Issues in monetary normalisation
Investors like simple narratives, which is why markets swing erratically and illogically between extremes of hope and fear. Reality is more complex. As F. Scott Fitzgerald remarked “the true test of a first-rate mind is the ability to hold two contradictory ideas at the same time”.
The bond market is currently struggling to reconcile contradictory fears about inflation and recession, not always successfully.
The medium-term outlook for the U.S. economy is dominated by the risk of inflation as massive injections of liquidity eventually fuel a rebound in economic activity accompanied by widespread price increases, starting with oil and other commodities and spreading to the rest of the manufacturing system. In effect, this would be a destabilising repetition of conditions that characterised the period between 2004 and 2008.
But in the short term, risks are concentrated on the downside. Households and businesses scarred by recession and burdened by a legacy of excessive debt from the boom years are unlikely to boost spending and investment significantly in the next year or two. So in its early stages, the recovery is likely to be halting and tepid, requiring significant support from monetary and fiscal stimulus.
The challenge for both markets and policymakers is to respond to a scenario in which monetary policy will remain ultra-loose for an extended period (to entrench the recovery) and then need to be tightened fairly rapidly (to prevent an inflationary breakout).
Past experience suggests the Federal Reserve and other central banks will find the first part easier than the second.
Until recently, investors appeared to be doing a good job holding these contradictory views (a short term dominated by deflation and recession, a medium term dominated by recovery and inflation) at the same time.
Yields on benchmark two and three year U.S. Treasury notes, the part of the curve most sensitive to the short-term outlook for monetary policy, had remained basically unchanged since February. In contrast, yields on five year and especially 10-year notes, which are dominated by the outlook for recovery and inflation, had risen steeply.
The market was pricing a period of low interest rates lasting 12-18 months followed by a return to normal conditions thereafter, marked by a pronounced steepening of the yield curve.
But in the past two weeks, rates on 2 and 3-year paper have risen sharply as signs of stabilisation from payrolls and manufacturing surveys have encouraged the market to price in a much earlier increase in interest rates.
The market is almost certainly being too aggressive. The Fed’s track record suggests policy is unlikely to be tightened significantly until the middle of 2010. Here are 6 reasons why:
(1) Policymakers’ fondness for injecting liquidity in response to a crisis and difficulty removing it in a timely manner afterwards is well-documented. But the “Greenspan put” could just as readily be described as a “Bernanke put”; there is no perceptible difference between the current Fed chairman and his predecessor on this issue.
(2) Fed Chairman Ben Bernanke has accepted regulators’ mistakes contributed to the crisis, in particular weakness in bank supervision. But he has not accepted criticism that the Fed kept rates too low for too long after the last recession in 2000-2001. If the Fed does not believe it did anything wrong then, there is no reason to think it will behave differently this time.
(3) The decision to postpone interest rate rises after the last recession was a response to a weak and fitful recovery. Policymakers, led by Bernanke, expressed repeated concerns about the lack of a “self-sustaining” expansion, the risk that it would stall, and that deflationary forces would take hold. If, as is likely, the current expansion is similarly patchy, there is no reason to think the Bernanke Fed will behave differently.
(4) As a student of the Great Depression, Bernanke is aware of criticism that the Fed’s decision to reduce “excess liquidity” in 1937 and 1938 by raising reserve requirements, prompted by sharp increases in the price of steel and other raw materials, is blamed by historians for short-circuiting the recovery and plunging the economy into renewed recession. He will not wish to repeat the error.
(5) Officials believe there is little danger of sustained price increases while manufacturers have large amounts of spare capacity. U.S. manufacturers are currently using only 65 percent of theoretical capacity, well under the 80 percent cyclical average since 1972. Until this slack has been reabsorbed, fierce competition should prevent isolated increases in the price of raw materials (such as oil) from being passed on to final consumers, limiting the risk of an inflationary breakout. This cushion of spare capacity gives the Fed plenty of time before policy needs to be normalised.
6) Even if oil prices and other commodities continue to rise sharply, the Fed will portray this is a one-off readjustment in relative prices (Adam Smith’s “invisible hand” at work) rather than as a generalised increase in the price level (inflation) requiring a response from monetary policy.
For all these reasons, monetary policy is likely to remain on hold until well into 2010. The Fed may decide to tinker with policy around the margins by tapering off the volume of U.S. Treasury securities bought back as part of the quantitative easing programme.
Even then the Fed may feel compelled to maintain at least some small-scale purchases to make its preference for low short term rates effective. But any rise in the federal funds target is likely to be postponed until 2010.
In this context, holding contradictory views about a weak recovery nearby and the threat of inflation further out requires a steeper yield curve. The recent sell-off in two year and three year notes relative to the 10-year looks ripe for a partial reversal as the market once again decides it is possible to hold contradictory views.