Lessons learned from the Fed’s $745 billion mistake
Have the Fed's massive interventions to keep down long-term interest rates failed to neutralize expectations driving the bond market behavior?
The answer from some of the Fed's leaders would be an emphatic "no." They believe that their "operation twist" (buying long-term bonds by selling short-term Treasury securities from September 2011 to December 2012), and the $85 billion monthly purchases of long-term bonds and mortgage-backed securities have been "successful."
That is as one might expect. After all, the Fed is unlikely to agree that the net addition of $745 billion to its $3.4 trillion balance sheet since September 2011 was an ill-advised fools' errand. But please note that the Fed is not defining the word "successful" in terms of any particular achievement in the realm of real economy.
Before we discuss that, let's see what the Fed was trying to do.
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In a laudable effort to accelerate the U.S. economic recovery, the Fed thought that large and sustained purchases of long-term Treasury and mortgage debt would hold down the bond yields underlying an entire range of credit costs. That, the Fed expected, would speed up the growth of interest-sensitive components of aggregate demand – household consumption and residential investments, which account for nearly three-quarters of American economy.
The decision to start twisting the yield curve in September 2011 also implied the Fed's conclusion that its virtually zero interest rate policies (in place since December 2008) were not working. Indeed, one now learns that this extraordinary measure was taken because the Fed feared a recessionary relapse of the U.S. economy.
An ill-judged decision
Looking at the evidence, it seems that this was a puzzling error of judgment, because most of the data available at the time the Fed began its "operation twist" could not justify fears of an incipient recession. The gross domestic product (GDP) was growing at an annual rate of 1.7 percent since the spring of 2011, retail sales were growing (in volume terms) at an average annual rate of 3.3 percent in June, July and August of 2011, private consumption was advancing at a rate of 2.6 percent, and the residential investment was rebounding at a rate of nearly 5 percent, marking the beginning of a robust and strengthening upturn of the housing sector.
These numbers are much stronger than the GDP growth of 1.3 percent and private consumption growth of 1.8 percent in the first half of this year. Should one conclude then, using the Fed's own logic, that "operation twist" and asset purchases have been a massive policy failure?
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And here is an even more important question: In view of this dismal result, should the Fed follow last week's advice from the IMF to keep blowing up its balance sheet with continued asset purchases, or should the Fed observe the folksy imperative of the first law of holes -- "when you are in a hole, stop digging?"
The answer is clear. The bond market has led the Fed to its epiphany, whispering that it was an ill-judged decision to try and manipulate the yield curve (the fools' errand if there ever was one).
Here is an example showing the futility of the Fed's attempt to suppress market forces.
The 30-year mortgage rate bottomed out in December 2012 at 3.35 percent and continued to edge up to 3.51 percent in mid-May of this year (before the Fed started dropping "tapering" hints), despite Fed's monthly purchases of $40 billion of mortgage-backed securities and the fact that, over that period, the yield on the benchmark 10-year Treasury note was roughly stable around 1.85 percent.
What happened? Credit markets were responding to the strong demand for mortgage financing as residential investments in the first half of this year soared at an annual rate of 14 percent. Last Friday, the 30-year mortgage rate was 4.78 percent, almost 30 basis points higher than in mid-May.
Clearly, the Fed could not hold down, much less reverse, changes in the term structure of interest rates unleashed by the constellation of recovering employment, household incomes and low mortgage costs.
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Those who are now blaming the Fed's allegedly clumsy communication for the sinking bond prices, fail to see that bond market vigilantes have been anticipating the Fed's retreat (i.e., "tapering") ever since the middle of last November, when the yield on the 10-year Treasurynote bottomed out at 1.59 percent (the yield was up at 2.82 percent last Friday).
Something to take home
What are the messages one can draw from this episode of Fed's policies?
First, a swift stop-loss move is all you can do if you are still caught in U.S. bond markets because you did not heed my advice last November to get out. Stocks have also been hit, but subdued wage gains, rising productivity and a growing economy will support profits and offer attractive stock picking opportunities in a broad, deep and liquid U.S. equity market. Buying the market is over, though.
Second, always vote with your feet (preferably in good time) to sanction Fed's inappropriately easy money policies. That's what gold bugs have been doing ever since they settled for $252.80 for an ounce of fine gold in mid-1999. Having paused after a speculative peak last April, gold bugs are at it again. Remember, the sub-prime crisis and its sequels were caused by Fed's prolonged and excessively loose monetary stance since the turn of the millennium.
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Third, trust the bond market vigilantes. They will begin to react much before your email boxes get clogged up by spams that you have been "pre-approved" for credit lines and "great" mortgage refinancing deals. [I am getting quite a bit of those every week.]
Fourth, don't be outraged when you hear that the German finance minister sternly called last week for rising interest rates in the euro zone – a disaster area barely emerging from recession with a 12.1 percent unemployment rate. If you look at the euro's climbing exchange rate, you will see that investors like that idea; they apparently feel confident that the European Central Bank (ECB) will respond to German pressures for stable and steady non-inflationary policies.
Fifth, Japan will rue the day when it decided to copy the Fed. Japan does not need free money. Japan needs better relations with its neighbors and long-overdue structural reforms. There was nothing wrong with Japan's earlier monetary policies.
Sixth, listen carefully to President Obama's job description for the new Fed chief. It sounds like he might be looking for the intellectual clone of that stability-obsessed German finance minister, or for the 85-year old former Fed Chairman Paul Volcker. The president realizes that the U.S. has to stop hurtling from one economic crisis to the next. He also knows that a stable and steady economic growth is a key condition for American security and strategic sway in a world where both could soon be increasingly challenged.
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Finally, President Obama understands that the dollar is doomed unless the U.S. can provide the world with a stable transactions currency and a reliable store of value. That is a strategically important role the U.S. must retain, and I believe that will be one of the key objectives the Fed's new leadership will be expected to pursue.
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Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia.