The Unlikely Miracle of an Immaculate Monetary Exit

Recently, The Economist magazine reported (see here) that Richard Barwell of the Royal Bank of Scotland had made the comment that, for central banks to withdraw from the massive monetary stimulus they have delivered to the economy without any problems, then the stimulus should be withdrawn before the economy really is back on track again, and also for "central banks' economic forecasts to be unerringly accurate".  But in my view there is much more to this than just the timing of the withdrawal of the stimulus, particularly in the US, or the accuracy of central bank forecasts.

If one looks at the 10 and 30 year US government bond yields going back to the beginning of 2008, so just before the "great recession" started, from the chart below you can see that 10 year bonds were at 4% and 30 year bonds were at 5%.  What is astonishing about this chart is the big fall in US long bond yields that occurred in the late summer of 2011, and you might immediately assume that this marked the beginning of one of the "QE" programs of quantitative easing mounted by the Fed.  But you'd be entirely wrong here - it was essentially the beginning of "operation twist", where the Fed committed to buying more longer term Treasuries, or moving further down the maturity spectrum by buying more longer term bonds and selling shorter term ones.

We have never returned to those post-recession higher levels for 30 year bond yields ( - the 4-5% range), nor the 10 year bond ( - 3-4% range), despite having inflation that is roughly the same, if not higher than during that period.  Even during the "taper tantrums" of 2013, 30 year rates never quite got to 4%, and 10 year bond yields only briefly touched 3%.  Not only that, but the gap between the yield rates has been shrinking so that since early 2013 it is a full 0.5% smaller.

Let's have a look at real bond yields for the same maturity bonds (courtesy of the US Treasury's bond pages here). What's clear is that the "operation twist" announcement sent US 10 year real bond yields into negative territory for all of 2012 and the first half of 2013.  It's also noticeable that US real long bond yields are now not negative ( - but of course short term bond rates are). But it is also clear that it would be pretty exceptional circumstances that would send the US 10 year real bond yield into negative territory. In other words, to quote the pop band Yazz - "the only way is up"!

That also makes sense when considering both inflation and real GDP.  Current inflation is 2.1% on a year over year basis in June,   and current real economic growth on a year over year basis in Q2 is at 2.43%, not at all bad, considering the set back to output that the economy had in Q1 due to all the bad weather. Heck, some components in the CPI are just skyrocketing - such as Meat, Poultry, Fish and Eggs (up 7.5% yoy).  These are all products that we eat, and no doubt they will feed into higher grocery bills pretty quickly.  These levels of macroeconomic performance hardly warrant long interest rates in nominal terms at 2.5% or in real terms at 0.25%.

 

In other words, I would expect to be seeing both short and long interest rates at much higher levels than they are right now, but particularly longer rates, given that the economy is likely to be going through more rapid growth going forward than it has in the recent past.  All these predictions about continuing sluggishness in the economy have been underpinned by the Fed's continuing commitment to low interest rates ( - Yellen's claim that the FOMC is in "no hurry" to raise rates), and their "gradualist" ( - some might say irresponsible) and non-differentiated taper. 

 

And that is the danger.  The "gradualist" approach might be just a tad too gradual - and stimulative.  As central bankers are fond of saying, the Fed's job is to pull away the punch bowl just as the party gets going. But in my view the trouble is that the Fed is still spiking the drinks, when already some of the party guests appear to be a little tipsy. 

 

One of the biggest dangers that Fed Chairperson Janet Yellen faces is that she doesn't act quickly enough. After previous recessions, the Fed was often too late in tightening policy and the result was having to rapidly adjust interest rates upwards extremely quickly. Unfortunately the slowdown in Q1 might have laid a trap for the new Fed Chairperson, in that it was a brief blip that has perhaps served to obscure what is really happening with the real economy.

 

All I can say is that I hope I am wrong here, and that the Fed is on course, but I think as each week passes the likelihood is that it is falling rapidly behind the curve on this recovery, and probably more worrisome, as the long bond yields show, that the bond markets have bought the Fed's arguments, lock, stock and barrel.

Why is the Fed ignoring a "differentiated taper"?

“I believe I am a sensible central banker and these are unusual times” - Janet Yellen, Testimony before Congress, February 11th, 2014.

In watching Janet Yellen's Testimony before Congress in February, and in reading Edward Luce's excellent commentary on the Fed in the FT (see here), it struck me that although Janet Yellen appears to be boxed in in terms of having an appropriate policy tool to get us out of the apparent slow growth US economy we now find ourselves in (see here for the latest Larry Summers opine about secular deflation), she is not.  And I'm not referring to "forward guidance" as the appropriate policy tool ( - a tool which I think has been ridiculous and based on flawed thinking).

As usual with these things, the answer is staring her right in the face.  Yes, the taper itself offers up the solution.  How?  Well in one of my previous blogs I outlined one exit strategy (see here) that I thought might be appropriate for the Fed to adopt. Although the Fed is currently reducing the purchases of both T Bills and mortgage backed securities (MBSs) at equal rates by $5bn each to $35bn of Treasuries and $30bn of MBSs (as most recently announced by the Fed on March 19th in the Fed's press release), this doesn't make too much sense to me in the current climate.

Why is this?  First, the Federal government Treasury interest rates really need to rise, and to be honest the Fed should be selling Treasuries right now, and certainly not buying anymore, given their recent (unwarranted) rally.

Second, the Federal government purchases were a way of stimulating the economy in two ways during the Federal government's economic stimulus a couple of years back - that is now not necessary as the stimulus is over and if anything the government deficit is rapidly shrinking. The chart below shows the US government budget deficit over the last decade, and we are now below the levels of deficits in terms of % of GDP that we experienced in the last major recessions, and more to the point, the trend line looks promising in terms of where we are going.

Third, with enough geopolitical risks in the rest of the world, I think it is safe to say that US Treasuries have enough demand support to weather a withdrawal of Fed support, so these purchases are really not optimal in terms of the objectives of monetary policy.

So I would argue that the Fed should heavily cut back on its purchases of US Treasuries while at the same time continuing to stimulate the housing market through purchases of MBSs.  I am calling this a "differentiated taper" as instead of just cutting purchases of both US Treasuries and MBSs, we can lower the overall amount of purchases while at the same time having a differential effect on the markets for each type of security.

Why is the concept of a "differentiated taper" important?  The reason why is that purchases of MBSs have an indirect impact on the housing market, as it lowers mortgage rates, thereby stimulating the construction of new housing.  Specifically, it should stimulate the employment of both blue and white collar workers in the construction industry, as more housing construction equals more hiring of architects, builders, contractors and subcontractors. What does purchases of government Treasury securities get us?  Lower borrowing rates for government, that's for sure, but not much else. Certainly there is no stimulus to the job market there right now as the government is cutting back on spending to move towards a balanced budget.

So if I were working at the Fed right now I would at the least be recommending a "differential taper" with an increase in purchases of MBSs of around $10bn, and a reduction in purchases of Treasuries by the Fed of around $20bn. This still balances out to a "taper" of $10bn, but it is differentiated, by stimulating the housing market, while allowing a longer term correction to the yield curve, a correction in my view that is now sorely needed.