By Dan Kervick
It’s starting to look like QE might be indirectly responsible for a dangerously volatile situation in US financial markets. And 10-year Treasury notes hit a 2-year high following today’s Fed statement.
But, in my opinion, it’s not the intrinsic nature of the policy itself that has created the danger, but all of the ridiculous and misleading hullabaloo and punditry that has surrounded it. I don’t blame the Fed for using asset purchases to hold down long-term interest rates. But I do blame all of the market pundits and neo-monetarist theorists out there who have grossly misrepresented these asset purchases as something they are not: an all-embracing attempt to manage aggregate demand, gross spending and employment by “pumping money into the economy.”
Unfortunately, there now seem to be a not-insignificant number of people who believe:
1. The Fed has been “keeping the economy afloat” by its asset purchases which “pour money into the economy.”
2. The future volume of Fed asset purchases depends inversely on its perception of the health of the private sector economy.
The second claim is certainly true, but the first is ridiculous. But as a result of believing both of these things together, Mr. Market now responds to good news by taking bearish actions, thus turning good news into bad news. And it responds to bad news by breathing a sigh of relief and taking economically positive steps that turn the bad news into good news! If indicators tick up, the markets believe the Fed will taper its bond-buying early, and so their misguided believe in claim #1 leads them to act as if they just received bad news. If indicators are sour, they assume that means the Fed will not taper early and they turn bull.
The result could be that the popularity of the neo-monetarist theories of central bank omnipotence have produced distorted psychological dispositions that amount to a self-regulating mechanism for keeping the economy is a stagnant, low-output equilibrium. This is nuts. I think it would be wise for the Fed to communicate more clearly and bluntly about what asset purchase policies do, and what they don’t do. The economy can’t function normally if economically important groups of fools think a maestro is controlling it it all. Of course some monetarists, who are deeply authoritarian at heart, have sometimes actually endorsed having an economy run by this kind of slavish awe and psychological manipulation.
Here’s what Warren Mosler has to say about the current situation. Mosler’s recommendation is that rather than set the Fed Funds rate only, and then letting the market set Treasury rates in response to Fed communication, the Fed should simply target risk-fee interest rates and peg the entire set of Treasury rates along the yield curve at their target ceiling:
… the ‘markets’ have become concerned about ‘supply side’ effects of ‘tapering’, fearing fewer Fed purchases will mean higher term rates, and particularly higher mortgage rates, even as the Fed funds rate remains well anchored at current levels.
So what we are seeing is a ‘market determined’ decision to hike longer term rates based mainly on supply fears and not on fears of ‘excess demand’ driving up rates.
And adding to the volatility is the notion that should the Fed someday decide things have ‘normalized’ and the economy no longer ‘needs’ negative real rates, that would translate into the Fed shifting the Fed funds rate to maybe 3-4% to be at some ‘neutral’ spread to ‘inflation’ etc.
So it’s pretty much binary- we stay near 0 (life support) until it’s time to ‘normalize’ to 3-4%.
All of this makes it rational for market indifference levels to shift a full 1% or more-turning term financing on or off- on nuances of Fed language.
All of which comes back to the fact that the term structure of risk free rates, with floating fx, is necessarily a policy decision, best left to political decision vs market decision, because with floating fx ‘market decision’ is necessarily nothing more than forecasting reaction functions of those setting the rates. That is, the ‘feedback’ from today’s rates determined by market forces is nothing more than what markets think the Fed will vote into policy down the road.
And I see no value in paying the real price of the volatility/uncertainty we are seeing to get that kind of information.
So best to cut the highly disruptive volatility that goes with letting markets determine longer term risk free rates by having the Fed peg the entire term structure of risk free rates with, for example, a bid for the entire tsy curve at their target rate ceiling, along with an open ended securities lending facility.
That is, in my humble opinion best for the FOMC to vote on the entire term structure of risk free rates than today’s policy of voting on just the Fed funds rate and using ‘language’ to influence the curve.
Cross-posted from Rugged Egalitarianism