Thursday, December 9, 2010

Long-term Bond Yields and QE2

One of the fundamental things I learned when working in the Federal Reserve System and in running financial institutions was that the Federal Reserve could only temporarily lower long term interest rates.

In attempting to achieve a goal of lowering these rates, the yield on long-term Treasury securities would initially dip below its previous level and then rise to a point where it was above the previous level. The moral of this market behavior was that attempts to keep long term interest rates lower than the market desired only ended up causing the rates to go up as the market adjusted to the efforts of the central bank.

In my professional career I have not observed anything that would lead me to change this viewpoint.

Yet, supposedly, the QE2 efforts of the Federal Reserve are aimed at reducing the yield on long-term Treasury securities so as to encourage a more robust recovery of the economy. The argument given is that there is little or no indication that inflation will pick up because, if anything, the probability that we might enter into a period of deflation is high enough to be of concern.

As recorded in my post yesterday, I believe that on the subject of inflation/deflation, Ben Bernanke is a lagging indicator. He always seems to be behind what is happening. (See “The Fed: Bubble, Bubble Everywhere,”

Let me start from where I am. First, the United States economy IS recovering. However, this recovery is going to be a very slow one because of all the re-structuring that needs to be done within the economy of the United States. We have considerable under-employment with one out of every four individuals of working age being under-employed. We have a capital structure in which a lot of capital is not being used: current capacity utilization is around 75% and the previous peak “high” was only about 81%. We have built too many houses and there seems to have been too much development of commercial properties. There is still too much debt outstanding: more deleveraging needs to take place. And, this doesn’t even come close to touching the needs of our educational system. (See “Top Test Scores from Shangshai Stun Educators,” And, so on.

I just do not believe that monetary stimulus, or, for that matter, further fiscal stimulus is going to achieve much faster economic growth.

The financial system is still fragile and this, I have argued is the real reason for the Fed’s attempt to flood the world with liquidity. Banks, other than the largest 25 banks, are still extremely distressed. State and local governments face huge fiscal problems. And, the federal government is going to post $15-$18 trillion in new debt over the next ten years given the current budgetary posture. Financial markets must be kept calm so that the FDIC and others can work off insolvent banks; where pension accounting in government can be brought into line; and assets values can be written down throughout the economy.

Let me reiterate: the economic recovery is progressing.

And, what about inflation?

According to the implicit price deflator of Gross Domestic Product, inflation was running at about a one percent year-over-year annual rate in the third quarter of this year. I prefer this measure of inflation as opposed to the Consumer Price Index (CPI) because of all the expert “fussing” with this latter measure over the past 15 years. Also, I do not really trust an indicator that has a large component relating to the rental price of owner-occupied housing that is estimated and has been shown to have substantial biases.

As can be seen from this chart, the year-over-year rate of change in prices did not turn negative during the Great Recession and seems to be on a relatively steady upward movement. It is my belief that the inflation shown in the GDP Implicit Price Deflator will continue to rise, but not explosively.
That is, the economy will continue to grow, but only modestly over the near term. And, I believe that the longer-term trend in prices in the United States economy is up. Furthermore, I believe that the longer-term trend in the value of the dollar is down.

In terms of the last forecast I believe that the value of the dollar will continue to decline in world markets over time in spite of the best efforts of Europe to “prop up” the dollar through the absence of leadership and guts that seems to prevail in the halls of the European Union.

Now, back to bond yields. Within the scenario I have described above, I really cannot see how the Federal Reserve, through its QE2 efforts, can keep long-term Treasury yields down. I guess my major question becomes, is this really the goal of the Federal Reserve? Or, are the statements coming out of the Federal Reserve a diversion to keep people from looking too deeply into the continuing problems of the banking system, and of the state and local governments, and asset values? Are the efforts of the Federal Reserve just a holding action while the value of assets, those of banks, those of state and local governments, those of home owners, and those of businesses, are written down?

To me, long-term bond yields should rise over time. I just can’t see how the Fed can keep them down.

What is most disturbing in all of this to me is the fact that the Chairman of the Board of Governors of the Federal Reserve System has become the primary spokesperson of the Obama administration. Tim Gaithner has failed in that role; Christina Romer has failed in that role: and Larry Summers has failed in that role. Now, Ben Bernanke has become the voice of Obama on economic affairs. How sad!!!

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