Cheap money means a bond bubble
By Martin Barnes / Financial Times June 23, 2003
The writer is managing editor of the Bank Credit Analyst
In its increasingly desperate attempts to steer the US economy away from deflation, the Federal Reserve Board is blatantly encouraging increased leverage and speculation. Having almost exhausted the potential to cut short-term interest rates, the Fed's focus is now on flattening the yield curve by pushing down long-term rates. The Fed's strategy is to make an explicit commitment that short rates will be held down for an extended period, bolstered if necessary by purchases of long-term securities.
This is extremely powerful stuff. Essentially, the Fed is telling the markets to have a party because the punch bowl will stay in place for a long time. Moreover, if the party starts to get too dull, the Fed will add another bottle of booze to the bowl.
How long is a long time? The implication of recent Fed statements is that a rise in interest rates will not be contemplated before inflation rises. That is at least a year away. So the markets can be confident that short-term rates will stay at or below current levels for another 12 months or longer. That reality is now reflected in 12-month forward markets.
Although long-term Treasury yields have already overshot on the down side, the Fed is implicitly encouraging investors to keep on playing the carry trade: buying and holding bonds in the expectation of rising prices. Treasuries are in a bubble but the Fed must keep it inflated, the reasoning runs. It is vital to keep mortgage rates down and housing strong until the economy is on a sound footing.
The prospect of a year of extremely easy money is a gift to hedge funds and speculators. It is a signal to take on leverage and to purchase risky assets. Of course, this assumes that the Fed will be successful in keeping the economy out of a deflationary hole. But that seems a good bet. The overall policy environment in the US has never been more stimulative, with monetary and fiscal policy and the dollar all working in the same direction. The economy will probably be growing strongly by the end of the year.
The Fed's aggressive efforts to steer the economy away from deflation will be conducive to mini-bubbles in a range of asset markets. The Fed does not necessarily want more bubbles to grow but they are seen as an acceptable price to pay. The Bank of Japan's fear of reinflating an asset bubble contributed to its policy error of easing too timidly in the early 1990s; the Fed is determined not to repeat that mistake.
Of course, once the US economy is growing strongly, thoughts will turn to timing a reversal of Fed policy. Currently, the Fed wants to reassure the markets that there is scope for a significant rebound in the economy before interest rates will need to be raised. Nevertheless, the markets will know that it will be only a matter of time before stronger economic activity translates into a shift away from deflationary conditions.
This is where the game of chicken comes in. The Fed is implying it is OK to buy long-term Treasuries at yields near 3 per cent and to engage in leveraged activities. But if the Fed is successful, it will not ultimately pay to hold bonds at these overly depressed yields and leveraged deals and investments based on persistent low rates may blow up.
The Fed will face a huge challenge in managing its exit strategy from deflation-era interest rates if it wants to avoid turmoil in the markets. In early 1994, investors were caught off-guard when the Fed tightened after a long period of low interest rates, resulting in the worst bond bear market on record. The Fed learnt from that episode and now does a better job of telegraphing its intentions. However, even if the Fed tries hard to avoid surprising the market, the subtlest hint that the days of interest rates below 1 per cent are numbered will trigger a stampede for the bond market exit.
Playing the Fed's game of chicken boils down to the "greater fool" theory of investing. You may know that it makes no sense to buy Treasuries at current yields but the game is worth playing if you can get out before the mass of investors. The fact that many investors undoubtedly take the same attitude sets the scene for dramatic marke reversals down the road.
The Fed is right to take all possible steps to avoid deflation. If this means feeding speculation by promising to keep interest rates at negligible levels for a long period, so be it. But investors should make sure they have their eyes wide open when they play the Fed's game.
Escaping the trap of deflation
June 23, 2003
What can you do when interest rates are as low as they can get but prices are still falling?
By Michael Woodford / Taipei Times
Michael Woodford is professor of economics at Princeton University.
US Federal Reserve Chairman Alan Greenspan's recent speech to a conference of bankers in Berlin -- admitting the desirability of "insurance" against the risk of deflation in the US, even if it has not yet appeared -- focused attention on a crucial issue. What can be done to stabilize an economy when nominal interest rates cannot be lowered any further, but prices still fall and the output gap -- the difference between what it can produce and what it actually does produce -- remains wide? What was a theoretical curiosity raised by John Maynard Keynes in the 1930s has become the fundamental issue confronting policymakers in the world's largest economies.
Japan poses the clearest example of this problem. Growth there remains anemic, and deflation lingers, suggesting a need for monetary stimulus. But the benchmark interest rate in Japan has been essentially zero for the past four years, so the standard form of monetary stimulus -- reducing short-term nominal interest rates -- is unavailable. With the Fed's operating target now only 1.25 percent and signs of recovery in the US fragile, many now fear that the US is poised to confront a similar situation. The recent cut in the European Central Bank's (ECB) policy rate amid warnings of possible deflation in Germany lead some to fear that the euro zone may be equally at risk.
Some economists recommend fundamental changes in the way monetary policy is conducted to avoid ever reaching this "zero bound" on interest rates. Paul Krugman, for example, calls deflation a "black hole": once you fall into it, monetary policy becomes ineffective because no amount of monetary expansion can further reduce interest rates. So policymakers must prevent deflationary expectations from ever taking root by targeting a sufficiently high inflation rate at all times.
But what if it's too late, and the zero interest-rate bound is reached while prices are falling? Is there any point in having an inflation target that cannot be met? Kunio Okina, director of the Bank of Japan's Institute for Monetary and Economic Studies, resists inflation targeting for this reason. He argues that "because short-term interest rates are already at zero, setting an inflation target of, say, 2 percent wouldn't carry much credibility."
Wrong. The "zero bound" on short-term rates does represent an important constraint on what monetary stabilization can achieve, but it is a more modest barrier than deflation pessimists insist. Monetary policy is far from powerless to mitigate a contraction in economic activity when deflation strikes, or when an economy flirts dangerously with it.
The key is to create the right kind of expectations regarding how monetary policy will be conducted in the longer term. For expectations regarding policy in the future determine the severity and duration of the output gap that results from hitting the zero bound now.
If the Bank of Japan, for example, were to commit itself to a target path for a broad price index, and credibly commit to keeping interest rates low until that target is reached, this commitment would influence investor behavior. For the more that prices fall, the greater should be the confidence in future inflation, and hence perceptions of lower real interest rates.
A commitment to a price-level target path above the current level would imply a commitment to keep nominal interest rates low for a time in the future, even after prices begin to rise again. A commitment to hold down nominal interest rates for a longer period of time should stimulate aggregate demand immediately. This is true even when current rates cannot be lowered any further -- and even if inflation expectations remain unaffected -- owing to the effects of the expected future path of short rates on current long-term interest rates and on the exchange rate.
The fact that an official price-level target is not hit immediately need not impugn such targets. The existence of an official target is crucial, even when it is not being reached, because it allows the private sector to judge how close the central bank is to a point at which it would feel justified in abandoning its zero-interest-rate policy. The current gap between the actual and target price levels should shape private-sector expectations regarding how long interest rates are likely to remain low.
But why should the private sector believe that the central bank is serious about hitting its price-level target, if all that is observed in each period is a zero nominal interest rate and another target shortfall?
Ideally, the best way to make its policy credible would be for the central bank to demonstrate its commitment to the price-level targeting framework before the zero bound is reached. In practice, and especially when deflationary fears are already present, managing private-sector expectations demands considerable subtlety.
The private sector is likely to scrutinize the bank's current actions for clues to its future behavior. So "signaling" effects, such as shifts in the central bank's portfolio towards long-term securities, could help make the bank's price-level target credible. If, say, the central bank starts buying long-term bonds from the private sector at below-market interest rates, this should help convince the public that the bank intends to stick to a future low interest-rate policy.
Such asset shifts would work because the level of long-term interest rates is an indicator of the markets' faith in the central bank's commitment to maintaining low short-term rates once inflation returns. So, if the private sector is skeptical about the bank's commitment, long-term rates will be too high. But if the bank buys long-term bonds, it will tend to show that skepticism is unwarranted.
The stabilizing effect of such asset purchases is due not to any mechanical consequence of the shift in portfolio balances, but to a change in private-sector expectations regarding future interest-rate policy. Any central bank facing deflation should commit itself in advance to a price-level target and pursue actions that convince the private sector that the commitment is genuine. Only that change in private expectations will make the bank's policy effective. |
