In the Trenches: As Good As It Gets
January 22, 2019·3 comments·In Brief
Four decades of falling interest rates created the most profitable era in modern investing. That era ended in October 2018. Now the Fed faces an impossible choice: it cannot raise rates without breaking an economy dependent on cheap capital, and it cannot lower them enough to solve the next downturn.
• The secular trend that rewarded investors for 40 years is reversing. A generation profited from Paul Volcker's inflation-fighting campaign and the rate decline that followed. That tailwind ended when 10-year yields approached a critical ceiling, triggering an immediate market sell-off.
• Companies have structured themselves around borrowing costs that no longer exist. Commercial and industrial loans now stand at $2 trillion, two standard deviations above norm. Short-term rates have quadrupled in two years. Firms expecting to refinance cheaply will face a wall of maturities beginning in 2020.
• The Fed's rate suppression created dependency rather than stability. By setting artificially low capital costs, central banks prevented defaults but encouraged overinvestment in low-return projects. Companies now expect rates to stay low. They have no plan for anything else.
• The tool kit for solving the next downturn is already nearly empty. Previous recessions required average rate cuts of 5.5 percent. Moving back to zero from current levels falls far short of what's needed.
• The credibility of monetary policy itself hangs on whether the Fed can exit now. If central banks resort to full debt monetization to manage the next crisis, they admit that decades of suppression were emergency measures all along, not sustainable policy.
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Comments
Among the major central banks in the world, the Fed stands out as the only one that is pursuing a policy of increases in its nominal interest rate target. This policy, referred to as “normalization,” was initiated in December 2015. Normalization, however, is projected to take place slowly and is not motivated explicitly by Neo-Fisherian ideas, though James Bullard, president of the Federal Reserve Bank of St. Louis, has shown interest.
What is the risk associated with Neo-Fisherian denial—a failure to take account of the Fisher relation in formulating monetary policy? Neo-Fisherian denial will tend to produce inflation lower than central banks’ inflation targets and nominal interest rates that are at central banks’ effective lower bounds—the low-inflation policy trap. But what of it? There are no good reasons to think that, for example, 0 percent inflation is worse than 2 percent inflation, as long as inflation remains predictable. But “permazero” damages the hard-won credibility of central banks if they claim to be able to produce 2 percent inflation consistently, yet fail to do so. As well, a central bank stuck in a low-inflation policy trap with a zero nominal interest rate has no tools to use, other than unconventional ones, if a recession unfolds. In such circumstances, a central bank that is concerned with stabilization—in the case of the Fed, concerned with fulfilling its “maximum employment” mandate—cannot cut interest rates. And we know that a central bank stuck in a low-inflation trap and wedded to conventional wisdom resorts to unconventional monetary policies, which are potentially ineffective and still poorly understood.
https://www.stlouisfed.org/publications/regional-economist/july-2016/neo-fisherism-a-radical-idea-or-the-most-obvious-solution-to-the-low-inflation-problem
The Fed on its current path will reach the expected NGDP numbers thru QE unwind ivo end of 2022 if it stays the course??? …is the Fed trying to cut away from interest rate manipulation without collapsing the market….what is normalization? is it getting back to market-based outcomes to exist again? What happens when the unwind stops?
A couple of questions.
If nominal GDP is the sum of trailing growth rates in working age population, productivity & inflation; how can declining growth rates in these three series lead to structurally higher NGDP growth & higher interest rates? 2018 was debt fuelled growth advanced from the future. Using trailing 10 yr growth rates for the 3 series, NGDP potential is around 3.2%; real sub 2. Track potential NGDP using trailing 10 yr growth rates for the 3 series and the realized R squared is > than 90%. Then smooth USGG10YR index (constant maturity 10 Yr) and you have a crazy graph. The belly of the curve has an amazing correlation to potential nominal GDP. Is this why rates in countries with declining working age populations have structurally low rates?
Question 2; if QE and central bank distortions of interest rates are the only reason for low bond yields, why have yields remained low and in recent months declined as the FED’s reserves have declined? Could there be primary investment flows that actually affect rates more than the FED? Since 2007 flows into combined fixed-income mutual fund and ETF portfolios are double the flows into equity funds. Did record flows into fixed income over the past three years have any affect on rates? On the aggregate quality of fixed income indices and ETFs?
As an aside, capitalization weighted indices might make sense in equity markets: winners have the biggest impact. They make no sense in debt markets: biggest borrowers have the most impact. Biggest borrowers are at most risk of ratings downgrades, there is no way you want to to be market weight.
The Fed seems to try really hard to not let their rate deviate too far below LIBOR. LIBOR’s continued rise is why I thought they would hike in December despite the perception of a slowing economy, and they did exactly that. If LIBOR continues to rise do you think they’ll continue to try to stay within shouting distance, or will they accept the risks associated with the deviation and try to avoid being blamed for any downturn by holding off on rate hikes?
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