Fed could expand its balance sheet by acquiring government securities, ignoring the interest rate and focusing on the volume of bank reserves. The purchase of long-term securities by the Fed could lower long-term interest rates, stimulating recovery of the economy by increasing investment. The Fed borrowed by paying interest rates on reserves deposited by banks and by Treasury depositing the proceeds from the issue of short-term Treasury bills at the supplementary account of the Fed; these deposits were invested by the Fed in long-term Treasury securities and MBS. The Fed balance sheet increased by 115.7 percent from $855.1 billion in February 2008 to $1844.9 billion in February 2009 (Pelaez and Pelaez, Regulation of Banks and Finance, 225-6, Financial Regulation after the Global Recession, 158-9). The Fed balance sheet for the week ending December 30, 2009, lists holdings of $909.6 billion of MBS, $707.6 billion of Treasury notes and bonds and $159.9 billion of Federal agency securities. At some point the Fed would sell that portfolio of about $1.6 trillion of long-term securities, causing a decrease in their prices that is equivalent to an increase in their yields. The total retained portfolio of mortgages of Fannie and Freddie stood at $1.6 trillion in the second quarter of 2009 according to their supervisor the Federal Housing Finance Agency (FHFA). The combined portfolio of Fannie and Freddie is 45.5 percent of the value of total residential mortgages and 31.8 percent of total MBS while the retained portfolio is 13.7 percent. The total residential mortgage value outstanding in the US in the second quarter of 2009 was $11.8 trillion of which the Fed, Fannie and Freddie held about 21 percent. The Congressional Budget Office forecasts the federal deficit as percent of GDP at 11.2 percent in 2009, 9.6 percent in 2010 and 6.1 percent in 2011. The debt to GDP ratio would increase from 40.8 percent in 2008 to 65.2 percent in 2011.
The combined pressure on interest rates is formidable consisting of raising the fed funds rate from 0-0.25 percent to a new higher level, unwinding the portfolios of the Fed, Fannie and Freddie and issuing debt to finance deficits of the federal government and refinance maturing debt. The increase in interest rates together with an ambitious regulatory agenda in most of the economy may frustrate the high rates of growth of GDP required to absorb the unemployed. Unwinding past aggressive policy impulses may take many years of lower growth and employment creation. Exuberance in easy monetary policy results in interest rate increases while similar exuberance in easy fiscal policy ends with tax increases. The combination of high interest rates and taxation will restrain the capacity of the private sector to drive growth and job creation. The risk is increases of interest rates for all maturities, or parallel shift of the yield curve, but with sharper increases in long-term interest rates, or steepening of the yield curve. Stress tests of balance sheets should include aberrant behavior of interest rates that may increase in capricious paths by the mere anticipation of changing policy. The unwinding strategy should balance the need of regulation by allowing sufficient dynamism for the private sector to create, finance and implement innovation. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)