Quick thoughts on Fed policy and the potential for QE
Last August, the Fed went for what I call "rate easing". If the economy weakens this year what will it do?
I am not convinced it will be quantitative easing. In general, I think the Fed, while looking to support the growth side of its dual mandate, wants to look to the data before acting since monetary policy acts with a lag. Recent statements by voting members of the FOMC suggest like last year the Fed will pause to assess the economy before doing anything else. Again like last year, If economic growth in the US does not falter in the second half of 2012, the Fed will look to drain excess reserves from the system as preparation for an interest rate hike at some unforeseeable future date. The path is entirely dependent on the economy as Bernanke has reiterated multiple times
Sophisticated market watchers know this. That is why interest rates go up or down as their expectations of future monetary policy change according to the latest economic data. Right now, most watchers expect the fed to keep on hold through 2012 but some are expecting a robust recovery could precipitate hikes already in 2013. When the economic data were particularly good in January and February, rates backed up a lot as a result. But notice, this has nothing to do with the market sending a signal to profligate fiscal overlords. It is merely a reflection of anticipated future policy rates. Long-term interest rates are a series of future short-term rates.
As I explained last year, each time the Fed has conducted one of these campaigns of non-traditional stimulus, there has been a vocal political opposition to it. So, the Fed feels constrained. They will expand their balance sheet only if things really look terrible. Otherwise they will look for other forms of non-traditional policy. We saw this in August when the Fed telegraphed its intention to keep rates at zero for two years. They subsequently increased this stance to three years. My view is that the Fed will continue to target long rates or move into adjacent markets like mortgage-backed securities before it engages in any outright QE.
What is the effect of all this on the economy?
Private portfolio preferences have shifted considerably. An article in today’s Wall Street Journal "Junk Bonds Feed a Hungry Market" shows the way, with a lot of quotes about people reaching for yield because Treasury yields have been suppressed:
U.S. companies with junk credit ratings are piling into the debt markets at a record pace, seizing on some of the lowest borrowing costs in history and strong demand from investors craving higher returns.
Companies and investors both have benefited. Many corporate borrowers have been able to refinance debt at much lower rates, and others have been able to raise money cheaply for investments. And so-called junk bonds, those with below-investment-grade credit ratings, have handed investors among the best returns of any fixed-income asset this year, according to Barclays PLC. Junk bonds pay higher yields because they are considered riskier investments.
Some 130 U.S. junk-rated companies, from commercial lender CIT Group Inc.to car-rental company Hertz Global Holdings Inc. have sold $75 billion in junk bonds this quarter, according to Thomson Reuters, up 12% from the same period last year and a record for any quarter going back to 1980 when Thomson began keeping data. "This is nirvana" for many low-rated companies, said Jim Casey, co-head of global debt capital markets at J.P. Morgan Chase & Co.
Investors of all stripes have been diving into junk. Many of them are searching for investments that yield more than the meager rates offered by Treasurys and investment-grade corporate bonds. They are flooding into high-yield mutual funds and exchange-traded funds, market data show.
"It’s the only place I can find any yield whatsoever with a reasonable risk," said Lee Hevner, an individual investor who said he started buying junk bonds this year for the first time. In January he put about 15% of his $500,000 savings into an exchange-traded fund that holds junk bonds.
For some companies, the interest-rate decline over the past few years has been stark. CIT, which emerged from bankruptcy protection in December 2009, two weeks ago sold $1.5 billion of bonds maturing in six years with a yield of 5.25%. That is less than the 5.8% CIT paid on similar debt in 2006, when it was rated investment grade. A CIT spokesman declined to comment.
You see what’s going on here, right? Look at CIT. Here’s a company that emerged from bankruptcy and is now getting lower yields than when it was considered an investment grade company at the height of the largest credit bubble in history. The CIT story screams malinvestment. It is not as much CIT itself but what the CIT story represents in terms of borrowers using artificially low yields to stay afloat and expand. This feels good right now. But down the line it will be very painful.
Let me give you a quote from Ludwig von Mises from 1936 on Austrian Business Cycle Theory (highlights added):
"The lowering of the rate of interest stimulates economic activity. Projects which would not have been thought "profitable" if the rate of interest had not been influenced by the manipulations of the banks, and which, therefore, would not have been undertaken, are nevertheless found "profitable" and can be initiated. The more active state of business leads to increased demand for production and the wages of labor rise, and the increase in wages leads, in turn, to an increase in prices of consumption goods. If the banks were to refrain from any further extension of credit and limited themselves to what they had already done, the boom would rapidly halt. But the banks do not deflect from their course of action; they continue to expand credit on a larger and larger scale, and prices and wages correspondingly continue to rise."
"This upward movement could not, however, continue indefinitely. The material means of production and the labor available have not increased; all that has increased is the quantity of the fiduciary media which can play the same role as money in the circulation of goods. The means of production and labor which have been diverted to the new enterprises have had to be taken away from other enterprises. Society is not sufficiently rich to permit the creation of new enterprises without taking anything away from other enterprises. As long as the expansion of credit is continued this will not be noticed, but this extension cannot be pushed indefinitely. For if an attempt were made to prevent the sudden halt of the upward movement (and the collapse of prices which would result) by creating more and more credit, a continuous and even more rapid increase of prices would result. But the inflation and the boom can continue smoothly only as long as the public thinks that the upward movement of prices will stop in the near future. As soon as public opinion becomes aware that there is no reason to expect an end to the inflation, and that prices will continue to rise, panic sets in."
"Some enterprises cut back their scale of operation, others close down or fail. Prices collapse;crisis and depression follow the boom. The crisis and ensuing period of depression are the culmination of the period of unjustified investment brought about by the extension of credit. The projects which owe their existence to the fact that they once appeared "profitable" in the artificial conditions created on the market by the extension of credit and the increase in prices which resulted from it, have ceased to be "profitable." The capital invested in these enterprises is lost to the extent that it is locked in. The economy must adapt itself to these losses and to the situation that they bring about. In is case the thing to do, first of all, is to curtail consumption and, by economizing, to build up new capital funds in order to make the productive apparatus conform to the actual wants, not to artificial wants which could never be manifested and considered real except as a consequence of the false calculation of "profitability" based on the extension of credit."
Right now, we are in the boom. But when the economy turns down, the artificial nature of much of the boom will be found out. That’s why I have been saying that we can play the cyclical booms but that we have to be aware that these are cycles and that there is no guarantee this is a secular boom. I see this as still part of a secular bust until the malinvested credit from the housing boom has been written down.