Monday, December 7, 2009

The Fuel: Monetary Policy (Part 2)

Between January 2001 and May of 2003, the Federal Reserve Open Market Committee cut the Federal Funds Rate from 6.5% to 1%, and then left the rate at 1% for a year. Such a low level meant that the FFR had become negative in real (inflation-adjusted terms)---the logical investment thesis outcome was to borrow now and pay the loan back with cheaper dollars later (akin to a giant short position on the dollar). These decisions were justified at the time because the US economy had been subjected to the implosion of the dot.com bubble, a series of very serious accounting scandals, and the 9/11 attacks. Perhaps we would have faced greater economic calamities if the Fed had not been so aggressive---some counterfactual speculations have argued that things in fact could have been far worse if the 1% policy had not been executed. However, we do know that the negative real FFR was highly correlated with the housing bubble and subsequent debt-deflation crisis, and I would submit that in this case the correlation is indicative of causality.

In the early 1990s, the economist John Taylor of Stanford University proposed what has become known as the the Taylor Rule. Taylor had studied central bank rate-setting methodologies in a number of countries and used regression analysis to determine a formulaic approach to interest rate targeting (the approach that historically would have yielded the most consistent, effective monetary policy). The result of this study, the Taylor Rule, allows a central banker to plug two critical monetary policy variables---inflation and GDP growth---into a simple model and then generate a target rate based on the rule's coefficients. The specific recommendation is this: the Taylor Rule interest rate=1.5 times the inflation rate plus .5 times the GDP gap (the distance between recent GDP and the normal trend level---moving average---of GDP) plus 1.

In Taylor's own words, "The rule was originally meant to be a recommendation of what the Fed should do to keep inflation low and recessions mild and infrequent; in other words, it was meant to be normative rather than positive. It was derived from monetary theory or more precisely, from monetary models that describe how the interest rate affects the economy...over time, however, people began to observe that the policy rule was often accurate at predicting future interest rates...the rule was not designed for forecasting; it was meant to be normative, not positive, yet it turned out to be both."

With the interest rate cuts that began in 2001, the Federal Reserve departed from the Taylor Rule and entered into a regime that it had not been practicing in the contemporary era. The departures were not trivial; Taylor insists that "no greater or more persistent deviation of actual Fed policy from the rule had been seen since the turbulent days of the 1970s". The interest rate would not converge with the Taylor Rule's prescriptions again until 2006.

In terms of OECD members, the countries that had the largest deviations from the Taylor Rule (such as Spain and Ireland) also had the largest housing bubbles, and those with the smallest deviations (Austria) had the smallest changes in housing investment as a percentage of GDP.

Much has been written about Greenspan's role in the creation of the bubbles and his intellectual incoherence in being a Keynesian when it came to downside risks and an efficent markets enthusiast when the equity markets were performing well. For our purposes, it is sufficient to describe the effects that a negative real interest rate have in terms of the signals that are provided to the markets.

In a previous post I mentioned how the interest rate targeted by the Fed is used by the economy as a price signal (for the time-value of money), and how this signal is a critical part of the market's effort to coordinate production across time periods. In a free market, a lower interest rate would indicate greater savings and would signal to businesses that they should undertake longer-term projects. A higher interest rate would indicate lower savings and the incentives to undertake longer-term projects would be reduced.

As Thomas Woods of the Ludwig von Mises Institute puts it: "The interest rate can perform this coordinating function only if it is allowed to move up and down freely in response to changes in supply and demand...on the free market, interest rates go down because the public is saving more. But when the Fed lowers rates artificially, they no longer reflect the true state of consumer demand and economic conditions in general...long-term investments that will bear fruit only in the distant future are encouraged at a time when the public has shown no letup in its desire to consume in the present. Consumers have not chosen to save and release resources for use in the higher stages of production. To the contrary, the lower interest rates encourage them to save less and thus consume more, at a time when investors are also looking to invest more resources. The economy is being stretched in two directions at once, and resources are therefore misallocated into lines that cannot be sustained over the long term."

In the case of the housing bubble, the Fed's interest rate excursions from the Taylor Rule meant that the initial "teaser rates" of adjustable-rate mortgages (ARMs) could also be set very low, with predictable consequences in terms of increasing housing demand. Another side effect of a very low FFR is that a "carry trade" mentality quickly forms, with a variety of market operators acting as virtual "3-6-3" bankers by borrowing short-term at the FFR and then buying longer-dated bonds, using the higher coupons received from the long bonds to pay for financing at the FFR rate and pocketing the difference as profit. Hedging techniques can be employed to try to lock in the spreads, but this is always a safer bet if the Fed has used language that clearly states an intention to keep the FFR low for an extended period of time (as was the case in 2003-2004).

The effect of the carry trade is that yields for longer-dated securities become suppressed due to all the demand, and the term structure of interest rates---the yield curve---flattens. A "conundrum" that Greenspan noted was that, even as the Fed did eventually begin to raise the short-term rate again, long-term interest rates did not seem to budge (normally you would expect the rise in short-term rates to be transmitted through the yield curve and medium- and long-term rates to adjust upwards as well).

Regardless of its cause, Greenspan's yield-curve conundrum indicated that it was difficult for the Fed to influence the 20- and 30-year interest rates on which many mortgages are based. It goes to show how the price-distortion machine, once started, may be difficult to stop until it has fully run its bloody course.

The very loose monetary policy also distorts stock market prices: most investors know that equities tend to surge on news of an interest-rate cut by the Fed, but the true sensitivity of stocks may be greater than commonly realized. John Rutledge of Rutledge Capital has calculated that only 2% of the intrinsic value of the S&P Industrial stocks is based on profits earned in the first year. The first 10 years account for only 25% of the Industrials' value. Startlingly, an analyst has to go out nearly 30 years into the future of estimated cash-flows to account for 50% of the value of the S&P Industrial stocks (FYI, this 50% threshold is what is calculated when bond analysts calculate a bond's duration, or sensitivity to changes in interest rates. Long-term bonds are much more sensitive to interest rates than are short-term ones). Based on this kind of analysis, the stock market can be as sensitive to interest rates as a very long-term bond.

In his General Theory, Keynes displayed a deep-seated mistrust of the market's ability to determine the proper interest rate level. He openly stated his feeling that interest rates have tended over the course of human history to be much too high and went so far as to say that "I should guess that a properly run community...ought to be able to bring down the (interest rate) approximately to zero within a single generation" (!).

I think that all but the most rabidly zealous Keynesian enthusiasts believe that a permanently-set zero interest rate/unrestrained printing-press policy would ultimately lead to catastrophic inflation and asset bubbles, as all cash flows from investment options---whether occurring next year or in a century---were essentially considered equivalent from a time-value of money standpoint. A more reasonable discussion would be whether or not the Fed should continue to operate from a discretionary mandate, or should carry out monetary policy algorithmically through the mechanical application of an explicit formula such as the Taylor Rule. My own opinion is that if we are going to have a central banking apparatus at all (and there are things to be said for a free banking system, as Selgin and others discuss), we probably do need monetary policy to be constrained by a narrow, predefined operating band, insulated from political pressure or unavoidable operator biases.

I should note that there is a competing argument about the low interest-rates encountered during the bubble period, and it is one that Greenspan himself has made. According to this alternative explanation, the cause of the easy-credit situation in the United States was not the actions of the Federal Reserve, but a "global savings glut" that depressed interest rates around the world. John Taylor has addressed this argument at some length---the main problems for this causal explanation are that: A) average global savings were lower than normal during the critical 2002-2004 period; and B)the US was running a large current account deficit during this time (US savings was lower than investment, causing a negative "savings gap" that was filled by financing from countries abroad)and soaking up "excess" savings. The latter would prevent relatively higher savings rates in other countries from creating a positive saving gap (higher savings than investment) and pushing down global interest rates---the savings were used to finance the US current account deficit.

After flooding the banks with cash reserves to push the FFR down to 0%, the Fed can also undertake a practice that was beta-tested by the Bank of Japan when the Japanese first faced their real estate-fueled debt deflation: quantitative easing. This phrase, which implies a kind of surgical precision, really just means that the Fed attempts to reflate a deflationary economy by purchasing other assets---such as longer-dated Treasury securities---to "drop cash from helicopters" (using Bernanke's own, infamous phrase). This is generally considered a last-ditch, nuclear option. The Fed began a process of quantitative easing in the late fall of 2008.

We all may find ourselves in a very...interesting monetary policy situation before long. The Federal Reserve pushed the FFR down by flooding the banking system with over $1 trillion in excess reserves. Keep in mind what we discussed regarding fractional-reserve banking and the bank multiplier effect. Even the Fed was apparently scared about this one, so they came up with a plan to try to prevent the banks from flooding the economy with cash. The trick? Paying the banks interest on these reserves so they would not loan them out. I was baffled that this did not receive more attention---Barney Frank was at one point arguing that the banks needed to start loaning money out, when in fact the Federal Reserve had taken steps to prevent them from doing this.

The serious problems would come if the economy recovers, the velocity of money in the system picks up, and the yield curve steepens. If the interest that banks can get farther out on the yield curve starts to attractively exceed what they are getting from the Fed for holding those reserves, the banks will go out and start making A LOT of longer-term loans to enjoy that positive interest rate carry. The question will then be if the Fed is able to start raising rates and getting liquidity out the system before an inflationary scenario takes hold.

For Further Reading: John Taylor's "Getting off Track" reveals the startling departures from previous, moderate Fed policy and their connection to the creation of the housing bubble. John Rutledge's "Road Warrior" contains his thoughts on interest-rate effects on equities (as well as many other insights). "Meltdown" by Thomas Woods has an excellent discussion of the distortions that can be created by the manipulation of interest rates.

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