The prospect of continued tepid economic growth, if not recession, might be taken as evidence that the Fed will not taper its program of quantitative easing anytime soon. I actually think this inference is incorrect. It’s important to distinguish between two policy responses – one being a reduction in the pace of new purchases of Treasury and agency securities by the Fed, and the other being actual sales to reduce the size of the Fed’s balance sheet. Based on the tight historical relationship between the monetary base (per dollar of nominal GDP) and short-term interest rates, we estimate that the Fed would have to actually reduce its balance sheet by over $400 billion simply to nudge short term interest rates up by 0.25%. This is nowhere in the Fed’s plans, and numerous statements from Fed governors have made that clear. The Fed has no plans – zero – to raise its policy rates in the foreseeable future. Accordingly, material reductions in the size of the Fed’s balance sheet are highly unlikely. Any economic weakness will push off the date of even the first tiny hike in short-term interest rates even further.
However, “tapering” really has nothing to do with raising interest rates. It simply implies a reduction in the pace of new purchases. As we’ll probably find in the minutes of the last Fed meeting, many members of the FOMC are increasingly concerned about the distortions created by QE, along with the fact that even the present near-frantic purchases are having diminishing effect. A reduction in the pace of purchases is long overdue absent a full-blown economic crisis. The Fed can and should be expected to reduce the pace of new purchases in the next few months. It may even stop new purchases sometime in 2014, though I doubt that will happen until Bernanke is gone.
On the inflation front, we’ve always argued that the price level is the ratio of two marginal utilities – the extra benefit people get from an additional unit of goods, divided by the extra benefit that people get from an additional unit of money. A unit of money throws off benefits by providing a store of value and a means of payment, and each successive holder gets a tiny bit of that benefit. The marginal utility of an additional unit of money is just the appropriately discounted sum of all of those tiny bits. Inflation actually reflects an increase in the marginal value of goods at a faster rate than the marginal value of money. Creating huge quantities of money when interest rates are near zero and where there is a great deal of economic slack is far less inflationary than creating the same quantity of money when interest rates are high and the economy faces supply constraints.
I doubt that QE will produce material inflation pressures in a weak, crisis-prone economy. Nor will it produce economic growth. It is simply fruitless policy that fails to address any economic constraint that is actually binding, and it insults the economy by encouraging the diversion of scarce savings to speculative and unproductive activities. To borrow a line from Keynes, “when the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”
Larger inflationary risks will most likely be in the back half of this decade, after the next recession ends. The argument for reducing the pace of QE is not that it is creating inflation. Rather, pace of QE should be reduced because the risk of systemic disruption and financial distortion grows with every new purchase, along with the difficulty of eventually normalizing policy. Untethered inflation could certainly emerge if the present monetary policy stance was met with some kind of supply shock, but that would require an unexpected event that constrains output (like the OPEC shock or the strike of German workers in the Ruhr in the 1920’s).
The bottom line is this. Short-term interest rates will be pegged at zero for quite a long time, because raising them even slightly would require not just tapering, but a massive reduction in the Fed’s balance sheet. The securities that compete most closely with default-free short-term money is default-free long-term money, which is why I view Treasury bonds as increasingly compelling as interest rates rise, particularly in a tepid economy with no material inflation pressures. Security types that normally carry significant risk premiums (like stocks and corporate bonds) have already seen all of the likely benefits of QE, and any return to historically reasonable risk premiums is likely to batter these securities.
So while I view a reduction in the pace of the Federal Reserve’s quantitative easing purchases as likely in the months ahead, regardless of the course of the economy, an actual reduction in the amount of those holdings seems unlikely for years. As a result, short-term interest rates are likely to be pegged near zero for a very long time, and the lack of yield on short-term default-free investment options is likely to support demand for the most comparable default-free options – namely medium and long-term Treasury debt. I don’t believe that the same argument extends well to securities such as stocks or corporate bonds that have traditionally been priced to reflect significant risk premiums, and where we estimate present risk premiums to be extraordinarily thin.
In my view, much of the recent selling has been based on the idea that the 30-year secular bull market in bonds is over. The more relevant issue is that there are no material upward pressures on short-rates, inflation, or economic growth here, the difference in yield between 10-year Treasuries and 3-month Treasury bills is already greater than the long-term norm of 1.4%, and the potential for credit shocks remains material. In that environment, I believe the main consideration is to have the flexibility to extend durations on spikes in yields and reduce durations when yields are depressed.
For example, consider a 10-year Treasury bond with a face value of $100 and a coupon of 2.5%. If the yield-to-maturity remains at 2.5% for a year, the total return on that bond would be 2.5%. An increase in the yield to 3.0% over the course of a year would produce a capital loss, offset by interest income, for a total return of -1.4%. A decline in the yield to 2.0% over the course of a year would produce a total return of 6.58%. The corresponding figures for a 100 basis point increase and decrease in yield are -5.11% and 10.86% respectively. A lower coupon would widen that range of outcomes slightly, while a higher coupon would narrow it. Given that I view economic risk to be asymmetrically to the downside, I would not rule out those lower ranges for yield.
Last week, the Bank for International Settlements – essentially the central bank of central banks – made the following observations in its Annual Report. They are the most concise evaluation of Fed policy I’ve seen. A few excerpts:
“Originally forged as a description of central bank actions to prevent financial collapse, the phrase ‘whatever it takes’ has become a rallying cry for central banks to continue their extraordinary actions. But we are past the height of the crisis, and the goal of policy has changed – to return still-sluggish economies to strong and sustainable growth. Can central banks now really do ‘whatever it takes’ to achieve that goal? As each day goes by, it seems less and less likely. Central banks cannot repair the balance sheets of households and financial institutions. Central banks cannot ensure the sustainability of fiscal finances. And, most of all, central banks cannot enact the structural economic and financial reforms needed to return economies to the real growth paths authorities and their publics both want and expect.
“What central bank accommodation has done during the recovery is to borrow time – time for balance sheet repair, time for fiscal consolidation, and time for reforms to restore productivity growth. But the time has not been well used, as continued low interest rates and unconventional policies have made it easy for the private sector to postpone deleveraging, easy for the government to finance deficits, and easy for the authorities to delay needed reforms in the real economy and in the financial system. After all, cheap money makes it easier to borrow than to save, easier to spend than to tax, easier to remain the same than to change.
“Alas, central banks cannot do more without compounding the risks they have already created. Instead, they must re-emphasise their traditional focus – albeit expanded to include financial stability – and thereby encourage needed adjustments rather than retard them with near-zero interest rates and purchases of ever larger quantities of government securities. And they must urge authorities to speed up reforms in labour and product markets, reforms that will enhance productivity and encourage employment growth rather than provide the false comfort that it will be easier later.”