Bonds, risk and Bernanke’s intentions
Will bond investors keep faith with U.S. government debt amid signs of growing global inflation?
In the end, as with all banks, even central banks, it boils down to trust.
Asked on Wednesday at an appearance before the U.S. House of Representatives Budget Committee if the Fed’s $600 billion programme of quantitative easing amounted to monetization — that Peter to Paul transfer when a government prints money to pay for a shortfall — Ben Bernanke said an interesting thing:
“Monetization involves a permanent increase in money supply though money creation. (QE) is a temporary measure that will be reversed. Money will be normalized and there will be no permanent increase in outstanding balance sheet or inflation.”
So, because he intends to undo it later, he’s not doing it now.
This is both demonstrably false and deeply, at least for now, true.
False because, of course, money is being created to fund the purchase of debt issued by the Treasury. True because Bernanke can avoid the disaster often associated with monetization so long as he retains the faith of the world’s investors that he not only intends to unwind QE but will be able to do so at the right time in the future.
Monetization is an inflammatory term because so often in the past the practice of funding a revenue shortfall by buying debt with newly printed money has worked out poorly, resulting in an inflationary spiral that beggars creditors and kills the real economy.
You can bet your last Confederate dollar that all the previous central bankers who bought their own bonds with their own printed money promised that they too would withdraw before it was too late. And some of them actually did withdraw the extra money, including some of Bernanke’s predecessors at the Fed during and for a time after World War II.
Daniel Thornton, a vice president at the St Louis Fed, suggests a slightly broader but still self-referential definition of monetization, in essence saying that it can only be judged not by action but by comparing a central bank’s performance against its targets. <http://research.stlouisfed.org/publications/es/10/ES1014.pdf> That is well and good, but really leaves investors with nothing to rely upon but faith.
NO SIGN OF PANIC
So far, at least, the signs are that the world’s bond buyers believe Bernanke; so-called 5yr5yr forwards, a measure of inflationary expectations in five years’ time, show an uptick of about a percentage point since QE2 came on to the agenda last August, but only up to a pretty tame 2.8 percent or so. It is likely that some of that move represents rising risk of runaway inflation, but it also reflects rising confidence in growth.
Despite medium- and long-term concerns about the budget and the economy, Bernanke is in a reasonably strong position; he represents the world’s largest economy and its principle reserve currency.
That said, the loss of confidence, if it came, would be swift and devastating, more all of a sudden than little by little.
While Bernanke’s recent comments give little indication that a rethink of QE is coming soon, his colleagues are now sounding a lot less enthusiastic.
“Barring some unexpected shock to the economy or financial system, I think we are pushing the envelope with the current round of Treasury purchases,” Dallas Fed President Richard Fisher, a noted hawk, said in a speech on Tuesday.
“I would be very wary of expanding our balance sheet further; indeed, given current economic and financial conditions, it is hard for me to envision a scenario where I would not use my voting position this year to formally dissent should the FOMC recommend another tranche of monetary accommodation.”
Fisher goes on to blame Congress for creating the debt, but the message and fear are clear: monetization should be rolled back.
In speeches the same day, Jeffrey Lacker of the Richmond Fed recommended that the Fed consider adjusting QE in light of improving data while the Atlanta Fed’s Dennis Lockhart said he thought no more bond buying would be needed after the expiry of the current $600 billion plan at the end of June.
Those are still minority views, and will be until Bernanke changes his tone. Given the very mixed signals coming out of the U.S. jobs market, don’t expect that to happen any time in the next month. Remember too what happened last year, when the Fed stepped back from QE1 only to see the economy weaken undesirably as the year wore on. Markets only revived once Bernanke all but promised another round of bond buying at the end of August.
For now, the controls are still in Bernanke’s hands, but keep watching the bond market.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. email: firstname.lastname@example.org)