MacroScope

Federal Reserve Chairman Ben Bernanke has been trying for some time to fend off critics of his bond-buying policies who argue the central bank is making it easier for the federal government to run deficits. In remarks to the Economic Club of Indiana on Monday, he seems to have found a useful way to help illustrate his point.

It follows logically that those who say the Fed is abetting profligate governments might want to see higher interest rates that would discourage excess federal borrowing. Bernanke pursues this line of thinking to its natural conclusions – and is very uncomfortable with the results:

I sometimes hear the complaint that the Federal Reserve is enabling bad fiscal policy by keeping interest rates very low and thereby making it cheaper for the federal government to borrow. I find this argument unpersuasive. The responsibility for fiscal policy lies squarely with the Administration and the Congress. At the Federal Reserve, we implement policy to promote maximum employment and price stability, as the law under which we operate requires. Using monetary policy to try to influence the political debate on the budget would be highly inappropriate.

For what it’s worth, I think the strategy would also likely be ineffective: Suppose, notwithstanding our legal mandate, the Federal Reserve were to raise interest rates for the purpose of making it more expensive for the government to borrow. Such an action would substantially increase the deficit, not only because of higher interest rates, but also because the weaker recovery that would result from premature monetary tightening would further widen the gap between spending and revenues. Would such a step lead to better fiscal outcomes? It seems likely that a significant widening of the deficit – which would make the needed fiscal actions even more difficult and painful – would worsen rather than improve the prospects for a comprehensive fiscal solution.

Jonathan Spicer contributed to this post

An important part of the Federal Reserve’s recent decision to embark on an open-ended quantitative easing program was a fresh indication that the central bank will leave rates low even as the recovery gains steam. According to the September policy statement:

To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.

Just why does the Fed believe promising to keep policy stimulus in place for a long time might help struggling economies recovery? Mike Feroli, chief U.S.economist and resident Fed watcher at JP Morgan, traces the first inklings of the idea to the work of Paul Krugman, the Nobel-prize winning economist and New York Times columnist.

Some say the European Central Bank will cut rates. Some say they won’t.

The odds that either prediction could turn out to be true on Thursday are more even than since Reuters first began polling on ECB rates in 1999.

Even during the highly volatile, uncertain time that followed the collapse of Lehman Brothers, Reuters polls of ECB watchers always resulted in a clear majority of economists leaning toward one particular rate cut size.

In the Reuters poll taken last week, 36 of 70 economists expected the ECB to leave the refi rate at 0.75 percent, while almost as many, 34, said it would cut it to 0.50 percent.

By Rahul Karunakar

The spread between 2- and 10-year U.S. Treasury yields will shrink to 180 basis points in a year according to the latest Reuters bonds poll – the narrowest margin since August 2008, the month before Lehman Brothers collapsed.

Historically, that spread has been a key indication of what investors and traders are thinking about the economy’s prospects: the narrower it gets, certainly with short-term rates already at rock bottom, the darker the outlook.

It wasn’t looking particularly good in August 2008, and of course we all know what happened the following month: the start of an epic financial and economic crisis the world is still struggling to shake off.

So much for policy coordination. Just days after the Treasury published a note touting its progress in lengthening the average maturity of its outstanding bonds, the Fed decided to extend Operation Twist – a policy aimed at doing the exact opposite. By selling an additional $267 billion in short-dated bonds to buy long-term ones, the Fed is trying to take Treasuries with longer maturities out of the market, to lower yields and entice investors to take on more risk.

In a narrow sense, the Treasury’s approach is perfectly reasonable: U.S. interest rates are at historic lows, so it stands to reason that the government should lock in that low cost of borrowing for the longest period possible. However, in the context of an economy that remains exceedingly weak – and where the only source of stimulus appears to be a reluctant central bank – the move could be viewed as somewhat incongruous.

Fed Chairman Ben Bernanke himself addressed the issue when he was asked during the post-meeting press conference whether it would make sense for the U.S. government to issue more longer-term bonds given the current low-rate environment.

Are politicians playing chicken with central bankers? More to the point, if the U.S. Federal Reserve or the European Central Bank step up, yet again, to protect their economies from the global slowdown, will it take U.S., German, Spanish, Italian, Greek and other governments off the hook?

Such questions are swirling as Europe’s financial crisis boils and starts to bubble over into Asia and the Americas. Expectations are growing that the Fed will take more monetary policy action when it meets June 19-20. The messy possibility that Greece could exit the euro zone was not enough to prompt the ECB to cut interest rates last week – and that was before a deal over the weekend to bail out Spanish banks was dismissed by markets as just another kick of the can. Underlining the standoff between monetary and fiscal policymakers, ECB President Mario Draghi told European Parliament this on May 31:

Can the ECB fill the vacuum of lack of action by national governments on fiscal growth? The answer is no.

The fluctuating fortunes of the British economy in the last year have left forecasters in a fix, unable to make up their minds how much longer the Bank of England’s money printing presses need to roll on.

Forecasting gymnastics on the subject could make many economists Olympic contenders for the gold medal.

Deutsche Bank, Morgan Stanley and Lloyds Bank are the latest to predict the BoE will announce that it will buy an additional 50 billion sterling worth of government bonds, taking the total amount spent in the programme to 375 billion sterling.

Another reason the Federal Reserve may have additional room for monetary easing: Inflation expectations fell sharply in May, according to the latest Thomson Reuters/University of Michigan survey of consumer sentiment. Inflation expectations five years out dropped to 2.7 percent in May, the lowest since January. Fed officials often say expectations are a key leading indicator of actual price increases.

Daniel Silver, economist at JP Morgan:

This level of longer-term inflation expectations is towards the bottom of the range that has been reported in recent years – 2.7% has been hit on several occasions (most recently between October 2011 and January 2012) and 2.6% was only reached back in December 2008 and March 2009, early on in the crisis period. Most other inflation measures that the Fed watches (including core PCE inflation and the 5yr-5yr breakeven inflation rate) have signaled that inflation expectations are still anchored and underlying inflation pressure is modest.

The downshift comes in the wake of inflation figures for April that also pointed to a tame price environment. This is why Eric Green at TD Securities argues “U.S. inflation favors the doves.”:

Jonathan Spicer and Van Tsui contributed to this post.

This week, for the second time ever, the U.S. Federal Reserve published policymakers’ forecasts for when the central bank should start raising rates. The chart suggested a split Fed, with three policymakers expecting a rate rise this year, three next year, seven in 2014 and four in 2015. That’s useful information, as far as it goes.

But as much as the Fed has embraced transparency in recent years, it stopped short of saying which policymaker backs a rate hike in which year – a key bit of data for grasping where the voters on Fed Chairman Ben Bernanke’s policy-setting committee stand, and how their positions shift over time.

Below is the bar graph that the Fed published Wednesday, with Reuters’ best estimates of who fell where. We stand ready be convinced otherwise by readers offering evidence or insight that supports a different view. Send us an email, gives us a call, write a comment or shout us out on Twitter.

One trillion euros is a lot of money. And as we have previously noted on this blog it did a lot for stock markets early this year but not much for the real economy.

But recent bond auctions in the euro zone suggest the impact of two rounds of cheap 3-year ECB funding on the region’s struggling bond market may also be fading.

Italian three-year borrowing costs surged more than a full percentage point at an auction to 3.89 percent – its highest since mid-January.