Bob Dylan’s big Nobel Prize win means that this week’s Insights piece features a Dylan-esque theme. I was struggling with narrowing down his vast collection, that is until I looked up at my Bloomberg and read this from Boston Federal Reserve President Eric Rosengren, “The combination of slow GDP growth and rapid decline in unemployment is one of the clear puzzles of the recovery.” President Rosengren set off a firestorm last month when he “went rogue” and apparently went from being a dove to a hawk for having the audacity to suggest that maybe it was time to hike the Fed Funds rate once in 2016. He went on to say that the negative real return for 10-year Treasuries “Suggests a lack of confidence in U.S. and global growth prospects, and in the ability of policy authorities to offset weak growth.” And there it was, the Dylan moment I was hoping and searching for!
“The pump don’t work ‘cause the vandals took the handles.”
That was almost too easy. President Rosengren seems to be coming around to the fact that global monetary policy has hit its limits with regard to what it can do for global growth. I also have an inkling that he is beginning to see that pushing past these limits can actually cause more harm than good. He alluded to this when he said, “Because of financial stability concerns, the balance sheet composition could be adjusted to steepen the yield curve.” I am really surprised the market didn’t keel over in shock at this comment. I think what President Rosengren is admitting is that through the Fed’s Quantitative Easing program, specifically the continued monthly $30 billion to $40 billion reinvestment purchases from the runoff of the Fed’s $1.76 trillion Mortgage Backed Securities (MBS) portfolio, the Fed has kept long-term interest rates down far too much and far too long. I spoke about this a few weeks ago.
What puzzles me is that it seems like the Fed is not seeing the strong correlation between its extraordinary low-interest rate policy and living standards, not to mention spending and saving. The Fed, in addition to keeping the Funds rate close to zero, continues to maintain the balance of its $1.76 trillion Mortgage-Backed Securities (MBS) by purchasing anywhere between $25 billion to $40 billion Freddie, Fannie, and Ginnie MBS a month. This program started in 2010 and six years later, it is still running as strong as ever. While it’s true the Fed isn’t adding to the portfolio, by reinvesting the runoff, they are keeping roughly $20 billion of 10-year US Treasury duration equivalents out of the market every month. This essentially neutralizes the supply of real 10-year notes the Treasury auctions every month. This continued activity, coupled with the Quantitative Easing (QE) programs of the other major world central banks, has squashed the yields of relatively safe yielding bonds that savers need.
I think that President Rosengren’s statements show that he is beginning to see the correlation and is very concerned about it. The argument for the Fed to normalize monetary policy sooner rather than later has more to do with the damage these abnormally low long-term rates are having on things like long-dated insurance and pension obligations, retirement savings and retirement income than it does on causing the labor market to overheat.
However, normalizing monetary policy by “adjusting” the Fed’s balance sheet now, as I think President Rosengren is hinting at, would be met with a complete market meltdown, much like taking the pain medication away from the patient. Long-term interest rates would skyrocket, and we would most likely be thrown into recession. However, rates would eventually stabilize and be met with the huge demand for higher long-term yields both domestically and globally. Eventually, the recession would end and markets, at least in the United States, would take a great step toward becoming normal functioning, non-central bank manipulated ones. The relatively short-term pain taken now would head off the terrible problem of underfunded liabilities coming due years from now if long-term rates continue to be artificially held down by the Fed.
President Rosengren is on to something. However, I have full confidence that the Fed would not take the risk of inflicting pain now to head off something worse in the future. Very few leaders and institutions are ever in favor of dealing with severe problems today when they can be someone else’s problems tomorrow. The only one who comes to mind is one leader, Paul Volcker, when he whipped inflation. Therefore, this gives me great confidence that the direction of long-term rates, despite the latest increase in yields, is lower. The increase in long-term rates we have seen recently is primarily due to what I think are incorrect assumptions about the resolve of the European Central Bank and The Bank of Japan to continue on the path of Quantitative Easing. This and the inflationary panic that is taking place in the United Kingdom, as the fear of a “Hard Brexit” has driven their currency down nearly 6% and 10-year government bond yields (Gilts) up over 36 basis points in the past two weeks.
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