Very Interesting Hilsenrath

January 8th, 2015 7:30 am | by John Jansen |

Via Jon Hilsenrath at the WSJ:

Falling long-term interest rates pose a quandary for Federal Reserve officials.

Yields on 10-year Treasury notes have fallen for eight consecutive trading sessions, by a total of 0.31 percentage points to 1.95% Wednesday. The 10-year yield is now around levels that prevailed before the famed “taper tantrum” of the summer of 2013, when it was considering ending its bond-buying program known as quantitative easing.

If falling yields are a reflection of diminishing inflation prospects, as is typically the case, it ought to prompt the Fed to hold off on raising short-term interest rates in the months ahead. If, on the other hand, lower long-term rates are a reflection of investors pouring money into U.S. dollar assets, flows that could spark a U.S. asset price boom, it might prompt the Fed to push rates higher sooner or more aggressively than planned.

The latter interpretation is less conventional, but it is one that New York Fed President William Dudley made at length in a speech in December. He argued the Fed had the wrong reaction to lower long rates in the 2000s, a mistake that might have contributed to the housing boom that ended disastrously.

Here is a key passage:

During the 2004-07 period, the (Fed) tightened monetary policy nearly continuously, raising the federal funds rate from 1 percent to 5.25 percent in 17 steps. However, during this period, 10-year Treasury note yields did not rise much, credit spreads generally narrowed and U.S. equity price indices moved higher. Moreover, the availability of mortgage credit eased, rather than tightened. As a result, financial market conditions did not tighten. As a result, financial conditions remained quite loose, despite the large increase in the federal funds rate. With the benefit of hindsight, it seems that either monetary policy should have been tightened more aggressively or macroprudential measures should have been implemented in order to tighten credit conditions in the overheated housing sector.

Mr. Dudley’s conclusion was that the pace of the Fed’s short-term interest rate moves this time around ought to be dictated in part by whether the rest of the financial system is moving with or against the Fed’s intentions when it decides it ought to start restraining credit creation:

When lift-off occurs, the pace of monetary policy normalization will depend, in part, on how financial market conditions react to the initial and subsequent tightening moves. If the reaction is relatively large—think of the response of financial market conditions during the so-called “taper tantrum” during the spring and summer of 2013—then this would likely prompt a slower and more cautious approach. In contrast, if the reaction were relatively small or even in the wrong direction, with financial market conditions easing—think of the response of long-term bond yields and the equity market as the asset purchase program was gradually phased out over the past year—then this would imply a more aggressive approach.

The challenge for the Fed is that one can make any number of arguments about the cause of falling long-term rates today. Tumbling oil prices and slow growth overseas suggest there is downward pressure on global inflation which ought to give Fed officials pause about raising rates as planned in mid-2015. At the same time, a stronger dollar and rising – albeit volatile – stock prices suggest the U.S. is attracting foreign capital which could charge up U.S. financial conditions and prompt an early or more aggressive Fed move.

The Fed’s next policy meeting is three weeks away. It is clear officials will spend a considerable time debating the correct response to a perplexing lurch down in long-term rates.

-By Jon Hilsenrath

Be Sociable, Share!

Post a Comment