Across the Curve

· The latest issue of Barron’s calls for the Fed to “stop talking about an ‘exit strategy’ and to start implementing one.” It argues that rising asset prices, a weakening dollar, signs of “incipient inflation,” and insufficient incentives for saving all suggest interest rates should move to a “more normal 2%.”

· We emphatically disagree. Rising asset prices and a (modestly) weaker dollar represent easing in financial conditions—just what the doctor ordered to confront the biggest recession in more than a half-century. As for inflation, we think most signs point towards lower core inflation over the coming year. Incentives for higher saving are the last thing we need in the very short term if the economy is to expand.

· Recent comments by Federal Reserve officials, as well as a statement today by the Federal Reserve Bank of New York, suggest that as a whole, key policymakers still view tightening as a long way off.

The latest issue of Barron’s calls for the Fed to “stop talking about an ‘exit strategy’ and to start implementing one.” (The article is “C’mon, Ben!”, by Andrew Bary, in the October 19 issue.) It argues that the Fed is taking part in a “dangerous financial and fiscal game” and should quickly wind down asset purchases and take the funds rate to a “more normal 2%”. The article cites 1) rising asset prices, 2) a weakening US dollar, 3) rising commodity prices and other signs of “incipient inflation,” and 4) insufficient incentives for saving as warning signs that policy is too easy.

We emphatically disagree with this conclusion, which will come as no surprise to our regular readers. We think these financial market outcomes are more good than bad in the near term, and think the degree of concern expressed in the Barron’s article is unwarranted, or at least very premature. We first address the four areas of concern raised in the article and close with a few thoughts on the optimal level of rates and the Fed’s balance sheet.

1. Rising asset prices. It’s not every day you see a publication focused on the stock market portray rising equity values as a bad thing. But the Barron’s piece warns that low rates are “fueling financial speculation,” even though equities remain more than 25% below their average level in the year before the crisis. In fixed income, the concern is large purchases of Treasury and agency securities, which have “forced the usual institutional buyers of mortgage securities into other markets,” contributing to the broader credit rally. This is of course precisely what Fed policymakers wanted to achieve: rising equities and lower yields signify easier financial conditions, which is just what the doctor ordered in an economy operating far below its potential.

2. A weakening dollar. The concern appears to be that a weakening dollar will alienate foreign creditors, potentially raising interest rates and weakening the economy down the road. But it’s important to keep in mind that on a broad trade-weighted basis, the dollar is still above its average level in 2008 and only marginally below its level in 2007. While we certainly would be concerned by a sharp decline in the dollar, gradual weakening should improve the competitiveness of US exports abroad, help reduce the US trade deficit, and ultimately contribute to a constructive rebalancing of global supply and demand. As with rising asset prices, a weaker currency signifies easier financial conditions and a potentially better growth environment.

3. Rising commodity prices and other signs of “incipient inflation.” The only reason not to celebrate a better growth environment would be if it were accompanied by a resurgence of inflation pressures. Some see rising commodity prices as a sign of higher inflation, although again we would remind that in most cases commodity prices remain well below 2008 highs. The article also claims “Inflation is back,” citing increases in the Consumer Price Index over the last two months. This is very premature, in our view: a look “under the hood” of the inflation data reveals that the most persistent parts of the index are showing the lowest inflation; as an example, residential rents actually have exhibited deflation over the past three months. And massive spare capacity points to further disinflation in the core indexes ahead. (See “Deflating Inflation Fears,” GS Global Economics Paper No. 190, for much more detail on our inflation views.)

4. Insufficient incentives for saving. A final concern relates to the impact of low nominal interest rates on household saving behavior. To us, insufficient incentives for saving seem an odd thing to worry about at a time when household saving just recently touched its highest level in a decade (5.9% in May). In the short term, higher saving would mean weaker spending and a still-weaker economy. This is not a desirable thing if you are hoping for a robust economic recovery.

Suspending our disbelief for a moment, where should interest rates actually be if they need to go higher? The article suggests 2%–but provides no justification or analytical framework for this choice, other than to argue a “quick move up to 2%…might shock global markets.” Indeed it might! We certainly agree with Barron’s that equities and commodity prices would fall and the dollar might rally in this scenario—not a healthy combination for an economy still struggling to emerge from the deepest recession in the last half-century.

Luckily, there is an analytical framework available for thinking about the Federal funds rate—the well-worn “Taylor Rule,” which relates the funds rate to the current rate of inflation as well as the performance of the economy relative to potential (the so-called “output gap,” often proxied by the unemployment rate). As we have chronicled repeatedly, our version of the Taylor rule—relying on estimated parameters rather than the original 50/50 weighting on the output and inflation components—suggests a funds rate of roughly -5% currently. Even with the traditional Taylor formulation and even if recent data overstate economic weakness somewhat, it would be difficult to come up with a positive funds rate, let alone the 2% suggested by Barron’s.  (For more on the Taylor rule calculations and our longer-term Fed views, see “The Outlook for Fed Policy,” GS US Economics Analyst 09/34, August 28.)

The Barron’s article concludes by stating that “If a resilient US economy can’t tolerate 1% or 2% short rates, this country really is in bad shape.” Unfortunately, “bad shape” sounds to us like an apt description of an economy with credit contracting at a record pace, the unemployment rate just shy of a 60-year high, and housing vacancies near an all-time record. We do see some initial signs of improvement, but the economy has a long way to go to emerge from the hole dug over the past two years.

The most recent comments by Fed officials suggest that on the whole, they do not envision a need to tighten anytime soon. (Indeed, the Barron’s article acknowledges this.) We discussed the likely views of various FOMC members in a comment last week (“Through the Cacophony of the FOMC: Not Much Appetite Yet for Tightening,” US Daily, October 15.)

In addition to public comments by Fed officials, this morning’s statement by the Federal Reserve Bank of New York regarding the potential use of reverse repurchase agreements appears designed to quell speculation that implementation of an exit policy is imminent. The statement does nothing more than reiterate that the New York Fed has been (1) engaged in discussing large reverse repos with the dealer community for about a year and (2) continues to explore the possibility of expanding the list of counterparties to such transactions in order to accommodate the anticipated scale of the reverse repos when they are needed. Pointedly, the statement says that “no inference should be drawn about the timing of monetary tightening” from this process.

By way of background on item (2) above, we noted in the September 24 daily comment (“Fed Lays Groundwork to Offset Another Increase in Excess Reserves”) that the Fed might conduct large reverse repurchase agreements in coming weeks to forestall a large increase in excess reserves that would otherwise occur over the succeeding six months. This increase reflects (1) the Treasury’s need to pay down approximately $185bn in special cash management bills issued last year under its Supplemental Financing Program (SFP) to help the Fed neutralize part of the surge in its balance sheet and (2) the increasing likelihood that the unwinding of liquidity and short-term credit facilities would fail to offset the completion of its asset purchase programs, which had just been reaffirmed in the FOMC’s policy statement. By our calculations, these two trends could boost excess reserves by another $500bn over and above the $854bn that had already been created as a result of the Fed’s policy of credit easing up to that point. Although we do not see an immediate need to offset this additional increase in excess reserves at a time when the volume of bank loans are declining, Fed officials may feel that allowing another increase will fuel the same sort of inflation fear that has prompted calls for implementation of a more immediate exit strategy.

As the Fed statement notes, triparty reverse repos have been conducted with the dealer community since 1999 (“triparty” refers to the fact that a clearing bank stands between the Fed and its ultimate counterparties in repo and reverse repo transactions).  However, the scale until now has been much smaller.  Thus far, the maximum amount has been $25bn, held in place for a period of a few weeks at the end of 2008.  Before that, the largest was $5bn.  In the current circumstances, both the scale and the term during which the repos were in place would have to rise substantially — by an order of magnitude (or more) in the case of the amount and for far longer than the customary overnight term of the reverse repos they have conducted in the past.  This has raised operational issues that are beyond the scope of this comment but which Fed officials would ideally be able to test before they feel it necessary to tighten policy.  The problem is that such a “test drive” may not be practical given that it could easily be misinterpreted by market participants as the first step in the exit strategy.