The Fed Policy Conundrum, Irving Fisher, the Yield Curve and the Budget Deficit
Carlos M Pelaez

The view of the Fed is that the economy expanded at a rate of about 4 percent in the second half of 2009 but a substantial part of that growth is explained by reduction of inventories, which is temporary, and the fiscal stimulus is phasing at the end of the year such that private sector final demand for goods and services will be the driver of growth (http://www.federalreserve.gov/newsevents/testimony/bernanke20100224a.htm ). The job market is not yet dynamic and over 40 percent of the unemployed have been without a job for six months or more. The central tendency of the forecast of the Federal Open Market Committee (FOMC) is for GDP growth in 2010 of 2.8 to 3.5 percent, accelerating to 3.4 to 4.5 percent in 2011 with long-term trend of 2.5 to 2.8 percent. The unemployment rate would remain at 9.5 to 9.7 percent in 2010 declining to 8.2 to 8.5 percent in 2011 and to 6.6 to 7.5 percent in 2012. PCE inflation would remain in the 1 to 2 percent range. There is significant uncertainty in economic forecasts especially turning points. In retrospect, the Fed finds that the coordinated efforts with Treasury and other authorities jointly with substantial stimulus by monetary and fiscal policies prevented sharper decline and “are supporting now a nascent economic recovery” (http://www.federalreserve.gov/newsevents/testimony/bernanke20100224a.htm ). The FOMC finds that low utilization rates of resources, restrained current inflation and stable expectations of inflation “are likely to warrant exceptionally low levels of the federal funds rate for an extended period” (http://www.federalreserve.gov/newsevents/testimony/bernanke20100224a.htm ).
To be sure, short-term indicators only provide specific snapshots of conditions in a given segment of economic activity and need not point to overall economic conditions. However, various indicators during the past two weeks have raised doubts in the views on the dynamism of the economy. The most comprehensive indicator is the annualized rate of growth of 5.9 percent of GDP in QIV2009 but the breakdown shows that the most important contribution in percentage points (pp) is the change in private inventories by 3.88 pp followed by 1.23 pp for personal consumption expenditures, 1.09 pp by equipment and software, 0.30 pp by net exports of goods and services and -0.23 pp by government (http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=2&ViewSeries=NO&Java=no&Request3Place=N&3Place=N&FromView=YES&Freq=Qtr&FirstYear=2007&LastYear=2009&3Place=N&Update=Update&JavaBox=no ). Strengthening of the dollar in a world of “beggar-my-neighbor remedies for unemployment” may close the avenue of growth by net exports (Joan Robinson in her Essays in the Theory of Employment, Macmillan 1937; for comprehensive review of the Great Depression see Pelaez and Pelaez, Regulation of Banks and Finance, 197-217, and for current trade issues Pelaez and Pelaez, Government Intervention in Globalization: Regulation, Trade and Devaluation Wars, 174-84, Globalization and the State, Vol. I, 157-206, and Globalization and the State, Vol. II. 205-13). The issue is whether the government has tools to increase private demand for goods and services without deteriorating further the precarious fiscal situation. The index of consumer confidence of the Conference Board declined sharply in Feb by 10 pp to 46.0 from 56.5 in Jan (http://www.conference-board.org/economics/ConsumerConfidence.cfm ). The US Census Bureau and Housing and Urban Development reported a decline in new residential sales of 11.2 percent in Jan 2010 relative to the revised annualized, seasonally adjusted rate for Dec 2009 of 348,000 units sold, corresponding to decline of 6.1 percent relative to the rate of 329,000 in Jan 2009. The supply of unsold residences corresponds to 9.1 months at the current sales rate (http://www.census.gov/const/newressales.pdf ). New orders for manufactured durable goods reached $175.7 billion in Jan, corresponding to an increase of $5.2 billion or 3 percent after an increase by 1.9 percent in December. However, excluding transportation, new orders decreased 0.6 percent and increased by 1.6 percent excluding defense (http://www.census.gov/manufacturing/m3/adv/pdf/durgd.pdf ). Authorizations for building permits of houses declined by 4.9 percent in Jan relative to Dec partly because of the upward revision for Dec but still were higher by 16.9 percent relative to Jan 2009; housing starts increased by 2.8 percent in Jan relative to Dec and by 21.1 percent relative to Jan 2009 (http://www.census.gov/const/newresconst.pdf ). Existing home sales declined by 7.2 percent in Jan relative to Dec but are still higher by 11.5 percent relative to Jan 2009 (http://www.realtor.org/press_room/news_releases/2010/02/ehs_january2010 ). Seasonally adjusted initial unemployment insurance claims reached 496,000 in the week ending on Feb 20 for an increase of 22,000 relative to the prior week with the four-week moving average increasing by 6000 to 473,500 (http://www.dol.gov/opa/media/press/eta/ui/current.htm ). The employment report will be released on Mar 5, the IMS manufacturing index on Mar 1 and personal income and outlays on Mar 1 in a week rich in economic reports.
There are two views about the timing and doses of interest rate increases analyzed by Kelly Evans in the Wall Street Journal (http://online.wsj.com/article/SB10001424052748703503804575083873402927544.html?KEYWORDS=Bernanke+%22Kelly+Evans%22 ). First, the market view anticipates increases in the policy rate perhaps even this year because of the possible signal in the discount window increase by 25 basis points and shortening of the term to overnight. The market view resuscitated by the Treasury debt management guidance of increasing the Supplementary Financing Program (SFP) from $5 billion to $200 billion, corresponding to the level during Feb-Sep 2009, by eight $25 billion auctions of 56-day SFP bills every Wednesday beginning Mar 24 (http://www.ustreas.gov/press/releases/tg560.htm ). The proceeds of $200 billion from the issue of SFP bills will be deposited at the Treasury account at the Fed (for the origin of the FSP and its use in quantitative easing see Pelaez and Pelaez, Regulation of Banks and Finance, 225-6, Financial Regulation after the Global Recession, 158-9). The objective could be increasing the three-month Treasury bill from its near zero current level while withdrawing excess reserves without using the open market operations by the desk of the FRBNY and/or recreating an alternative liability to excess reserve deposits matching the securities assets in the Fed’s balance sheet. Second, the view of economists is that employment conditions, financial markets and economic recovery must be strong for the Fed to move into a tightening mood. In the past two recessions, characterized by milder loss of output and jobs, the Fed waited 33 months on average before increasing the policy rate and financial indicators were much stronger than currently (http://online.wsj.com/article/SB10001424052748703503804575083873402927544.html?KEYWORDS=Bernanke+%22Kelly+Evans%22 ).
Stress tests of banks use parameters of the bond market crash in 1994, which started in the US by the tightening of the fed funds rate from 3.00 percent in Feb 1994 to 6.0 percent in Dec 1994 (Pelaez and Pelaez, International Financial Architecture, 114-5, The Global Recession Risk, 206-7). The yield of the US 30-year Treasury bond increased by 150 basis points, causing declines in bond prices because increases of yields of 100 basis points caused declines of prices of 13 percent, which were magnified by typical leverage of 10:1. There was an increase in 30-year mortgage rates of 200 basis points that caused the loss of most of the value in funds of asset-backed securities. Europe was lagging the business cycle in the US and bond strategies consisted of long positions in higher-yielding markets that eventually also turned sour. Traders with long leveraged fixed-income and derivatives exposures waited for decoupling of European bond prices that continued declining during 1994. The correlation of bond yields of the US, European Union and Japan was only 0.18 and that of equities 0.40. Available statistical models failed to capture the much higher fed-tightening event correlation of fixed income and equities used in subsequent stress tests much the same as changes in correlations and effectiveness of hedge ratios caused by flight out of risk during the Long Term Capital Management (LTCM) event in 1998, converting LTCM’s hedged position into a short naked option (Philippe Jorion cited in Pelaez and Pelaez, The Global Recession Risk, 12-3). The Mexican crisis of 1994 was significantly influenced by the flight from risk and duration caused by the doubling of the policy rate by the Fed in 11 months, causing shocks in Argentina and Brazil. The 1994 episode resembles the increase of the fed funds rate from 1 percent to 5.25 percent from Jun 2004 to Jun 2006 that had strong effects in the credit quality of mortgages. The strength of labor and financial markets and the real economy were not major factors of fed policy. In the increase of rates in 1994 the Fed was concerned with inflation originating in commodity price increases that failed to spread to general prices. In the increase after Jun 2004 the Fed was escaping the 1 percent interest rate and forward guidance after deflation also failed to materialize, which was an important determinant of the credit/dollar crisis and global recession (Pelaez and Pelaez, The Global Recession Risk, 207, 221-5, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). The fed has been managing monetary policy with aggressive changes in interest rates based on the view of the economy and financial markets six months ahead. There may not be sufficient knowledge about central bank policy for controlling the effects of these wide swings in monetary policies (Pelaez and Pelaez, Regulation of Banks and Finance, 108-112, Financial Regulation after the Global Recession, 74, 84-6, International Financial Architecture, 230-7).
The major conundrum of monetary policy at the moment is not potential inflation as in 1994 or potential deflation as in 2003 but rather the probable impact of the budget deficit and national debt in shifting upwards and twisting the shape of the yield curve. At the close of markets on Feb 26, the yield of the 3-month Treasury bill was 0.124 percent per year, within the target of fed funds of 0 – ¼ percent, along a virtually flat yield curve short-dated segment, rising sharply with 0.816 percent for the 2-year note, 3.619 percent for the 10-year note and 4.560 percent for the 30-year bond in a sharply-sloped long-dated segment (http://online.wsj.com/mdc/public/page/mdc_bonds.html?mod=mdc_topnav_2_3012 ). Using the central forecast of the Fed as proxy for inflationary expectations, the Irving Fisher real rate of interest, or the nominal rate discounted by inflationary expectations, is negative for the Treasury maturities below three years (The Theory of Interest, Macmillan 1930, http://www.econlib.org/library/YPDBooks/Fisher/fshToI19.html ). The Fed may wish to revive the short-dated end of the yield curve by raising the rates closer to its central forecast for inflation. A danger of this policy could be the unquantifiable, uncertain repetition of the 1994 bond market crash during an incipient or nascent recovery. The alternative of doing nothing is perpetuating a negative real rate of interest with potentially more adverse effects of its future adjustment. Combinations and sequences of the arsenal of Fed policy tools are not immune to high risk of disrupting again financial markets.
The long-dated end of the yield curve may prove to be more difficult to manage because of two restrictions. First, the Fed’s balance sheet, as of Feb 24, 2010, shows $1227 billion of reserve balances of member banks deposits at Federal Reserve Banks and $1907 billion of holdings of securities of which $709 billion in Treasury notes and bonds, $1032 billion in mortgage-backed securities and $166 billion in federal agency securities (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ). There are no doubts on the number and effectiveness of tools: the Fed has five instruments of withdrawing reserves, the interest rate on excess reserves held by member banks at the Fed and now again the Treasury SFP that can be used in various combinations and sequences (http://www.federalreserve.gov/newsevents/press/monetary/fomcminutes20100127.pdf ). The uncertainty is whether the effects of withdrawing reserves and increasing rates on bond markets and financial institutions funding with short-dated funds will be smooth or turbulent as in 1994 and after 2004. For example, a minute policy impulse could have much stronger effects on financial markets and possibly even the real economy if it triggers risk flight out of duration in Treasuries notes and bonds and mortgage-backed securities. Second, the financing of the deficit and refinancing of maturing debt can cause rapidly rising yields of notes and bonds.
The environment of monetary and fiscal policy is complex and difficult to influence even with the arsenal of monetary policy tools and the Fed’s expertise. Budgetary deficits and the growing government debt take time for adjustment and sometimes the adjustment is forced by fire sales of debt and sharp increases in yields. Because of the easier control of monetary policy in the short-term, it is inopportune to engage in legislative exercises that weaken the Fed and its independence in technical conduct of monetary policy. National financial regulation efforts should follow global efforts that postpone implementation until full recovery of financial markets and economic activity. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)