In my final post Friday I mentioned that some of my contacts in the market were opining that the terminal funds rate would be something lower than 4 percent which many had previously considered an expression of monetary neutrality. In this insightful article by Jon Hilsenrath he points out that the Federal Reserve itself in its statement last week projected a funds rate barely above 2 percent by the end of 2016. Hilsenrath cites evidence that the colossal calamity of 2008 and 2009 so weakened and taxed the body economic that its recuperative abilities have been wounded and a lower funds rate for longer is a necessary precondition for a full recovery. It does jive with what I have heard as I converse with market participants. If there be truth to this theory then a 2.75 10 year note and a 3.65 Long Bond aint such a bad deal.
Via Jon Hilsenrath and the WSJ:
Federal Reserve Chairwoman Janet Yellen caused a stir last week when she suggested the central bank might start raising short-term interest rates a little sooner than investors were expecting.
In focusing on that, Wall Street might have glossed over news of greater consequence.
The Fed, in its official policy statement, said it planned to keep short-term rates below what it sees as appropriate for a normal economy even after the unemployment rate and inflation revert to typical levels.
In 2016, for example, the Fed projects the jobless rate will reach 5.4%, economic output will be growing at a rate near 3% and inflation will be just below 2%. That level of unemployment would be lower than the average over the past 50 years.
Yet officials see the Fed’s target short-term interest rate at just over 2% at the end of 2016, well below the 4% they consider appropriate for an economy running on all cylinders.
Why do they want to keep short-term interest rates so low for so long? What risks are they taking in the process?
The official policy statement didn’t explain. Ms. Yellen in her news conference acknowledged that even though officials agreed on the rate outlook, they don’t agree on the reasons for it.
“Members of the committee have different views about why this is likely to be true,” she said. “For many, it’s a matter of headwinds from the crisis that have taken a very long time to dissipate and are likely to continue being operative.”
Households are still recovering from the borrowing binge of the 2000s, which has curbed their access to credit during the recovery. The government’s tax and spending policies have become more restrictive after the big fiscal stimulus of 2009 as it tries to reduce budget deficits. The economy might look like it is getting back to normal, but beneath the surface it isn’t.
As Ms. Yellen put it: “The general assessment is that even after we’ve had an accommodative monetary policy for long enough to get the economy back on track in the sense of meeting our objectives, the stance of policy that will be appropriate to accomplish that will be easier or involve somewhat lower than would be normal short-term interest rates.”
Put another way, the economy can’t bear a level of interest rates that looked normal in the past because it has been so deeply scarred by the financial crisis.
There is a precedent for this view. The Fed kept rates extraordinarily low throughout the 1940s as the economy recovered from the Great Depression. It emerged from that period stronger, though a comparison to the present is muddied by the fact that the U.S. was embroiled in a global war back then.
A lot is riding on the Fed’s current low-rate bet. If it keeps interest rates too low it could spur another financial bubble or inflation.
“Is that a risk? I think it’s a risk,” said James Bullard, president of the Federal Reserve Bank of St. Louis, in an interview Friday. He said he thinks short-term rates will need to be closer to 4% by the end of 2016 to prevent such an outcome.
“Ultimately, I think the committee will do the right thing” and move to that position, said Mr. Bullard, a self-described inflation hawk who opposes policies that might push consumer prices substantially higher. If his view prevails, the Fed’s assurance of lower-than-normal rates would ultimately lack credibility.
Some former Fed officials gently chided the Fed for not giving a clearer explanation for why it sees rates staying so low for so long, even after unemployment falls further.
“The explanation is slowly coming out,” former Fed Vice Chairman Donald Kohn said on a panel discussion at the Brookings Institution think tank Friday. “I’m trying to be positive here.”
Alan Blinder, another former Fed vice chairman, in an interview put it more bluntly: “It is a problem” that the Fed hasn’t clearly explained its position on this complex subject. He thinks the central bank is quietly following a prescription for the economy put forth by Columbia University economist Michael Woodford.
Mr. Woodford has argued that when the economy is so weak that it needs lower short-term interest rates, but rates are already near zero and can’t go lower, the Fed should promise to keep rates low long enough for inflation to overshoot the 2% objective. The anticipation of low rates and more inflation would spur spending and investment, Mr. Woodford has argued.
Ms. Yellen didn’t specifically embrace this idea last week, and New York Fed President William Dudley, who generally supports policies to boost growth because he sees little risk of inflation, rejected it last year in a speech in Mexico City. “This is not a policy that has been adopted by the Federal Reserve,” he said.
“I hope we continue to get more explanation,” said Mr. Kohn.