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,” http://seekingalpha.com/article/240732-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,” http://www.nytimes.com/2010/12/07/education/07education.html?ref=education.) 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!!!

Bubble, Bubble, Everywhere!

The Federal Reserve just doesn’t seem to get it!

Monetary ease can cause bubbles and not just in the United States. Bubble Ben at the Fed still denies that the Federal Reserve had anything to do with the bubbles in asset prices in the early 2000s in housing and the stock market. Bubble Ben, in 2005, placed blame on the Chinese and other countries for the “Global Savings Glut” that helped to finance the budget deficits of the United States government thereby allowing the interest rates in the America and other countries to be excessively low, causing substantial concern about world inflation and international resource misallocation.

Bubble Ben continues to see price moderation as a problem, just as in 2006 and 2007 he saw inflation as a problem far beyond the period when inflation was a problem. When it comes to price movements and asset bubbles, Ben Bernanke is a lagging indicator!

What is happening in the real world, Ben?

We see the headlines, “Investors Pile into Commodities”, (http://professional.wsj.com/article/SB10001424052748703963704576005933072423242.html?mod=ITP_moneyandinvesting_0&mg=reno-wsj.) “Investors are holding their biggest positions on record in the commodities markets as prices surge…Hedge funds, pension funds and mutual funds dramatically ramped up their holdings in everything from oil and natural gas to silver, corn and wheat this year. In many cases, the number of contracts held for individual commodities now far exceeds the amount outstanding in mid-2008, the last time commodity markets were soaring to records and debate raged about whether excessive speculation was driving up prices.”

We read in the Financial Times, “Crude Oil Tipped to Bubble over $100 a Barrel,” (http://www.ft.com/cms/s/0/cfb5cd58-022f-11e0-aa40-00144feabdc0.html#). “For the first time in two years, oil bulls are starting to outnumber bears.” Have you noticed that the price of gas has jumped $0.30 or so over the past month or two. And, the price of gasoline at the pump is going to continue to rise.

And the same picture arises for worldwide commodity prices, “Material Difference,” (http://www.ft.com/cms/s/0/d1e31d98-023d-11e0-aa40-00144feabdc0.html#axzz17WmrNvT3). “World prices for cotton have risen by 73 percent since the start of June.” This is just one item; one can go to other commodities and see substantial increases. This is sure going to help the economic recovery?

“In other words, a generation that has grown up with food and clothing deflation must now get used to paying more for the shirts on their backs and the bread on their table. The options: less breakfast cereal in the carton and hair-raisingly static-inducing nylon shirts, or pummeled profit margins for the global food and clothing industry.” That is, world commodity inflation is causing cost pressures that must surface somewhere. And, this is going to help the recovery?

And, we are seeing China, Brazil, and India, among other countries, raising interest rates and restricting bank lending so as to combat increasing levels of inflation. Governments are very concerned.

Last week, the Federal Reserve released information about the financial and non-financial institutions that it assisted throughout the world during the recent financial crisis.

Commentators responded by referring to the Federal Reserve System as the “world’s central banker.”

The Federal Reserve System has become the “world’s inflator”!

International financial markets have become so interlinked and flows of funds have become so fluid that pumping up the world’s reserve currency can affect almost every corner of that world. If the Federal Reserve creates an environment in which investors can borrow at 25 to 50 basis points and lend elsewhere at much higher rates, money is going to flow from the United States into these other opportunities.

And, bubbles result...worldwide!

What the Federal Reserve fails to understand is that industry and finance in the United States is in need of a massive re-structuring. Efforts to pump funds into the U. S. economy in a short-run attempt to put people back to work is just resulting in the money going “off-shore”. These efforts are not helping people and businesses de-leverage and modernize; it is not helping them re-structure.

And, these efforts are not helping America compete in the 21st century when its educational system is just producing students that are average or just above average in science, math, and reading when compared with other children throughout the world.

Also, the Federal Reserve does not understand the role it has played in exacerbating the increasing gap in incomes between the highest earners and the rest of the income spectrum.

As a consequence, the Federal Reserve is just producing bubbles everywhere and it is hard to see how this is really going to help us.

Bubble Ben, the Bubble Maker

It seems like all Ben Bernanke can do is blow bubbles. He joined the Board of Governors of the Federal Reserve System in September 2002 and served until June 2005. The effective Federal Funds rate was 1.75% at the time of his arrival. By July 2003, this rate was 1.00%. The effective Federal Funds rate remained at 1.00% until July 2004.

Bernanke not only supported this exceedingly low rate during the year it served as the Federal Reserve target, he provided a large portion of the intellectual support for such a policy. Remember Bubble Ben was an historical expert of the Great Depression and former head of the Princeton Economics Department.

The consequence of the Federal Reserve policy? Bubbles in both the stock market and the housing market.

He then went off to become the Chairman of the President’s Council of Economic Advisors, another tough executive position with lots of leadership challenges, where he stayed until January 2006 when he was appointed as the Chairman of the Board of Governors of the Federal Reserve System, the second most powerful executive position in the United States government.
In February 2006, the effective Federal Funds rate was 4.50%. Now, of course, Bernanke’s major concern was inflation, so the effective Federal Funds rate was pushed up to 5.25% until July 2007 after the bubble had already burst. He stayed too long at the dance! The Fed Funds rate dropped below 4.00% in January 2008 and below 3.00% in February 2008.

Once the financial crisis spread Bernanke saw the Fed Funds rate drop below 1.00% in October 2008 and by December 2008 the effective Federal Funds rate dropped below 25 basis points where it has remained ever since.

Now we have another “Spaghetti” experiment called “Quantitative Easing 2, where we have Bernanke saying that the Fed will buy up to $900 billion in United States Treasury securities over the next eight months or so. (See “Bernanke’s Next Round of Spaghetti Tossing”, http://seekingalpha.com/article/233773-bernanke-s-next-round-of-spaghetti-tossing. Also see http://seekingalpha.com/article/234814-the-fed-s-850-billion-bet-negative-long-term-implications.)

Mr. Bernanke, “Bubble Ben”, is erratic and subject to panic. He seems calm and rational and “in control” but his actions imply something else. His volatility in response to what he considers to be a crisis, whether it is a financial collapse or inflationary pressures is not consistent with outstanding leadership qualities. But, why should we expect such leadership qualities from someone who has only been tested in the confines of the economics department at Princeton?

The problem is that what Bubble Ben is doing is impacting the whole world. The American stock market is booming. Commodity markets are booming. The price of gold hit an all-time high. The bond market is soaring…”A bevy of household names rushed to sell cheap debt on Thursday after the Federal Reserve said it would pump at least $600 billion into the financial system…At least $12 billion in high-grade bonds came to market making it one of the busiest days in nearly two months.” (http://professional.wsj.com/article/SB10001424052748703805704575594111859145030.html?mod=ITP_moneyandinvesting_5&mg=reno-wsj) And you can expect a lot more high-grade companies coming to the market to issue more debt in coming days.

And the value of the dollar is tanking. Against major currencies, the value of the dollar is down by about 7% since late August.

The expectation is that massive amounts of dollars will flow out of the United States into, especially, emerging nations. “The US Federal Reserve’s decision to pump an extra $600 billion into the economy has galvanized emerging market central banks into preparing defensive measures…China, Brazil and Germany criticized the Fed’s action on Thursday, and a string of east Asian central banks said they were preparing measures to defend their economies against large capital inflows.” (http://www.ft.com/cms/s/0/981ca8f4-e83e-11df-8995-00144feab49a.html#axzz14PXUVIN6) The expected outflow is already resulting in substantial stock market gains in emerging nations.

This move by the Fed is certainly not going to foster good feelings and co-operation among the leaders of the world as they get ready to “go-to-meeting” in Seoul, South Korea for the assembling of the G-20.

This surge in capital flows is being called “inappropriate and short-sighted” by many countries and the move is seemingly resulting in additional currency tensions and a high risk of capital controls and trade protectionism. This is not just a “textbook” exercise. This is real stuff. As Martin Wolf has said in the Financial Times, America is exporting inflation to the rest of the world.

The rest of the world is not going to stand by and let this happen.

But, this leads into another point. The United States is contributing to its declining influence in the global economy. The United States will not be dropped from its leadership position in the world, but other nations are becoming relatively important and are becoming more and more assertive in standing up to the United States in more and more important issues.

With this action the United States is making the unity of the G-20 impossible. America has taken its stance. It is solely focusing on its navel. Why should other countries bow down to it anymore?

In fact, if this action does anything, it seems that it is drawing these other nations together to possibly counteract the Fed’s actions.

For those nations that want to see the United States weakened, the Federal Reserve is playing right into their hands. In fact, I cannot think of a policy that would be more helpful in reducing the influence of the United States in the world as the one the Federal Reserve has set out on.

We can joke about “Bubble Ben” and how he likes to blow bubbles. Unfortunately, bubbles don’t last. Bubbles pop! And, when they pop many, many people suffer.

Unfortunately, there seem to be lots of bubbles forming and they seem to be spreading throughout the world. What is really going on here?