Federal Reserve Report: No Need for QE3

I keep reading that some people want to have the Federal Reserve begin a new round of quantitative easing…QE3.

I see nothing in the financial figures that calls for more quantitative easing.

For one, there seems to be no pressure on interest rates.  Looking over the last 13-week period the yield on the 10-year US Treasury (constant maturity) has remained relatively constant.  The weekly average for the week of November 4, 2011 was 2.07 percent: for the week of January 27, 2012 the weekly average was 2.01.  And, the market yield on 10-year Treasuries has been below 2.00 percent all of this week.

The European sovereign debt situation has certainly contributed to this weakness in yields.  Hence, there does not seem to be any demand pressure on interest rates at this time.

Economic growth continues to be modest and consequently is not adding any demand pressure on rates.

The commercial banking system is quiet and even though bank closures average around 2 per week adjustments are being made smoothly and with little or no disruption to the industry. 

Excess reserves in the banking system have fluctuated around $1.5 trillion over the past three months indicating little or no pressure on the financial system on the loan demand front.  This, too, is consistent with the modest economic growth.

Overt Federal Reserve actions have been absent over the past 13-week period indicating that the Fed is allowing operating factors to work themselves out without undue disturbance to the monetary system. 

The big change on the Fed’s balance sheet has to do with the European debt crisis.  Central bank liquidity swaps have risen by a little more than $100 billion since November 2, 2011 as the Fed moved to assist central banks in Europe.  It appears as if part of this increase went to take pressure off the market for Reverse Repurchase agreements with foreign official and international accounts.  The account recording this activity fell by about $41.0 billion over the same time period.

This has resulted in a net increase of about $53 billion in Reserve Balances at Federal Reserve banks but this has had little or no immediate impact on the United States banking system.

Actually, Reserve Balances at Federal Reserve banks declined by $7.0 billion over the past four-week period.  The increase in central bank liquidity swaps was just about totally matched by the decline in reverse repos with foreign official and international accounts as other factors removed reserves.

In terms of Federal Reserve open market operations, the securities account at the Fed actually declined in both the latest 4-week and 13-week periods.  Securities bought outright dropped by a little more than $11.0 billion since November 2 and by a little more than $5.0 billion since January 4. 

Over the past 13 weeks, about $20.0 billion in federal agency issues and mortgage-backed securities ran off in the portfolio.  The Fed only replaced this runoff by a little more than $8.0 billion.  In the latest 4-week period, the runoff in securities was across the board.

The conclusion I draw from the latest Federal Reserve statistics is that the Fed has had a relatively peaceful 13 weeks.  Money continues to flow into the United States Treasury markets seeking a “safe haven” from what is going on in Europe.  This, along with the mediocre economic growth in the country, has taken pressure off the Fed to buy more securities in order to keep interest rates low.  The fact that the securities portfolio at the Fed has declined over the past 13 weeks indicates that the Federal Reserve is letting market forces keep interest rates low and, for a change, is staying out of the market. 

If these conditions continue, I see no justification for any talk about another round of quantitative easing.

The money stock numbers are continuing to maintain excessive growth rates.  The year-over-year rate of growth of the M1 measure of the money stock for the week ending January 24, 2012 is 18.7 percent; the M2 measure of the money stock is growing at 9.7 percent.

Over the past three years I have been arguing that the reason that these money stock growth rates are so high, given the fact that commercial banks did not seem to be lending and that the reserves being pumped into the system by the Fed were going into excess reserves, is that the dire economic conditions have caused individuals and businesses to move their funds from interest bearing assets to transaction assets like currency and demand deposits.  The very low interest rates on the interest bearing assets also contributed to this movement.

Now, however, it seems as this re-arrangement of liquid asset holdings has slowed down.  This is something I think we want to keep our eyes on, for it could be that households and businesses have done all they can do to “be liquid” in bad times.  Thus, we will either see a slow-down in money growth measures (the rates have dropped since the first of November from a 20.0 percent year-over-year rate of growth for M1 and a 10.0 percent rate for M2) or we will see spending starting to increase as these transactions accounts are being used to actually buy things.  It will be interesting to see what happens here.

If people and businesses do speed up their expenditures, this fact would be another reason why another round of quantitative easing would not be necessary.  The Fed would have done enough.   

Long-Term Treasury Yields and Inflationary Expectations

The yield on the 10-year Treasury bond closed at 3.48 percent yesterday. Just a little over five months ago the yield on the 10-year Treasury bond was at 2.48 percent, a full 100 basis points lower than the current yield. What’s happening and where are we going?


Two extraordinary factors are impacting Treasury yields at the present time and have been there for quite some time now. The first of these is the effect that the quantitative easing of the Federal Reserve is having on market rates. The second is the “flight to quality” that has kept the yields on Treasury securities below what they otherwise might be. How do I account for these two factors?

Well, first I start out with a “rough” estimate of the real rate of interest. The base figure that I have used for years has been 3.0 percent.

(I just found out this morning that this is similar to what my former colleague Jeremy Siegel,
Professor of Finance at the Wharton School, UPENN, uses: http://www.ft.com/cms/s/0/00d6f8d0-2ec7-11e0-9877-00144feabdc0.html#axzz1Chh2pOYC.)

This figure, the 3 percent estimate is a “before-the-fact” estimate and therefore is a long term expectation. An “after-the-fact” estimate is often made by taking the nominal rate of interest, say the roughly 3.5 percent mentioned above and then subtracting actual inflation from this figure. This is “after-the-fact” because the numbers used to calculate the real rate have already occurred.

The 3 percent estimate is important because it can be compared to another, so-called, real rate of interest, the yield on inflation-protected securities, called TIPS. Yesterday, the yield on 10-year inflation-protected securities was 1.04 percent at the closing, substantially below the 3 percent estimate.

Siegel, I believe rightly, calls our attention to this discrepancy because he believes that the current yield on inflation-protected securities must rise toward the higher number and this will mean that the holders of these securities may suffer substantial capital losses on the securities because the price of the securities must decline to allow the yield to rise.



Investors are not fully aware that this decline might happen in this area of the bond market.

The difference between the current market yield on these securities and the “before-the-fact” estimate of the real rate of interest represents the impact that the Fed’s quantitative easing along with investor’s “flight-to-quality” is having on the current market yields. If this is true then the nominal bond yields in the market are roughly 200 basis points below where they would be without the Fed’s actions as well as including the international flight to safe United States Treasury issues.



If this is the case then we could argue that the yield on the 10-year Treasury security should be around 5.50 percent rather than 3.50 percent.

If this is the case then the longer-term “inflationary expectations” that investors have built into market yields would be around 2.5 percent.



The question then becomes, is this estimate of inflationary expectations “in the ball park”?
I like to look at the year-over-year rate of change of the GDP price deflator as my estimate of the rate of inflation because I have less concern that this figure is being “messed” with than the more popular Consumer Price Index. Looking at this measure of actual inflation we see that inflation does seem to be picking up.



In this chart we see that the rate of inflation is picking up and is now just below 1.5 percent. We can note that once inflation starts to pick up, it does not reverse itself in the near term. Furthermore, looking at the performance of inflation over the past ten years, an inflation rate of 2.5 percent is not unreasonable for a moderately growing United States economy. And, remember, this 2.5 percent can be interpreted as the compound rate of inflation over the next 10 years, a period far beyond the inflation that might be experienced over the next year or so.

Added to this is the fact that inflation is picking up, not only in the developed countries in the world, but also in the emerging countries. Inflation in the Eurozone is running a little above 2.0 percent, in the UK, a little under 4.0 percent, and in China and India, the rate of inflation is now in excess of 5.0 percent. Thus the trend in the world is for increasing rates of inflation.



My rough estimate that the yield on the 10-year Treasury bond should be around 5.50 percent in 2011 is slightly above the forecast I presented earlier. (See “Long-Term Treasury Yields in 2011: http://seekingalpha.com/article/243018-long-term-treasury-yields-in-2011.) The reason for this change, I believe, is that investors, world wide, are believeing that inflation is becoming a bigger problem than earlier expected. The European Central Bank has ceased its special purchase program of securities because of the rising concern over price increses. The Bank of England has experience similar concerns. The only central bank that does not seem concerned yet is the Federal Reserve.



And, of course, my forecast assumes that the Federal Reserve will, at some point this year, back off from quantitative easing.



But, why should we expect the Federal Reserve to back off from QE2 any time soon? Chairman Bernanke has been late on every shift in monetary policy since he has been a member of the Board of Governors. Why should we expect anything different this time?

The 10-year Treasury Bond Yield

On December 21, 2010, I made the following brash prediction:” my view of long term Treasury yields for 2011 is up, with the 10-year Treasury security reaching 4.5-5.0% in the upcoming year, a rise from around 3.3% to 3.5% now“ (http://seekingalpha.com/article/243018-long-term-treasury-yields-in-2011).

I still believe that this is where the yield on the 10-year Treasury security should be. The reason that it is not at this level for two reasons: first, because United States Treasury issues are still attracting a lot of money that is staying away from risk elsewhere in the world; and second, the Federal Reserve System is supplying lots and lots of liquidity to the financial markets (through QE2) in order to keep banks, state and local governments, and the housing market afloat (http://seekingalpha.com/article/246081-the-world-debt-crisis-lingers).

As can be seen from the chart, the yield on 10-year Treasury securities dropped off at the start of the recession which began in December 2007, but then nose-dived as the investor “flight-to-quality” accelerated in 2008. After some stability was re-established in 2009 the yield rebounded into the 3.5% to 4.0% range until 2010 when the sovereign debt crisis took place in Europe.

Note that the Federal Reserve maintained the effective Federal Funds rate within the 15 to 20 basis point range from December 2008 until the present. Excess reserves in the banking system that were less than $2 billion in August 2008, rose to just under $800 billion in December 2008 and averaged around $1,000 billion from October 2009 to the present. Thus, banking and financial markets were sufficiently liquid during this time period.

Right now, the yield on the 10-year Treasury securitiy seems to be dominated by what is going on in Europe. (See the next chart.) We see that this yield was moving in the 3.6% to 4.0% range at the start of 2010. However, as the sovereign debt crisis picked up momentum in the early part of the year, money flowed from European financial markets to United States financial markets.

As the European Union and the European Central Bank seemed to be working out a “bail out” plan for the eurozone nations and banks, confidence seemed to pick up in Euorpe and money once again flowed out of the United States and back into European financial markets.

Perhaps a leading indicator of this money flow could be the value of the United States dollar relative to the Euro. Although the yield on the 10-year Treasury did not begin to decline until April 2010, the United States dollar got stronger relative to the Euro beginning in January 2010. As the European bailout became a reality in the summer, the Euro began to gain strength in June 2010. The yield on the 10-year Treasury started to pick up again in August 2010 but its rise did not really accelerate until October 2010.

Note that as the concern over the sovereign debt problems in Europe rose again toward the end of 2010, the value of the Euro started to weaken again relative to the United States dollar. The rise in the yield on the 10-year Treasury security stalled.

This week, Greece issued bonds on Monday and these securities were relatively well received. Likewise, Portugal had a good reception for its issue of bonds brought to market yesterday. Spain comes to market tomorrow. Along with these successes, the value of the Euro relative to the US dollar rose slightly.

In addition to this, the yield on the 10-year Treasury issue rose Tuesday and was up again this morning.

It appears as if the near-term movement in the yield on the 10-year Treasury issue will depend more on how international investors move their money between European financial markets and the financial market in the United States.

The impact of the Federal Reserve on this? To me, the Fed is primarily interested in the liquidity available to the financial markets and the solvency of the American banking system. It is not going to change its policy stance at the current time. But, its effect on the 10-year yield will be minimal at this time.

Thus, the 10-year Treasury yield is going to bounce around as it has for the last year based upon how successful Europe is in overcoming its debt problems. I still believe that the Treasury yield would rise to the 4.5% to 5.0% this year if the European situation were not having such an impact.

Long-term Treasury Yields in 2011

Yesterday, I attempted to lay out how I thought 2011 would play out in terms of the value of the United States dollar. In “The U. S. Dollar in 2001” (http://seekingalpha.com/article/242766-the-u-s-dollar-in-2011) I argued that the general outlook for United States monetary and fiscal policy was more of the same policy stance that the United States government had taken for the last 50 years: credit inflation. (For more on this see the Financial Times/ Goldman Sachs business book of the year, “Fault Lines” by Raghu Rajan: http://seekingalpha.com/article/224630-book-review-fault-lines-how-hidden-fractures-still-threaten-the-world-economy-by-raghuram-g-rajan.)

The year 2011 will follow the pattern of large fiscal deficits and monetary ease and this will carry into the foreseeable future. As a consequence, the long term direction of the value of the United States dollar will be downward. I focus on this initially because this sets the stage for how financial market participants view the actions of the United States.

This downward movement, however, will be interrupted in the short run by the continued problems relating to the sovereign debt of various countries within the European Union. The United States, in 2011, will still be seen as a refuge from risk which will result in the dollar being supported by a “risk averse” investment community through much of 2011.

The turmoil in Europe is taking the pressure off of the policy makers in Washington, since they will be free of any criticism that might come their way because of a declining value of the dollar. As a consequence, the Obama administration will not need strong leadership to execute an “unpopular” monetary or fiscal policy: this was the case in the late 1970s and early 1980s as Paul Volcker, leading the Federal Reserve, put the brakes on the economy and the value of the dollar rose significantly; and Robert Rubin, leading the Treasury Department in the 1990s, helped to bring the federal budget from a deficit to a surplus, which produced another significant rise in the value of the dollar.

So, my basic expectation for the economy for the next year (and for the near future) is similar to that being called “the new normal”. The new normal incorporates sluggish economic growth, high unemployment, and weak inflation. (See “Champions of the ‘new normal’ stick to their guns,” http://www.ft.com/cms/s/0/b9c8a49e-0c5b-11e0-8408-00144feabdc0.html#axzz18l9xj6XV.)

The sluggish economic growth of the United States will remain around 3.0 percent to 3.5 percent, year-over-year, something way below what ordinarily has occurred in economic recoveries in the past. This modest growth rate under-scores the structural problems exhibited in the economy, the unusually low level of capacity utilization on the part of industry, the fact that the under-employment rate will remain in the 20 percent to 25 percent range as employers remain reluctant to bring back workers on a full time basis, and the fact that the year-over-year rate of growth of industrial production has been dropping off every month since June 2010.

I do see three ominous clouds on the horizon present in the financial sector. First, the solvency problems in the smaller commercial banks will continue to linger. As readers of this column know, I believe that the Quantitative Easing on the part of the Federal Reserve is more to keep the banking system afloat as the FDIC closes a sizeable number of banks over the next year or so. This will keep a lid on bank lending.

Second, there are the financial problems being experienced by state and local governments and these problems spill over into the financial markets for the bonds of these entities. The implications of this situation for the reduction in budges are huge.

Finally, large corporations have accumulated a huge chest of cash (both in the United States and Europe). It is my belief that this accumulation of cash is for “buying” purposes and we will see a sizeable pickup in mergers and acquisitions as the economic recovery continues. But, this restructuring of the economy will not create more jobs and increase production. In fact, it will do just the opposite. Large banks will also participate in this expansion of mergers and acquisitions. And, the big will get bigger.

Overall inflation will remain moderate. The year-over-year rate of increase in the implicit price deflator of gross domestic product remains around 1.0 percent and this probably will not go much above 1.5 percent this year, if it goes that high. Thus, general inflation does not seem to be a near-term problem.

However, given the current stance of monetary policy we see the possibilities of bubbles forming all over the place. (See “The Fed: Bubble, Bubble, Everywhere,” http://seekingalpha.com/article/240732-the-fed-bubble-bubble-everywhere.) As we saw over the past 25 years or so, general inflation was low and policy makers felt under control of things. Yet we saw bubbles here and bubbles there. Now, the actions of the Federal Reserve are being picked up in a rise in commodity prices, rising stock markets of emerging nations, and the buildup of inflationary pressures in export driven countries like China and Germany.

Putting this all together, my view of long term Treasury yields for 2011 is up, with the 10-year Treasury security reaching 4.5% to 5% in the upcoming year, a rise from around 3.3% to 3.5% now. The 30-year Treasury security will rise to the 5.5% to 6.0% range, up from around 4.4% to 4.5% now. The spread between the yields of these two maturities will be about 100 basis points, slightly lower than it is at the present time.

Bernanke will not be able to keep long-term interest rates down!

This just puts long term Treasury yields back at the levels they were for much of the 2000s.

From this, I argue that the long run expectation for inflation built into these securities would be in the 2.0 percent to 3.0 percent range. For myself, I find that this level of inflationary expectations over the next ten to thirty years is low. But, that is another story.

The major uncertainties in this picture? The first uncertainty pertains to the stability of the banking system. I believe, however, that the Federal Reserve will continue to flood the financial market with liquidity in order to allow the failing banks to be worked off in an orderly fashion. If this occurs, the recovery will continue but at a slow pace.

The second uncertainty pertains to state and local finance. My feeling is that the federal government will not allow this situation to get out of hand. Welcome to the bailouts of 2011.

The third uncertainty pertains to the bubbles that have been created or are being created. As we have learned, bubbles can last only so long. The question will remain about how long the bubbles created will last. Given that the Fed will continue to flood the market with liquidity, it is unlikely that the world will be bubble-free.

One thing mentioned above I believe will be an uncertainty only in timing. That is the increase in the amount of mergers and acquisitions taking place. I believe that 2011 will see a continuation in the acquisition splurge that has already started and will continue beyond this coming year. The only uncertainty related to this is the reaction of the federal government to the bigger companies. My guess is that the new Congress won’t challenge this and the Obama administration will not have the will to challenge it.

Is the United States Making the Emerging Nations Stronger?

Why is the rate of inflation so low in the United States when the government has pumped huge amounts of debt into the country and the Federal Reserve has loaded the financial system with large amounts of liquidity?

The same question was asked in the 1990s. Where was the United States inflation?

The answer for the 1990s…and for the present time period…is that the United States has exported inflation to the rest of the world…more specifically…Asia. As the accompanying chart shows, inflation seems to be heading up in Asia…as it is also heading up in many other emerging nations.

As reported in the LEX column of the Financial Times yesterday, global inflation has seemingly bifurcated. In the developed countries the current inflation rate is below 2 percent (Australia and the UK are exceptions). Morgan Stanley expects a 1.5 percent rate of growth for the wealthier countries in 2010. “By contrast, the emerging market inflation rate is about three times higher—expected at 5.4 percent in 2010…” (http://www.ft.com/cms/s/3/0c01f5a4-fb0d-11df-b576-00144feab49a.html#axzz16h9jdCiK)

The post-financial crisis stimulus is now feeding the inflation in the emerging countries. “A significant portion of the river of cheap money flowed into commodity markets. The initial price recovery caused no problems, but the trend now threatens to create a vicious circle.”

There is also the “carry trade” which takes United States dollars throughout the world seeking higher interest rates. This flow is certainly not insignificant.

In these days, it seems like it is very difficult to contain the international flows of capital. Maybe policy makers need to give this a little more weight in their policy discussions.

There is an argument that central banks, in some Asian countries, kept their interest rates “appropriately low” over the past year or so because of “concerns about the strength in their developed-market trading partners” especially the United States. Now, with inflation threatening to get out-of-hand in the emerging nations, these same central banks are faced with the need to raise their domestic interest rates higher and higher. (See “Emerging Wild Card: Inflation”: http://www.ft.com/cms/s/3/0c01f5a4-fb0d-11df-b576-00144feab49a.html#axzz16h9jdCiK.)

The article continues: “One conundrum for investors is how more aggressive tightening would play out in the currency markets. Most investors have been operating on the assumption that with the Fed keeping interest rates at zero for the foreseeable future, any moves by emerging-market countries to raise interest rates would attract even more money from yield-hungry investors.”

This seems to reflect a cumulative problem. By keeping interest rates low in the United States, dollars are flowing out into the rest of the world. This out-flow is threatening to bring about greater amounts of inflation in the emerging nations of the world. In order to combat this rising level of inflation, the central banks in emerging nations are raising interest rates. But, in raising interest rates, more United States dollars flow to these emerging nations.

And the flow of money into dollars from Europe as a “safe haven” has kept the value of the dollar stronger than it otherwise would be in such a situation which just enhances the return to investors from moving into the interest rates in the emerging countries.

So, the Federal Reserve continues to inject large amounts of reserves into the banking system, hoping to get the United States economy going again. But, individuals, families, and small businesses do not seem to want to be borrowing. Only large, healthy companies seem to be borrowing and piling up cash reserves. The money the Fed is printing seems to be going off-shore.

Therefore, instead of stimulating the United States economy, the Federal Reserve seems to be stimulating the emerging countries of the world. The two results of this seem to be that the United States is not getting stronger, but it is helping the rest of the world to get relatively stronger. The rest of the world needs to keep inflation under control, but the emerging nations feel the relative shift in power within the world and are taking more and more advantage of this increased power. See reports on the recent G-20 meeting. (http://seekingalpha.com/article/236430-release-from-the-g20-what-more-needs-to-be-said)
Only strong, self-disciplined countries come out on top. Right now, the United States is anything but self-disciplined and it is finding that its relative strength is slipping away. The unfortunate thing is that in its lack of self-discipline, the United States is feeding the rising relative strength of the emerging nations in the world. This is our fault, not the fault of other nations within the world.

Future Long Term Treasury Rates

The ten year Treasury yield hit 4.00% yesterday, a level not hit since June 6, 2009. Then one has to go back to October 31, 2008 for the next time this yield hit the 4.00% level. The big question is, of course, where is the rate going to go from here?

Many experts claim that the outlook for longer term interest rates depends upon what is going to happen to inflationary expectations in the financial markets. With the Consumer Price Index for All Items hovering around the 2.0%-2.5% range, year-over-year, and the CPI less Food and Energy at the 1.0%-1.5% range, year-over-year, actual inflation is extremely low given the experience of the past 50 years or so.


So, what is the market anticipating in terms of inflationary expectations for the next ten years?


If one uses inflation-indexed government bonds as an estimate for the real rate of interest, then for a ten-year Treasury security the market seems to be estimating that the real rate of interest is now around 1.50%. If so, then with the nominal 10-year Treasury security around 4.00%, one could say that the market expects inflation, over the next ten year period to run about 2.5% or approximately at the upper end of the current range for the CPI for all items.


However, one could argue that the Treasury market has been the beneficiary over the past 15 months or so of two unusual forces, both connected with the financial collapse that began in the fall of 2008 and continue to this day. The first of these forces is the huge amount of funds that have flown to the United States and to Treasury securities connected with the “flight to quality” from the rest-of-the world. This “flight-to-quality” began in late 2008 and continued throughout most of 2009 with lapses here and there.


The second factor is the quantitative easing on the part of the Federal Reserve. This has helped to sustain very low market interest rates, long-term as well as short-term. The quantitative easing has also been accompanied by the Fed’s huge purchase program of mortgage-backed securities and Federal Agency securities that have provided a substantial amount of liquidity to the financial markets.


Both forces have resulted in Treasury yields that are substantially below what I would consider to be normal on a historical basis. And, these forces have impacted the inflation-indexed securities as well as the nominal-yield securities. Expected real rates of interest just do not drop to the level that the inflation-indexed securities have fallen to.


Historically, for the last fifty years, the estimate I have used for the real rate of interest tends to be around 3.0%. I won’t argue with 2.8% or with 3.2% because that is not the crucial issue. Before the 1960s, the real rate of interest seemed to be about 2.5% due to the slow growth period of the 1950s and this helps to account for nominal interest rates being so low throughout most of that period of time. Beginning in the sixties, however, the higher, 3.0% rate, seems to provide a relatively better estimate for the “expected” real rate of interest.


If one assumes that the “expected” real rate of interest for the next ten years is 3.0%, then one could argue that the current “realized” real rate of interest from the inflation-indexed securities resulting from the international “flight-to-quality” and the quantitative easing of the Federal Reserve is 150 basis points below what it otherwise would be.


Carrying this argument further, one could argue that the nominal 10-year Treasury security should be around 4.50% once the influence of the foreign “risk-averse” money and the Federal Reserve easing is accounted for. This would imply that the inflationary expectations built into the Treasury yield by the financial markets was about 1.5%, a figure that is at the high end of the current rate of inflation indicated by the CPI less food and energy costs.


But, you could go further than this. The Fed and Ben Bernanke have stated that the “informal” inflation target of the Federal Reserve is about 2.0%. If it is assumed that the Fed is able to contain inflation at this 2.0% level for the next decade, then one would assume that the 10-year Treasury yield should be around 5.0% to reflect an expectation of inflation of about 2.0%.
If the market believes that in the long run, the costs of food and energy should be accounted for in inflation, then, assuming that the upper bound of the current rate of CPI inflation for All Items, 2.5% is achieved over the next 10-years, then inflationary expectations should be at this level and the nominal 10-year Treasury yield should be around 5.5%


Of course, there is another body of thought that looks at the $1.1 trillion of excess reserves in the United States banking system and contends that there is no way the Fed will be able to remove these excess reserves from the banking system before bank loans expand excessively, money stock growth becomes extremely rapid, and inflation becomes a major problem again. To these investors, the assumption of inflationary expectations of 2.5% is ridiculous. Consequently, even a 5.5% 10-year bond rate seems excessively low.


One can argue that, as in the decade of the 2000s, many foreign countries have helped to finance the United States deficit and, as a consequence, and this has also kept United States interest rates lower than perhaps they would have been otherwise. Some analysts believe that this will continue. One can argue from many different sides of this argument for a specific level of interest rates relative to expected real rates plus inflationary expectations. I don’t really find this “supply of funds” argument convincing.


I believe that long term interest rates are headed up. How far they will go depends upon a lot of things, some of which I have tried to present in this post. If the economy continues to strengthen, I feel that the 10-year yield on Treasury securities should, over the next two years, be closer to the 6.00% level than the 4.5% level. There, I am on the record.

A Critique of Quantitative Easing

Yesterday, I posted a report on the strategy of the Federal Reserve to exit its position of excessive monetary ease. (See http://seekingalpha.com/article/173556-federal-reserve-exit-watch-part-4.) In that report I mentioned that since August, the total reserves in the banking system had shown a substantial increase.

Looking a little further into the data we find that the Monetary Base, defined as all financial assets that serve as bank reserves or could become bank reserves, rose from an average of $1,649 billion in the two weeks ending August 12, 2009 to an average of $2,001 billion in the two weeks ending November 4. (These data are on a nonseasonally adjusted basis, but the seasonally adjusted data are not significantly different.)

The Monetary Base rose by $352 billion during this period of time. (This was both on a
seasonally adjusted bases as well as a nonseasonally adjusted basis.)

What I am interested in reporting on is the total amount of reserves available to the commercial banking system.

Technical Note: To get the figure for total reserves we must subtract the currency component of the money stock from the reported data on the Monetary Base. This amount, according to the Federal Reserve System, is total reserves (of the banking system from the H.3 release) plus required clearing balances and adjustments to compensate for float at Federal Reserve Banks plus an amount representing the difference between current vault cash and the amount of vault cash used to satisfy current reserve requirements. This total reserve amount is different from the total bank reserves reported in the H.3 release on Aggregate Reserves of Depository Institutions and the Monetary Base.

This calculated measure of total reserves in the banking system rose by $351 billion during the time period under review. In other words, currency in circulation outside of commercial banks increased by only $1.0 billion from the August 12 information to the November 4 data.

Excess reserves in the banking system increased in this 13-week period from $709 billion to $1,059 billion, a rise of $350 billion. Thus, all the increase in bank reserves during this time period came in excess reserves, the required reserves held behind the deposits of the banks remained flat!

The truly remarkable thing is that the Monetary Base averaged around $848 billion in the two weeks ending August 13, 2008 while the total reserves in the banking system calculated using the method discussed above amounted to $72 billion.

Thus, in the time between August 12, 2009 and November 4, 2009, the Federal Reserve added $352 billion to the reserves of the banking system, a system that only averaged $72 billion in total reserves in the two weeks ending August 13, 2008. That is, the Federal Reserve added about 5 times as many reserves to the banking system in a 13-week period in 2009 as the complete banking system had in total in August 2008!

However, during the later time period, total bank credit in the banking system dropped by about $150 billion, loans and leases falling around $142 billion.

While bank reserves were increasing rapidly, the effective Federal Funds rate remained relatively constant. It averaged 16 basis points in August 2009, 15 basis points in September and 12 basis points in October. It continued to average around 12 basis points in the first half of November.

The question that needs to be asked is whether or not this scenario was what the Federal Reserve hoped to achieve when it initially went into what it called Quantitative Easing. My understanding of Quantitative easing was that Fed actions were required to combat a Liquidity Trap, a situation in which interest rates could not be pushed lower by adding more reserves to the banking system. Because interest rates could not be pushed lower, aggregate economic demand could not rise. However, it was argued that as the central bank continued to add reserves to the banking system, loans would still be granted to customers and the money stock would increase. Having more funds available, even though the interest rate on the loans could not go lower, was the quantitative effect desired, and as these funds were added to balance sheets spending would increase and the economy would be stimulated.

I don’t sense in the figures presented above the presence of a liquidity trap. The banking system seems to be demanding reserves and, in order to keep interest rates from going up, the Federal Reserve is very abundantly supplying banks reserves. That is, rather than exhibiting a fear that short term interest rates cannot decline any further, the Fed is afraid that short term interest rates (as well as rates on longer term Treasury securities and mortgage rates) might actually rise. This is consistent with the almost obsessive effort the Fed is making to be sure that the market knows the Fed is not going to let interest rates rise and that it is going to keep interest rates at current levels for “an extended period” of time.

This, to my mind, is not Quantitative Easing. It is just a continuation of the strategy the Fed has been following since September 2008: in policy actions, do not err on the side of providing too little stimulus.

This is not a refined, sophisticated monetary policy. Throwing everything you can against the wall to make sure a sufficient amount of what you throw against the wall sticks to the wall is something one does when one is desperate and unsure about what one is doing. You can achieve your goal with this strategy but the problem is that you have a big mess to clean up afterward.

And, if I am correct in this analysis, the Federal Reserve is currently only exacerbating the size of the mess that will have to be cleaned up.

Looking For Signs of a Recovery

Amid everything else going on, we still continue to look for signs of a recovery. This weekend I spent some time looking at the investment side of the economy to see if I could pick up any sign of life on the capital spending front. At the end of the weekend, I gave up looking for encouraging information, either in terms of business investment or investment in real estate.

Let’s look at the supply side first, the companies and businesses that supply physical capital, either in terms of real estate or in terms of business equipment. In order to summarize the information on the supply side of the market there seems to be one favorable factor that would encourage the production of investment goods and two that are not encouraging concerning the production of capital goods or real estate.

The positive factor is short term interest rates. The supply of capital goods in the past has been dependent upon the cost of short term funds and right now, of course, short term interest rates are as low as we can ever expect them. If these rates stay at these levels and other factors encouraging investment production improve, we should start to see the economy recover. The word out of the Federal Reserve is that short term interest rates are going to be kept low for an extended period of time and this weekend we heard that these rates may stay low into the year 2011.

The two negative factors relate to the internal cash flow of firms and the terms on which lenders are willing to lend. In terms of internal cash flow, potential suppliers of investment goods are still in a position in which they are trying to de-leverage and actually reduce the amount of debt they have outstanding relative to their internal sources of funds. Thus, there is not much effort to expand production from the suppliers of goods because they have not yet got their balance sheets back in order as of this time.

Lenders, of course, are not lending. If anything, most lenders are still risk adverse and continuing to tighten up on the maturities and terms of any lending they do. As a consequence, we see very little willingness on the side of lenders to encourage the supply of funds to expand.

Therefore, whereas the Federal Reserve is consciously keeping short term interest very low and intends to keep them low for a long period of time, potential suppliers of capital have not seemingly restructured their balance sheets sufficiently to begin to produce again and lenders seem far from willing to take any chance on who they lend to. We are back in the position where bankers, and others, will not lend to someone unless the potential borrower does not need the money.

In terms of the demand side of the market the factors that tend to support investment expenditures all seem to be in the negative range. Long term corporate interest rates have fallen some over the summer and this is encouraging. Moody’s AAA corporate bond rate was at a yearly high in June averaging 5.61% for the month. This rate moderately bounced downward in July but seemed to be rising into the 5.50s toward the end of the month. Moody’s BAA corporate bond rate has declined significantly from March 2009 when it averaged around 8.40% and has fallen to the 7.10% range toward the close of July.

The decline in corporate rates has been encouraging and indicates that the financial market’s taste for risk has improved at the expense of longer term Treasury issues whose yields have been rising since March. The question here is whether there will be a continued rise in Treasury bond rates over the next 12 months or so. If Treasury interest rates continue to rise, as I believe they will, this will put a floor under corporate rates, one that will tend to rise as longer term rates rise in general. And, with the spread between AAA and BAA securities around 150-160 basis points one cannot see this spread getting much narrower as long term interest rates rise over the next year or so.

Less favorable trends appear to be the lack of growth in cash flows This means that those that want to acquire capital goods or real property still face the need to continue to de-leverage their balance sheets. This concern can be combined with the fear that many economic units have about the possibility that they could face default or foreclosure in the upcoming twelve month period. There are still a lot of financial issues that must be resolved and this attitude does not produce a lot of optimism on the part of businesses or individuals to extend their own resources into risky investments in the near future.

This attitude coupled with the economic forecasts that the recovery will be tepid at best for the next 12 to 18 months does not do much to create optimism about future profit expectations. Profits have increased but the general consensus is that a large portion of these profits have been achieved either through cost cutting or through trading operations. Neither one of these can be expected to contribute to a general increase in profit expectations for the future since cost cutting can only do so much and trading profits are sporadic and cannot be counted on on a regular basis. The prospect for growing profit expectations is not strong presently. Confidence can change rapidly, but it appears that it will remain relatively low for the near term.

There are some firms and some industries that are producing solid profits and can be expected to generate profits going forward. How much they will stimulate the sectors that are not performing well and how much they will contribute to a growing optimism concerning the future performance of the economy is anybody’s guess right now. These companies continue to look for an uptick in their business in the coming months as well. It is possible that these companies could lead the economy out of the recession, but they don’t seem to be in a mood to over extend themselves or to take on too much more than they are doing at the present time. They are happy to be making profits and intend to do so in the future: but, in a controlled and conservative manner.

The needed conditions for coming out of a recession are not really present at the current time. The Federal Reserve has, of course, have kept interest rates quite low and there has been the favorable movement in longer term, non-Treasury yields which have declined in recent months as financial markets have moved back into securities that are riskier than U. S. Treasuries. In respect to the cost of money, everything is in place for the recovery. The problem of achieving a sustained increase in real investment, either in plant or equipment or in real estate, rests upon the potential borrowers and the possible lenders. Neither seems to be in any shape to begin borrowing or lending in the near term and this shows both on balance sheets and in the market place.

We have observed in the past that “animal spirits” can be revived and they can be revived relatively quickly. Question marks are always present relating to the issues of what is going to set off the animal spirits and when are they going to be set off. We can only keep looking at the major factors that are related to the psychology of economic units and attempt to determine when the direction of the economy is going to change.

At present, there are indications that a recovery is possibly starting to mount. For example, the index of leading economic indicators rose recently for the third month in a row. Still, the dark clouds fail to go away. Unemployment is, of course, still a big concern. And, with unemployment benefits increasingly running out while unemployment continues to grow and with the further prospect of additional credit difficulties in the banking system while bank failures continue to rise, care still must be exercised before one extends ones self by taking on more debt and by committing ones self to the purchase of expensive capital goods. I don’t believe that animal spirits will be on the rise anytime soon.

The Fed's Quantitative Easing Goes Forward

Lots of transactions went on in central banking over the past month or so, not only in the United States but in the UK and Europe. Quantitative easing is the game and, at least, the central bankers are getting more and more comfortable with this.

Credit is given to quantitative easing for the drop in the dollar LIBOR rate. The three month LIBOR now ranges between 50 and 60 basis points over the target Federal Funds rate chosen by the Federal Reserve. This is the lowest this spread has been in a long time. For the five years previous to September 2008, the time the financial markets collapsed, this spread averaged between 20 and 30 basis points.

This move reflects the efforts of the Bank of England and the European Central Bank to push short term interest rates lower and to engage in monetary actions that pump more liquidity into the banking systems even though the interest rates do not show a proportional response. The drop is given as evidence that perhaps interbank lending is increasing in these nations and that this is possible evidence of a thaw in credit extension.

In the United States the Federal Reserve was particularly active in April although the total factors supplying bank reserves has increased only modestly in the last four banking weeks, rising just $21.2 billion. All of the action has happened within the balance sheet.

The interesting movement has come in excess reserves in the banking system, a series that is not seasonally adjusted. Excess reserves showed a huge rise, $100.0 billion, in April 2009 from March. I reported earlier that excess reserves in the banking system in April averaged $824.4 billion, almost the entire size of the Federal Reserve’s balance sheet one year earlier.

The combination of these two factors, basically the small increase in Federal Reserve sources funding the monetary base and the huge increase in excess reserves in the banking system, indicates that much of the activity was internal to the Fed’s balance sheet and not a source monetary expansion. Let me highlight the major changes.

Within the banking system itself, excess reserves averaged $771.3 billion in the two weeks ending March 25. This figure jumped to $804.8 billion in the two weeks ending April 8 and then rose to $862.4 billion in the two weeks ending April 22. This was tax time when funds flow into government accounts in the banking system but there were apparently other things going on as well in government accounts. In the two weeks ending May 6, excess reserves dropped back to $777.5 billion, roughly equal to the level they were at in the two weeks ending March 25.

One could argue that the April bulge was just “temporary”. However, a $100.0 billion increase in the excess reserves in the banking system is “eye-catching” when this measure only averaged around $2.0 billion for the eight months of 2008 before September of that year.

What was going on in the Federal Reserve? I can only describe the Fed’s activity as a part of its efforts to provide liquidity to different sectors of the financial markets and this is a part of the plan to provide quantitative easing to the financial system. Specifically, the amount of securities that the Fed holds outright jumped by $166.1 billion between the banking week ending April 15 and the banking week ending May 13. United States Treasury securities increased by $54.8 billion during this time, the largest increase in these holdings since the Term Auction Facility (TAF) was established in December 2007.

TAF was introduced to help allocate reserves into the banking system faster and more directly to the banks that needed the reserves at the time. It was an effort to increase the liquidity in the banking system to facilitate bank portfolio adjustments in the face of the “liquidity crisis” that occurred in December 2007. The Fed continued to use Term Auction Credit over the next 15 months or so to facilitate bank portfolio adjustment.

The “new” liquidity problem, however, seems to be connected with the Treasury bond market. Now, the Fed has entered into a program to supply funds to the Treasury market to help keep long term interest rates down, a goal it has not yet achieved. However, we see this shift in the quantitative easing strategy as the Fed is increasing its holdings of United States Treasury securities while at the same time letting the amount of funds allocated to the banking system through Term Auction Credit decline by $27.0 billion, the first substantial decrease in this total since the program began.

There is another sign of quantitative easing and this is in terms of the amount of Mortgage Backed Securities the Federal Reserve holds. During the four weeks ending May 13, 2009, the Fed’s holdings of these securities increased by $96.9 billion to $384.1 billion. Obviously, the policy makers at the Fed believed that there was serious liquidity problems in this segment of the capital market that needed their attention.

This huge increase brings the holdings of Mortgage Backed Securities up to two-thirds, 67%, of the Fed’s holdings of United States Treasury securities. Who would have ever imagined that this would have happened?

Again, reflecting the shift taking place in where the quantitative easing is being applied, the Commercial Paper funding facility at the Federal Reserve fell by $83.3 billion from the banking week of April 15 to the banking week of May 13. This decline can be interpreted as an indication that some easing is taking place in short term money markets, allowing the Fed to focus more upon the longer term end. The Fed, at its peak, had supplied over $250.0 billion to the financial system through this facility.

Furthermore, there was a drop in Central Bank Liquidity Swaps during this time period of $47.0 billion. Currency markets were apparently stable enough during this time so that these borrowings could be reduced. However, there are still about $250.0 billion in swaps still outstanding to other central banks.

This last month gives us a good picture of how quantitative easing seems to work. There was very little change in the total amount of funds that the Federal Reserve supplied the banking system, but there was substantial Federal Reserve activity within its balance sheet as it readjusted its focus upon which markets it believed needed the greatest amount of assistance with regards to the supply of liquidity. The crucial factor in this exercise seems to be that once the liquidity needs of a market are satisfied by the market itself, then the market participants that used the Fed’s facility pay back the funds that they have used. This allows the Fed to address other segments of the financial markets and, hopefully, satisfy the liquidity needs in these other areas.

Overall, the dream is that all the funds will be paid back to the Fed as the financial system and the economy turn around and begin to function effectively again. Not only will this allow the Fed to cease being the “fireman” that must run from fire-to-fire putting out the latest blaze, but will also get out of the “fire-fighting” business itself and allow its balance sheet to shrink back to an appropriate size. We are not there yet, but it does provide some comfort to see that the Fed can move from one current fire to another without another massive expansion of its balance sheet. However, whether this can really be accomplished remains to be seen.

Long Term Bond Yields and the Fed

The Federal Reserve is trying to hold down long term interest rates. The reason? To stimulate economic activity and encourage credit flow and especially mortgage lending. But, we have a problem. The Financial Times puts out headlines stating that “Rising bond yields present fresh challenge for the Fed.”

Long term bond rates have been rising lately. Yesterday, the 10-year Treasury hit 3.096%, a territory not breached since November 24, 2008. Last time I looked today, this yield was at 3.134%. The same was true for 20-year Treasuries topping 4.00% yesterday and today.

The Fed has been engaged in an effort to purchase longer term United States Treasury issues on a continuous basis as well as Federal Agency issues and mortgage-backed securities. It has made purchases in sizable amounts weekly. Now, the Fed seems to be losing its grip on yields in the long term end of the market.

The rationale given for this slippage? The record amounts of debt the United States government has to sell.

It is true that there are and will continue to be record amounts of debt issued by the United States government coming to the market now and for as far as we can see in the future. The supply issue may have some effect in the short run, but let me provide another possibility for the rise in rates in the longer term end of the yield curve.

The argument about whether or not the central bank can significantly impact yields in the longer term end of the yield curve has been going on for almost the entire length of my professional career. First, people think that the central bank can, and should, conduct open market operations so as to lower long term interest rates in order to spur on the economy. Then, research is produced that indicates that the Fed cannot achieve a significant reduction in long term yields through open market operations. A little later, some others think that it would be a good idea for the central bank to conduct open market operations to reduce long term interest rates. This is followed by another round of research indicating that the central bank cannot achieve this goal. Now, we are back at the point where policy makers believe that the Fed should attempt to keep long term interest rates low.

My reading of history is that the Federal Reserve cannot control, for any length of time, yields on long-term Treasury issues!

My reading of history also causes me to believe that the supply of Treasury securities cannot impact, for any length of time, the yields on long-term Treasury issues!

I am one that believes that long-term Treasury yields are determined by the appropriate expected real rate of interest and the expected rate of inflation. Since the expected real rate of interest does not change over short periods of time, the general movement in longer-terms interest rates will be determined by changes in expected inflation. And, expected inflation is dependent upon what the financial markets believe the Federal Reserve will be doing with respect to the monetization of the federal debt.

This, of course, has been a big fear in the financial markets. With all of the projected government debt coming down the road, many market participants believe that the Federal Reserve will have no choice but to monetize large portions of this debt. As more and more of the debt is monetized the probability that inflation will rise increases. And, this expectation gets built into long term interest rates.

If this is true, then the central bank faces a real dilemma. When the Federal Reserve attempts to keep long term interest rates low, it can cause a rise in inflationary expectations and this will create upward pressure on long term interest rates. If the Fed monetizes more of the debt to keep interest rates at the lower level, inflationary expectations will become even greater, putting even more upward pressure on long term interest rates. And, as long as the central bank continues to keep these long term yields below where the market wants them, the more damaging will be the consequences in the future.

In all my experience, I have not seen the Federal Reserve succeed in keeping long term interest rates below where the market wants them to be. I don’t expect them to succeed in their present efforts.

And, what about inflationary expectations? I believe that we can provide evidence from other markets that confirm this recent sensitivity to the increasing pressure on the monetary authorities to monetize the government debt. I am not concerned with the absolute levels of expected inflation, just the direction in which the spread has moved.

The spread between the 10-year government bond yield and the rate on 10-year inflation indexed government bonds is often used as an indicator of movements in inflationary expectations. The spread remained relatively constant from January 2009 through March. However, in April the spread has increased by 2 ½ times the January figure. This spread now is at a level we have not seen since early October 2008, right after the fall crisis hit. Market participants seem to be increasingly worried about what the Fed is going to have to do.

Furthermore, every time we see this spread increasing we tend to see a decline in the value of the United States dollar against the Euro and against other major currencies. Relative currency valuations are highly dependent upon changes in what central banks are expected to do because their actions can affect relative rates of inflation. If investors believe that the central bank in your country is going to monetize its government’s debt more rapidly than that of another country, the value of your currency will decline relative to that of the other country.

In this respect, the value of the United States dollar has declined over the past two days and tends to drop every time there is a rise in yields on longer term Treasury bonds. This would indicate that some of the same things affecting the yields on long term bonds are also affecting the value of the currency.

A final piece of evidence in support of this idea is that the market also responded to the minutes released yesterday by the Federal Reserve’s Open Market Committee. In those minutes the Fed stated that “the economic outlook has improved modestly since the March meeting…” It also noted that household spending “has shown signs of stabilizing while businesses have cut inventories, investments and staffing” implying that if consumer spending does stabilize or even increase, businesses will have to restock their shelves in order to support this spending which would be positive for economic recovery. Both of these statements foresee a stronger economy in the future, reinforcing the earlier fears of the market.

Long term Treasury yields were low because there was a flight to quality and because inflationary expectations were low. Unless there is another major shock to the system, I believe that the flight to quality is over and is in the process of being reversed. In addition, I believe that the Fed will continue to monetize the debt in increasing amounts for the Fed also emphasized in the minutes released yesterday that they will “stay the course” in the fight against an economic collapse. For both of these reasons, I feel that pressure will continue for long term Treasury yields to rise and for the value of the dollar to fall.

The State of the Bailout

Treasury Secretary Paulson gave a press conference yesterday and indicated that things had changed…that the focus of the bailout effort would not be on the purchase of ‘toxic assets’ but would be aimed to assist the capital needs of financial institutions and consumer finance. This ‘shift’ in focus has been duly noted by the press.

Is the ‘bailout’ program having any success?

To answer this question, I am roughly in the same spot of someone I heard being interviewed on Marketplace on NPR radio: the ‘expert’ was asked the following question “Has the efforts to add liquidity to financial markets and financial institutions shown any results to date?” His reply: “I think things are better than they would have been if the efforts had not been made.”

Does that give you a lot of confidence?

I just don’t think that at this time anyone can say more. We are in the middle of a situation that no one present has ever been through. Fed Chairman Ben Bernanke, an expert on the Great Depression, has seen to it that financial markets and financial institutions have been flooded with liquidity. From the banking week ending September 10, 2008, Reserve Bank Credit has risen from about $890 billion to $2.1 trillion in the banking week ending November 5, 2008. This is roughly a 210% increase in a matter of 8 weeks. (Dare I remind you that it took 94 years for the total of Reserve Bank Credit to reach just $890 billion and only eight weeks to add $1,167 billion more!)

The $700 billion bailout bill…is now turning into a provision of capital for financial institutions…a provision that the Treasury hopes will buy time for institutions to work out their bad asset problems. The unknown question here is whether or not $700 billion is enough or will Congress have to float more funds.

The underlying rationale for the provision of all this liquidity is that either (1) officials are going to be blamed for allowing another MAJOR economic bust to take place or (2) these officials are going to have a problem cleaning up for all the liquidity that they have supplied to the financial markets on such short notice. Success, in the eyes of the officials means that they will have to clean up all the liquidity once the financial markets begin working again. Failure…”is not an option.”

No one knows at this time what is going to happen…

The idea is to keep tossing more and more liquidity into the pot until financial institutions feel that enough is enough! No one has been here before! This is all new!

Your guess is as good as mine…

And then there is the need for fiscal stimulus. The Congress is going to consider a stimulus package which seems to be similar to the first stimulus package they passed earlier this year. It will be aimed at consumers and, although it may not be any more effective than the first package, it can be done quickly, and it will show that the Congress IS doing something AND any little stimulus to the economy will be appreciated.

But, a second stimulus bill is being talked up. This one would be more capital intensive and aim at real projects like projects to rebuild the United States infrastructure. The idea here is that consumers are not going to start spending much until their job security is enhanced and they are sure that they will hold onto their homes. Businesses are going to have to restructure their balance sheets and have some confidence that consumers are going to start spending again before they loosen their purse strings and begin to invest in capital projects again. We seem to be a long way from either of these so the argument goes that the Government needs to engage in some real “Keynesian” pump-priming. The problem with a Government expenditure program like this is that it takes time to prepare and then, once the bill is passed, it takes time for the projects to be implemented. So, help does not come quickly.

And, what about the stock markets? When are they going to come back? Well, we hear all the time that the price an investor is willing to pay for a stock is dependent upon future cash flows. Right now, market expectations concerning future cash flows are pretty depressed and uncertain. Investors must be able to sense a turnaround in future cash flows for them to develop any confidence to begin purchasing stocks. And, investors don’t really know the value of the assets on the books of a large number of companies. To me, a good argument can still be made for more asset charge offs, more bankruptcies, and more depressed forecasts of future cash flows. In my mind, we are not near the bottom here, particularly given the situation described above.

What about uncertainty?

There is lots of it. Much of the uncertainty pertains to the programs that will be coming out of the new administration and the leadership that is put into place by that administration. It is still a long way until January 20, 2009. The current administration has been reluctant to do anything in the past until it became absolutely necessary to do something about the financial markets and the economy. They still want to pass on as much of the decision making as possible to the newly elected administration. So, we are still in a limbo as far as the national leadership is concerned.

What about the international situation and international leadership?

Also an unknown. People are talking about a new Bretton Woods…the international financial structure set up after the second world war. First off, that conference had two years of preparation and negotiation before the meeting was held. There has basically been little or no preparation for the meetings to take place this weekend. Second, the first Bretton Woods conference had seasoned world leadership behind it. That is not the case at the current time. Third, there is almost no intellectual consensus concerning the cause of the current situation and what should be done about it. Fourth, the world is still going through a economic downturn with more countries declaring every week that they are now in a recession.

International coordination and cooperation are going to have to be vital components of the world economic and financial markets in the future but for right now, I don’t think that we can expect much concrete to be forthcoming from the world community.

So, in my view, we will continue to see a downward drift to stock markets with a substantial amount of volatility. What else is new?

For bond markets, United States government securities are going to continue to be the pick for risk-averse investors and spreads will continue to rise between the least risky debt and that considered to be more risky. I saw that the spread between Baa corporate bonds and Aaa corporate bonds exceeded 300 basis points last week. For even lesser credits the spread has been increasing at an almost exponential rate. If there is any indication that the credit crisis is NOT over, it can be picked up from the market place.

The only thing that seems to be positive news at this time is that the Bush plan to get the price of oil below $60 a barrel has been tremendously successful so far!

The Bermuda Triangle?

Is the United States flying into a period of economic turmoil that one can only describe as a Bermuda Triangle? Financial institutions are not out-of-the-woods yet in terms of cleaning up their balance sheets. The economy has surprisingly remained stronger than expected, yet there are layoffs in the airline industry, the car industry, the housing industry, and other industries that are bound to contribute to future weakness. And, there is talk within central banking circles that interest rates may need to be raised in upcoming months.

Furthermore, there seems to be some uncertainty among the pilots flying the monetary ship in the United States. After leading the Federal Reserve through a period of historically massive reductions in the Fed’s target Federal Funds rate, the introduction of major innovations in the way the Fed conducts its monetary policy, and after intervening into areas of the financial sector in ways that are reminiscent of the Great Depression (of which he is a major academic scholar), Chairman Bernanke has stated that maybe the Federal Reserve better look out after the decline in the value of the United States dollar.

But, now several other members of the Federal Reserve leadership have expressed doubts about how the Federal Reserve has acted in recent months. On June 5, Jeffrey Lacker, the president of the Federal Reserve Bank of Richmond has come out and expressed concerns about the Federal Reserve lending to major securities firms. Charles Plosser, the president of the Federal Reserve Bank of Philadelphia has also spoken out defining more clearly the boundaries of what the Federal Reserve System can and should do. Both raised concerns about whether or not the Fed should actually be doing these things.

But, these are not the only voices that have expressed concern. Two other presidents of Federal Reserve banks have expressed similar thoughts. Gary Stern, president of the Federal Reserve bank of Minneapolis, discussed, in April, the expansion of the Fed’s authority, while Thomas Hoenig, president of the Kansas City Federal Reserve bank discussed the threat of moral hazard in the financial system due to the Fed’s actions.

On the other side, Ben Bernanke, vice chairman of the Board of Governors of the Federal Reserve System, Donald Kohn, and Timothy Geithner, president of the Federal Reserve Bank of New York, have defended the recent actions taken by the Fed.

I cannot remember a time when there has been so much discussion, in public, about what the Federal Reserve is doing or has done by the individuals within the Federal Reserve System that have responsibility for making the policy decisions that the Fed executes. The Federal Reserve does no usually “wash its dirty linen” for the whole world to see. Just what is going on here?

One final point: the timing of the departure of Governor Frederic Mishkin to return to his teaching position at this time raises a question mark. This is a very delicate time for the Federal Reserve System because the departure of Mishkin will reduce the number of openings in the ranks of the Governors to four…out of seven. This, of course, is not Mishkin’s fault because the administration has made appointments for the other three positions. It is just that the Democratically controlled confirmation process has held up the confirmation on these other three appointments for over a year. But, Mishkin’s resignation is tremendously awkward at this time. I don’t want to make too big a point out of this, but the timing, given the internal debate within the Fed and with the shortage of Governors on the Board, the timing of the departure is curious.

But, let’s return to the other points mentioned above. First, the condition of the financial system. Foreclosures remain high and will probably continue to rise. Bankruptcies have increased and probably will increase. Charge offs of credit card debt are high and rising. There remains the question about further charge offs at major financial institutions. And, if the economy is going to get softer, delinquencies and other financial dislocations are going to increase. The question still remains…how stable are the financial institutions of the United States, particularly if short term interest rates need to rise?

Second, the state of the economy, although it has been stronger than expected, shows signs of growing weakness. It is kind of like watching this whole thing evolve in slow motion. The bad news piles up, yet the economy seems to be hanging in there. However, the unemployment figures are up and the impacts of the higher oil and gas prices seem to be spreading to more and more major industries. The unexpected strength in the economy has allowed Chairman Bernanke to express concern about the weakness in the value of the United States dollar, but one really wonders about how much can be done in this election year to actually combat its falling value if the economy gets softer and financial institutions remain in a tenuous state.

Finally, there is the reality that the United States is “out-of-step” with the rest of the world in terms of where it is policy wise. On June 5, the European Central Bank and the Bank of England, both left their target interest rates at their current levels, but, especially Jean-Claude Trichet, the president of the European Central Bank, they both stated that there was a strong possibility that these target interest rates would need to be raised in the future. The focus of these central banks on inflation remains firm in spite of weakening economies. These central banks are earning their reputation for trying to keep inflation in their areas under control.

The direct effect of this effort has been to cause renewed weakness in the value of the United States dollar and a rebound in the price of oil. And, this points up the main dilemma facing the United States government and the Federal Reserve. Policy wise, the United States is in a different place than is much of the rest of the world. The “go-it-alone” attitude of the Bush administration which thumbed its nose to the international community in foreign relations as well as in its economic and financial policies has now left it at odds with much of the rest of the world and isolated it in terms of what it needs to do. Whereas the United States seemingly cannot act to protect the value of the dollar because of the fragility of its economic and financial system, other major players in the world now are indicating that they, in all likelihood, will raise interest rates in the future. If others do raise interest rates this can only put the United States in a more difficult position because if the Fed does need to act to further protect the economy or even if it does not move from the targets it now has, the weakness in the value of the dollar will only continue. The actions of others will place the dollar in a relatively worse position than it is now

Once again, we see the problem of a major nation going off on its own path. Now, when the United States is reaping the consequences of its past actions, the only way others can contribute to helping it resolve its difficulties is to weaken their own discipline and act in a way that is not consistent with the long term welfare of their own people. The future direction of the United States economy and the health of its financial system is heavily dependent upon what others might have to do to maintain the health and welfare of their countries. We have already seen the United States president “beg” for relief on the oil front. Will he also need to “beg” for other relief?