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Why Fed’s Role as Fiscal Shock Absorber Is Ending
Published: Sunday, 17 Mar 2013 | 10:22 PM ET
Michael Ivanovitch
President, MSI Global

The U.S. Federal Reserve's huge quantitative easing programs are just a continuation of the government's bailout on an unprecedented scale. The fact that it is all presented as part of the Fed's official mandate to promote employment in the context of (undefined) price stability should fool no one. But it does. Markets apparently believe that the unemployment target of 6.5 percent is the loadstar to the Fed's monetary policy.

Markets' apparent belief? Yes, otherwise the bond market would be sinking. But it isn't: the yield on the 10-year Treasury note remains below the 2 percent inflation rate.

All that makes it possible for the Fed to finance the government's soaring debt at rock-bottom prices.

America's Big, and Growing, Fiscal Problem

To take the full measure of fiscal difficulties facing the U.S., you don't necessarily have to go as far as James Baker, the only person to have managed five presidential campaigns and to have served as the Secretary of the Treasury and Secretary of State. Here is what he says: the U.S. is a Greece without the dollar. In other words, a bankrupt state, but lucky enough to be able to write its own checks in a currency the rest of the world accepts as a means of transaction and a store of value.

This year's U.S. budget deficit is expected to shrink to slightly below 6 percent of the gross domestic product (GDP) from 7 percent last year. But the U.S. gross public debt is not shrinking: it is estimated to exceed 110 percent of GDP by the end of this year - double what it was 10 years ago.

And things will get worse. The nonpartisan Congressional Budget Office (CBO) is warning that budget deficits and public debt will continue to widen as a result of "an aging population, rising healthcare costs, an expansion of federal subsidies for health insurance, and growing interest payments on federal debt."

Just to stop the growth of public debt, the U.S. would have to begin running a budget surplus before interest charges on outstanding debt (technically called primary budget balances), as was the case in the second half of 1990s. We are nowhere close to that: at the moment, that particular measure of the budget shows a deficit between 3 and 4 percent of GDP.

Gathering Inflation Pressures

By monetizing nearly half of government debt issues over the last four years, and bringing the U.S. economy out of recession, the Fed has made a great contribution toward lower budget deficits. Its abundant and cheap credit supplies have also kept interest charges on public debt since 2009 at less than 2 percent of GDP, despite the fact that, over the same period, the net debt-to-GDP ratio increased by 30 percent. That is a big patch on Uncle Sam's gaping fiscal holes.

But all that is nearing an end for several reasons.

First, the economy is showing a sustained and broad-based upswing. The service sector activity (about 90 percent of the economy) is expanding at the fastest pace in the last 12 months, and so are the goods producing industries. Order backlogs are sharply up in both sectors. Construction business, a forward looking indicator, is on a sustained upward trend.

Clearly, the Fed-driven economy is now moving on its own steam.

Second, the headline and core inflation rates at 2 percent look relatively benign, but that will not be the case at higher activity levels. Service sector inflation is currently running at an annual rate of 3 percent.

More important, unit labor costs are pushing up. After an average 0.4 percent growth over the last three years, unit labor costs in the fourth quarter rose nearly 3 percent from the year before as nonfarm productivity sagged and labor compensation increased at the fastest pace in more than a year.

Third, with the Fed's monetary base at $2.9 trillion, three-and-a-half times what it was during the pre-crisis period in the middle of 2008, and banks' excess reserves (at $1.6 trillion) more than 800 times their amount at that time, it is obvious that the unwinding of this extraordinary monetary stimulus is long overdue.

But the Fed will have to be pushed by the markets, because it keeps adding oil to fire: the monetary base continues to grow strongly, and the effective federal funds rate at 0.16 percent is significantly below its 0.25 percent target.

Conclusion

The strengthening economy, underlying cost and price pressures and the huge excess liquidity suggest that markets will soon force the Fed to begin a long overdue withdrawal of an unprecedented monetary stimulus. That will also withdraw the Fed's enormous help to the fiscal consolidation process. The Congress and the White House will have to try harder to find an acceptable compromise.

Assuming (implausibly) that the current inflation rate (2 percent) remains constant for some time, the effective federal funds rate would have to be raised to between 3 and 4 percent – from the present 0.16 percent -- just to make the monetary policy neutral (i.e., neither tight nor loose). That means that in a very likely case of accelerating inflation, federal funds rate would have to go up much higher than that.

Investment strategy implications stated in my earlier posts remain unchanged. Fixed income markets will experience large losses. Equities will also come off their recent highs, because expectations of Fed's policy tightening are already weakening the underpinnings to stock market valuations.

Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia Business School.

http://www.cnbc.com/id/100561436

I thought the fund target rate remains at 0 - 0.25%, so 0.16 is still within range. What's wrong with that?

fed fund rate has almost nothing to do with real interest rate. hardly, anyone on the street can borrow from any bank at 0.16%. The real interest rate is always around inflation rate no matter what fed fund rate is.

Hi Freedom,

Here are my thoughts on your comments:

“I thought the fund target rate remains at 0 - 0.25%, so 0.16 is still within range. What's wrong with that?”

Agree:
It is within range of 0 to 0.25% and there was nothing wrong - the target rate used to be a specific rate, it was an unprecedented move of having a range since 2008 – I think there was a reason to it.

“anyone on the street can borrow from any bank at 0.16%”

Disagree:

If anyone on the street can borrow at Fed Fund Rate (0.16%) from any bank, how do banks made a profit then?

In US, the Prime Rate is normally at Fed Fund Rate + 3%

Man on the street and businesses would have to borrow at Prime Rate + a Marked-Up

Here is a good reference:

http://finance.yahoo.com/news/libor-fede...00826.html

“The real interest rate is always around inflation rate no matter what fed fund rate is”.

Disagree:

Your argument seem to imply : “real interest rate” is independent of “Fed fund rate” – which is in contradiction to the definition of real interest rate as defined by Fisher.

Real interest rate, according to Fisher, approximately equals nominal interest rate minus inflation rate.

Real interest rate ( r ) = nominal interest rate (i) – inflation rate (I)

Real interest rate is a function of nominal interest rate, which in turn is a function of Fed fund rate

There is dependency.

Believe it or not?

The statement "Assuming (implausibly) that the current inflation rate (2 percent) remains constant for some time, the effective federal funds rate would have to be raised to between 3 and 4 percent – from the present 0.16 percent -- just to make the monetary policy neutral (i.e., neither tight nor loose)" seems to suggest that:

the implied "neutral" Fed fund rate = real Fed fund rate = Nominal Fed fund rate minus inflation

which is contrary to your belief "fed fund rate has almost nothing to do with real interest rate"

See "How is the neutral fed funds rate calculated?"

http://www.frbsf.org/education/activitie.../0504.html

"Economists often describe the neutral rate by talking about the real federal funds rate— that is, the nominal fed funds rate minus a measure of inflation"

2% = 4% - 2%

(Feel free to correct any mistakes).

my assumption would be that Fed fund target rate should track US GDP growth rate instead of inflation.

and since great financial crisis, US GDP growth has been dismal. The current fed fund target rate is appropriate.

and you misinterpreted my meaning of "real interest rate". my meaning of "real interest rate" is what you can actually get from the banks, not some rate quoted by someone, such as Libor(now everyone knows that it is not to be trusted, as it is artificial).

Bank are like wholesellers. Not getting your widget at gross or wholesale price does not mean cost of input is faked. That's where disintermediation comes in, from MBS to REITS to your bulk purchase.

Since neo-monetarism, conventional wisdom is interest rates should track inflation for long term sustainable growth. Hence the concept of NAIRU. Ask EU under Trichet why he refused to cut rates even as EU economy tanked. The short term money supply and cost of money will form the basis for future inflation AND interest rates expectations. They are intrinsically linked. Not even Keynes or Hayek would argue otherwise, differing only in the mechanism.

Going forward REAL interest rates, as understood by the majority, would not be between 2-4% as in the 90s, because growth in the OECD is significantly curbed. That is the basic tenant of why Bill Gross of PIMCO coined the "New Normal".

In another thread I have stated that people overestimate the impact of Fed unwinding because the Fed can just let them mature, unlike "perpetual" securities like equities. Nonetheless the impact of Fed NOT buying bonds for QE is likely to be greater than Fed unwinding by letting the assets mature.

For those who are interested, here is an interesting 33 pages long report titled “Federal Reserve: Unconventional Monetary Policy Options” dated 19th Feb 2013, prepared by CRS for the Congress.

http://www.fas.org/sgp/crs/misc/R42962.pdf

It covers on issues such as:

- “Is the Fed Monetizing the Federal Deficit?”
- Does QE Distort Markets?
- “Exit Strategy” for the Fed, etc.

Here are the concluding thoughts of the report.

Concluding Thoughts
The Fed initially undertook its unconventional policies in 2009 in response to the deepest and longest recession since the Great depression. At the time, financial stability was still fragile, unemployment was in double digits, and inflation was very low, with fears among some economists that deflation would emerge. Since the second half of 2009, the economy has expanded at a steady but slow pace that has gradually reduced unemployment but has not yet returned the economy to full employment. Over the same period, inflation has continued to remain low and inflation expectations have remained relatively steady. An individual’s view on whether the Fed’s unconventional policies are currently justified, or whether the Fed should be undertaking more or less stimulus than it has, depends in large part on whether one believes that the Fed should do more or less in the face of slow but steady economic expansion. Some might feel comfortable with unconventional policy during periods of economic free fall, such as late 2008, but feel uncomfortable with unconventional policy once the economy has stabilized.

Although it is difficult to disentangle the effects of the Fed’s policies from other factors affecting interest rates, the fact that Treasury and MBS yields are at their lowest levels in decades suggests that the Fed’s unconventional policies have had the direct effects that were intended. It is less clear to what extent lower Treasury and MBS yields have fed through to lower private interest rates, a greater supply of private credit, and more interest-sensitive spending. Corporate and household deleveraging and risk aversion following the crisis has driven interest-sensitive spending down, so lower rates can only accomplish so much in the face of these headwinds. It is clear at this point that monetary policy alone is not potent enough to return the economy to full employment quickly, and there may be diminishing economic benefits from additional QE. Given that it is unlikely that the economy would return to full employment significantly sooner if the Fed purchased assets at a faster pace, some have argued for policies that are even more unconventional as a means to additional monetary stimulus. The economic benefits of such policies would need to be weighed against their costs—the economic risk that they would lead to high inflation and the political risk that they would undermine the Fed’s political support and possibly its credibility.

While the economic benefits of unconventional policy (monetary stimulus) have not been sufficient to restore full employment, the main perceived risks (higher inflation or higher
inflationary expectations) have not yet materialized several years after QE began. Thus, while some might argue that there has been limited upside from these policies, it could be argued that there has been limited downside to date. Some critics fear that unconventional policy is undermining the Fed’s credibility, and this could harm the future effectiveness of monetary policy. If unconventional policy were failing because it is undermining the Fed’s credibility, the evidence would be high interest rates, high inflation expectations, or both; to date, neither has occurred. At this point, the main drawback to unconventional policy is a hypothetical one: that it may complicate a smooth transition to conventional monetary policy when the economy has returned to normal, particularly because the “exit strategy” is untested.

They forget or choose to ignore the effect of QE on markets (e.g. Asia) outside the US where asset prices would have gone through the roof if not for admin measures by these jurisdiction.

The word "untested" is actually found in this para and in this context:

"Another option would be to give banks incentives not to lend out reserves by raising the interest rate that the Fed pays on reserves, thereby keeping the larger monetary base from increasing the broader money supply.73 Since there is no domestic and very little international experience with first increasing the monetary base and then tightening policy without reversing the increase in the monetary base, this strategy can be considered untested."

And the primary presupposition is that :"Quantitative easing has the potential to lead to high inflation if banks decided to begin using their reserve holdings to rapidly increase their lending, which would lead to a rapid increase in the money supply. In that case, the Fed would need an “exit strategy” from QE that could be implemented relatively quickly."

Key words are "rapidly" and "quickly", and if you believe in the "new normal", then the forward view might be different.

Orderly unwinding of bailouts are not unprecedented... From the brady bonds to the AMC of the S&L crisis to the pretty recent expiry of the Indonesian recap bonds. Nobody remembers when the bonds matured. Key is for the patient to recover and work to pay his bills. A dead patient can't pay bills.

Like a lot of things are viable or "sounds" viable when u stretch it long enough. A $1m HDB flat is cheap if you can get a 99 year loan or issue centennial bond. That was the mentality of Singapore car buyers with 10 year loan of 10 year COE and 100% financing

Central Bankers Say They Are Flying Blind

Financial Times
Published: Thursday, 18 Apr 2013 | 1:06 AM ET By: Chris Giles

Growing concern at the International Monetary Fund over the long-term side-effects of interest rates close to zero came as some of the leading figures in central banking conceded they were flying blind when steering their economies.

Lorenzo Bini Smaghi, the former member of the European Central Bank's executive board, captured the mood at the IMF's spring meeting, saying: "We don't fully understand what is happening in advanced economies."

In this environment of uncertainty about the way economies work and how to influence recoveries with policy, Sir Mervyn King, the outgoing governor of the Bank of England, said that "there is the risk of appearing to promise too much or allowing too much to be expected of us".

It is troubling for monetary policy experts that their crisis-fighting tools - rates stuck at zero, money printing operations to bring down longer-term interest rates and encourage private sector spending, and efforts to calm financial market fears - might have nasty side-effects.

The central bankers were clear that they had got it wrong before the crisis, allowing themselves to be lulled, by stable inflation, into thinking they had eliminated financial vulnerabilities.

Speaking to the IMF's conference on rethinking global macro-economies, Janet Yellen, vice-chairman of the Federal Reserve, said: "In the years before the crisis, financial stability became a 'junior partner' in the monetary policy process, in contrast with its traditionally larger role."

The question now was whether central bankers are making the same mistake in their efforts to secure a recovery. Might they be storing up financial distortions that will bite in the future?

The IMF was clear in its global financial stability report that it did not want to see an end to the extraordinarily loose monetary policy being implemented across rich countries.

José Viñals, its head of financial stability, said central banks' efforts were "absolutely necessary". But the fund urged countries to use the breathing space offered to repair financial systems and also to address the unintended consequences.

It cited three new risks that were all potentially associated with easy money. In the US it sees lax underwriting standards on corporate borrowing at a level normally associated with a late stage in a boom-bust credit cycle.

It also sees easy money policies spilling over to emerging economies, particularly in the form of foreign currency borrowing by emerging market corporates, leaving those companies vulnerable to foreign currency risks and emerging markets sensitive to hot money international capital flows.

Third, it worries that the exit from monetary easing could lead to a surge in market interest rates that could destabilise credit markets and the US economy.

"Put simply, we are in uncharted territory," said Mr Viñals.

Central bankers are divided on the relevance of such concerns. While Mr Bini Smaghi said central bankers had become cornered into ever more exotic monetary experimentation, Ms Yellen sought to reassure her audience that the Fed was getting the balance right.

"I don't see pervasive evidence of rapid credit growth, a marked build-up in leverage, or significant asset bubbles that would threaten financial stability. But there are signs that some parties are reaching for yield, and the Federal Reserve continues to carefully monitor this situation," she said.

The problem outlined by Sir Mervyn was that the uncertainty is so pervasive that no one can be sure that the expansionary monetary policy is appropriate in a world where nations are learning they are poorer than they expected, but are not sure by how much. How can we be sure "we really are [not] running the risk of reigniting the problems that led to the financial crisis in the first place?" Mr Bean asked the IMF panel.

His question underpinned the fear that the abilities of economies have been so damaged that expansionary policy is likely to go on for too long as central banks and governments seek to recover lost ground. Central bankers were not worried that monetary policy had already gone too far, but they were nervous the exit from easy money would prove too troublesome.

http://www.cnbc.com/id/100650518

I am a firm supporter of FED's QE policy. Long term interest rate should align with long term growth rate of GDP and long term inflation. Since the growth of world GDP is so low, there is no reason not to keep long term interest rate low enough. Only when the interest rate is low enough, investors will take higher risk and hopefully, great innovations come out and propel the world economy.

I can only say sorry to those retired. You have enjoyed the good times, either you have to lower your lifestyle, or you can come out of your retirement. It's unfair for the younger generation to pay for your retirement.