The Fed’s Interest Rate Conundrum

Two weeks ago I pointed out that the Fed is seemingly unaware of early signs of price inflation (see On being an FOMC member). The Fed is clearly ignoring the coincidental rise in USD LIBOR and the growth in bank lending, and is still prevaricating over interest rates, despite its full employment and price inflation conditions more or less being met.

My earlier article was an economic analysis. The purpose of this article is to point out other factors that impede a return to interest rate and monetary normality, and it concludes that a rise in US interest rates would probably be accompanied by more quantitative easing, perhaps on a discretionary basis.

Secular Stagnation And Bond Markets

Increasingly, economists are describing lack of economic growth as secular stagnation, a term of which we will hear more, implying that the free market is at fault for failing to respond to monetary stimulation. They ignore the fact that the private sector’s entrepreneurial qualities are being crushed by a lethal combination of overregulation and unsound money. They ignore the fact that capital reallocation from malinvestments to productive investment has all but ceased as a result of too-big-to-fail policies. To even consider these explanations would put the macroeconomic clock back to the abandonment of Say’s law, and no central planner is going to do that.

Instead, having latched onto secular stagnation as a condition to be addressed, there is a powerful argument being pushed by the doves that tightening monetary policy will be counterproductive, and the concept of interest normality needs to be readjusted downwards. Alternatively, the hawks are worried that zero and negative interest rates are not normal, and with employment and inflation targets broadly satisfied, rates should be raised sooner rather than later.

Which side wins the argument remains to be seen, but the most obvious problem facing the FOMC, if it raises interest rates, is the danger of triggering a bond bear market, not just in the US, but globally. We are told by the people who add these things up that there are now about $13 trillion of bonds on negative yields. Globally, bond markets are without doubt more overvalued than they have ever been, and while the Fed’s policies have contributed to the bond bubble, the main culprits are the Bank of Japan, the ECB, and they are now joined by the Bank of England. Three out of four top central banks are aggressively attempting to inflate their monetary conditions through unprecedented interest rate suppressions and quantitative easing.

These central banks have absorbed huge amounts of government bonds through market purchases, and continue to do so. The effect is to overvalue the government bonds being purchased, and that overvaluation spills over into others, as investing institutions hunt elsewhere for yield. This overvaluation is at its most extreme in both the Eurozone and Japan where negative yields stretch out to ten year maturities. And given the dollar is the world’s reserve currency, it is bizarre that US Treasuries now yield more than riskier paper in other currencies. 

In the distant past when sounder monetary regimes prevailed, and paper money held its value because it was convertible at the holder’s option into gold, history tells us that a real rate of return between two and three per cent was the norm for ten to fifteen-year maturity government bonds. A return to that normality, which with two per cent inflation equates to redemption yields of over four per cent, would imply at least a halving in the prices of medium-dated government bond prices.

That would be a catastrophe for all bond holders, but the banks which hold government bonds with two to five year maturities would also generate losses that will wipe out some of them, particularly certain systemically important banks in Europe. And as all market traders know, when you move from extreme overvaluation, you tend to move towards significant undervaluation, so there is no guarantee a bear market stops at normality.

It is in truth very difficult to climb down from an officially created bond market bubble in an orderly fashion, because the markets take back price control from the central banks. The discord in the FOMC probably reflects this background concern as part of the mix. But so long as the Bank of Japan, the ECB, and now the Bank of England continue with negative interest rate policies and quantitative easing, there’s not a lot the Fed can do. A return to normality, whatever that is, would risk a currency crisis and collapsing bond prices in Europe and possibly Japan. And one wonders what background briefings on other economic and monetary matters are worrying the FOMC members.

Brexit Worries

The committee’s members will surely recognise the obvious risks to the US economy from the economic condition of systemically important foreign states. And here, as well as secular stagnation, the phantom of Brexit haunts the European stage and is a major cause for debate.

There is no doubt, that to central planners the world over, Britain’s surprise referendum result is regarded as a very big spanner in the works. The Bank of England obviously thinks so, having lowered interest rates and announced a new round of QE in its wake. The forecasts upon which this easing is based were made before Brexit, and are demonstrably wrong to the impartial observer. It reflects little more than a severe case of groupthink at the top end of the central banking profession. I can reassure readers around the world that the British economy has not suffered at all from Brexit, and besides uncertainty over timing, it’s becoming clear that Britain will enjoy significant trade and investment benefits from being able to agree her own trade deals. The evidence, all other things being equal, is that the case for monetary tightening is building by the day, just as it is in America.

However, we must follow the groupthink trail to see where that takes us, and for the European political class it leads to a dawning realisation that Britain might be no worse off for leaving the EU, and indeed, might even benefit. That being the case, there are likely to be other states that will want to follow the British precedent. Ireland could be a case in point, because the UK is her largest trading partner by far, and this week’s subversion of her tax sovereignty by the European Commission in the Apple affair could turn out to be a step too far. The Czech Republic may also follow.

Already, there are rumblings of discontent all round Europe with the centralised bureaucracy in Brussels. The urgent need to rally round and reaffirm the European vision led to a meeting recently between Angela Merkel, Francois Hollande and Matteo Renzi on board an Italian aircraft carrier.

The fact that these three powerbrokers are trying to cook up a political solution, reportedly based on an acceleration of European integration and the establishment of its own army, is unlikely to persuade the national electorates of the individual EU member nations. If anything, the spin from this meeting and the ones that will inevitably follow could well backfire, as ordinary people see their leaders struggling to convince. And as the political situation in Europe deteriorates over the coming months, in the group-thinking establishment’s minds, so will the EU’s economic outlook and the future for the euro.

This matter is certain to be a hot topic at the regular Bank for International Settlements meetings between senior central bankers, and is bound to be discussed by them at the upcoming G-20 meeting in Hangzhou on 4-5 September.  With the Brexit issue on the table, attendees from the Fed will have to argue convincingly to an audience of their confrères that there is a strong case for a rise in dollar interest rates. There is no doubt the two most antipathetic central banking teams will be the Europeans and the Japanese. Furthermore, China has signalled her displeasure in the past at the Fed’s attempts to raise rates, presumably reflecting her desire for currency stability so she can manage her peg.

The Desire For Fiscal Stimulation

Notwithstanding these issues, the counter-arguments against the Fed raising rates are essentially weak. Central bankers have taken it upon themselves to rescue their economies from the threat of deflation by monetary means. Their policies have simply failed, so it could be argued that a planned return to normality should be a priority before further damage is done. That can obviously be ruled out in this group-thinking climate, and instead central bankers, seeing secular stagnation everywhere, all want their governments to turn to fiscal stimulation. But how do you do this where it is most needed, in the economies that threaten to undermine the whole system?

An obvious weak link is Italy, where government debt to GDP is already at 132%, or 275% of private sector GDP. In France it is 96% and 253% respectively. Instead of starting from the conventional Keynesian base case of going into a recession with a low level of government debt, key major economies are already maxed out. And that’s only what is on-balance sheet. The overall position of the welfare states’ finances is simply appalling.

All advanced welfare nations have enormous off-balance sheet liabilities in the form of the net present value of future welfare commitments. These are now being realised and are escalating rapidly. They are undermining the ability of these governments to fund anything else. On top of this, the problem is potentially being made worse by the failure of private sector pensions to keep up with their liabilities, requiring welfare states to act as the welfare-providers of last resort in these cases as well.

Central bankers must surely be aware of this problem, but that does not stop them wishing for fiscal stimulation as a solution. For the Americans, fiscal stimulation cannot be implemented anyway before a new president is installed in the White House next January.

There can be little doubt that the Fed’s team returning from Hangzhou will be put in a thoroughly bearish mood, having been made fully aware of the global consequences of the Fed raising interest rates while the rest of the world is easing. Some of their domestically-orientated FOMC colleagues are far from convinced as well, given there is every indication that the US economy will undershoot the Fed’s own economic growth projections in this election year.

If there is a compromise between the committee’s doves and hawks, the Fed Funds Rate could be increased to a target of ½ to ¾%, softened by a new round of discretionary QE. It has the merit of buying some more time, but looks like the very last kick of that can down the road.

The addition of a new round of QE is not yet a topic for the commentariat, but do not be surprised if it happens. If it does, it should be exercised at the Fed’s discretion, rather than on a formulaic quantity-per-month basis. It makes a compromise between the doves and hawks possible, and it would bring the Fed’s monetary policy more in line with the other major central banks, albeit with a slightly higher interest rate by about 1%.

A compromise solution of this sort has, for the FOMC at least, the merit of being unlikely to derail the US economy, and should avoid monetary policy becoming a political issue during the presidential election campaign. The signal to the markets would be less damaging than outright tightening, and could be spun as a wise move to commentators. The Fed needs to impress its epigones to recover its credibility, and they need the excuse to write reams on how imaginative the Fed is under Ms Yellen.

The addition of discretionary QE also has the merit of giving the Fed ammunition to manage the US bond market if needed and to give the incoming president some spending flexibility. It would also lessen the likelihood of subsequent counterproductive dollar strength. It would be a neat political resolution for the short-term, but from an economic perspective, it would actually resolve nothing by deferring the real interest rate decision, as experience elsewhere has demonstrated.

Alasdair Macleod

HEAD OF RESEARCH• GOLDMONEY

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