Monetary policy has been super "accommodative," as the technical term goes. Yes, this is in response to an unprecedented economic crisis and an overhang of debtors with severely damaged balance sheets. Yet, this policy isn't without critics. Three important (ex) central bankers let their voices be heard recently. Here is an overview of some of the arguments (which hardly came from those three bankers, as it happens. But we looked beyond their criticism).
How did we get here?
This is important to realize as Fed policy might not be the most important reason we have such low interest rates. In essence, we had a credit bubble bursting, which wiped out $9 trillion from household balance sheets (mostly via a fall in house prices) while leaving much of the associated debt in place.
In reaction, households started to save more and borrow and spend less, which got the economy in crisis (helped by a financial system in disarray as well). Businesses invested less as they had overcapacity and demand wasn't good. This lead to a huge savings glut, private sector savings in excess of private sector investment. While Fed policy controls rates at the short end of the yield curve, this excess of "loanable funds" is the main reason we have such low interest rates at the longer end.
So it's important to realize the Fed is not the only (or perhaps not even the main) responsible party for low interest rates in the economy. This is also visible now when the long end of the yield curve is starting to rise, without a change in Fed policy.
The Fed (like the Bank of England, the Bank of Japan and the European Central Bank) embarked on a drastic easing of monetary policy basically to stave off the risk of deflation. That risk is all too real, and the effects are terrible. We can easily see that in the aftermath of two similar financial crashes (and ensuing balance sheet recessions), the 1930s and Japan post 1990.
In the 1930s, the initial policy reaction was restrictive (in part the result of the gold standard). This had terrible consequences. Deflation set in, which increased the real debt burdens, and many households, firms, and banks succumbed under the pressure.
Japan post 1990s was slow to react although the policy reaction, when it came, was much more accommodating. Still, even here it couldn't prevent a mild form of deflation setting in.
So it is hardly a surprise that Bernanke, as a keen student of both periods, set monetary policy on a much more aggressive path and so far, this has precluded deflation to set in. We think that should be counted as a pretty big positive for current hyper-accommodative monetary policy.
The most vociferous critics point out the dangers of hyperinflation as the Fed has resorted to unconventional monetary policy like quantitative easing (QE). This money printing would sooner or later result in hyperinflation. While these predictions are at least three years old and no hyperinflation has yet materialized, it's not hard to see why.
Most of the money has stayed as excess bank reserves
The essence of a balance sheet recession is that credit demand is weak. It isn't exactly uncommon for even drastic liquidity injections to have little to no effect during balance sheet recessions. This is actually the norm and to be expected (see the three charts in here about Japan, the US and the UK).
In the U.S. version, households deleverage, cutting spending and borrowing, and as a result firms have little incentive to boost (credit financed) investment in new capacity. Banks themselves have damaged balance sheet so credit supply might also be tighter than normal (these issues are difficult to disentangle, only anecdotal evidence can shed some light on it but we believe a fall in credit demand has been much more important).
However, this isn't the whole story. Credit demand is returning at least to some degree as the economy improves. Refinancing mortgages through record-low interest rates is attractive. The US has strong demographic growth and demand from overseas is strong, so capacity utilization has come back.
There is no reason to assume that the Fed would not be able to reign in inflation should it raise its ugly head. After all, that is what it has been doing for decades.
When the economy produces below potential output (the output that the economy is capable of producing when all production factors are fully employed), the capacity itself becomes impaired. Plants cannot operate way below capacity for long, so some of them will close, decreasing the potential output the economy is able to produce in the process.
Part of labor, if unemployed for too long, loses skills, hope, work attitudes and the like, and risking being discriminated against in the hiring process when the economy finally picks up again.
This process itself not only lowers future potential output, but it is potentially inflationary. When demand returns to normal levels, it meets a supply side that is less capable of meeting it, and some wages and prices will tend to rise sooner compared to a situation without the impairment to the production capacity (the 'hysteresis' effect).
Low quality investment?
Prolonged very low interest rates could very well have a detrimental effect on the quality of investment. After all, with financing cost being so low, the target return rates of investment projects can be lower as well. Not everybody agrees here:
I don't think this makes any sense at all (neither does Harding). I could see a problem if low productivity projects are funded instead of high productivity projects, but presumably the latter would still be funded first in any event. In other words, I don't see that the low interest rate environment by itself would alter the composition of investment. And if we cut off funding for the less productive investments, the capital stock would grow more slowly, and that would certainly reduce potential growth. [Mark Thoma]
If you'd left it to simple market logic you would end up with starkly negative real interest rates, as only these equate the higher savings with the lower investment demand. However, since nominal rates cannot fall below zero, negative real rates have to be 'manufactured' though higher inflation expectations.
That, it has turned out, hasn't been all that easy. Ask the Bank of Japan. One could also argue that mild inflation would be a good thing, people in favor of nominal GDP targeting do just that. It would also erode the real value of outstanding debt. The problems, are twofold:
- How to engender higher inflationary expectations
- How to contain inflation from ratcheting up once higher inflation expectations have been 'engineered.'
This isn't easy stuff and we haven't seen any convincing answers to these conundrums.
Many argue that the Fed is disadvantaging savers with the super low interest rates. Well there is something in that. More especially pension systems can suffer in this low-interest rate environment. But there are a couple of caveats. First, as we have set out above, the low interest rate environment is certainly not the sole responsibility of the Fed. It's mainly the result of a savings glut.
Second, insofar as savers are bond holders, they've seen their wealth increase substantially as a result of falling rates, which translates neatly into bond rallies, although this is reversible (and a small reversal has already occurred on the back of an improving economy).
The strongest argument against the super low interest rates lies in the possibility that it could reinflate credit infused asset bubbles. We have already expressed concerns years ago about a "bubble cycle," where each bursting of a bubble is followed by easy money, which only reflates a new bubble.
However, we really have to stress that credit infused asset bubbles are by no means unavoidable byproducts of loose monetary policy. In the past decade, monetary policy was loose in numerous places, but this resulted in asset bubbles only in a few of these. The eurozone provides a good example, as it happens.
Joining the euro eliminated the exchange rate risk, setting off a wave of capital inflow from the center to the periphery (as good as any central bank expansion). But only in a few of them (Ireland, Spain) did this wave of incoming money create asset price bubbles. While Greece, Portugal, and Italy, suffered similar capital inflows they did not experience any housing bubble, simply because there was more regulation in place in the mortgage and/or banking sector to prevent this.
Perhaps the biggest practical reason against monetary tightening now is that this would make the dollar rise in the currency markets, worsening American competitiveness and widening an already large trade deficit. This could even snuff out much of the recovery.
Rates are rising anyway
Speaking about the recovery, which has been a little stronger than many anticipated (especially given the backdrop of the European recession and a slowing down of China), this is the main factor producing the rising rates at the longer end of the yield curve.
Rising rates investment consequences
To make the article a bit more actionable we provide some trading suggestions in case rates keep on rising (the chance of any imminent policy change has been well and truly snuffed out by Fed Chairman Bernanke on Monday).
Some time ago we wrote an article about muni bond funds, like Alliance California Municipal I (AKP), Blackrock California Municipal (BJZ), BlackRock New York Municipal In (BNY), Eaton Vance New York Municipal (ENX), Invesco California Municipal Se (IQC), Pioneer Municipal High Income T (MHI), Market Vectors Long Municipal I (MLN), Blackrock MuniHoldings Fund II (MUH), Blackrock MuniHoldings New Jers (MUJ), and Invesco Van Kampen California V (VCV), and how these kept on rising.
We were basically drawn by those nice upward sloping graphs. Things rarely go on forever, and these are in a bit of trouble. We'll give you the graph of one of them , but they move in lock-step.
There has been a brutal sell-off going on recently, some are even oversold. While there are more factors at play here (valuations, premiums, even solvability of some municipalities), the turn-around in the interest rate climate has been important. Should interest rate rise further, these funds will continue to be casualties.
Rising rates isn't good for the housing market either, like Lennar (LEN), Toll Brothers (TOL), Pulte Group (PHM), KB Home (KBH), Beazer Homes (BZH), D.R. Horton (DHI), or companies like US Home Systems (USHS).
Needless to say that bond funds will also suffer, like iShares Lehman Aggregate Bond Fund (AGG), Total Bond Market ETF (BND), iShares Lehman 1-3 Year Credit Bond Fund (CSJ), Barclays Agency Bond Fund (AGZ), Build America Bond Portfolio ETF (BAB), Grail McDonnell Core Taxable Bond ETF (GMTB), Guggenheim U.S. Capital Markets Bond ETF (UBD), Inter-Term Bond ETF (BIV), ishares 10+ Year Credit Bond Fund (CLY), ishares 10+ Year Government/Credit Bond Fund (GLJ), iShares JPMorgan USD Emerging Markets Bond Fund (EMB), iShares Lehman Credit Bond Fund (CFT), iShares Lehman Government/Credit Bond Fund (GBF), iShares Lehman Intermediate Credit Bond Fund (CIU), iShares Lehman Intermediate Government/Credit Bond Fund (GVI), iShares Lehman MBS Fixed-Rate Bond Fund (MBB), Long-Term Bond ETF (BLV), PIMCO Enhanced Short Maturity Strategy Fund (MINT).
If you feel daring you can trade the leveraged bond ETFs, like double leveraged (2x) bond funds: ProShares UltraShort 20+ Year Treasury Bond ETF (TBT), iShares Lehman 20+ Year Treasury Bond Fund (TLT), iShares Lehman TIPS Bond Fund (TIP), iShares iBoxx US Dollar Investment Grade Corporate Bond Fund (LQD), iShares Lehman 1-3 Year Treasury Bond Fund (SHY), iShares iBoxx $ High Yield Corporate Bond Fund (HYG), SPDR Lehman High Yield Bond ETF (JNK), 1-30 Treasury Ladder Portfolio ETF (PLW).
Or you could try the triple leveraged funds (3x), like Direxion 10-Year Treasury Bear 3X - Triple-Leveraged ETF (TYO), Direxion 10-Year Treasury Bull 3X - Triple-Leveraged ETF (TYD), Leveraged ETF, Direxion 2-Year Treasury Bear 3X - Triple-Leveraged ETF (TWOZ), Direxion 2-Year Treasury Bull 3X - Triple-Leveraged ETF (TWOL), Direxion 30-Year Treasury Bear 3X - Triple-Leveraged ETF (TMV), Direxion 30-Year Treasury Bull 3X - Triple-Leveraged ETF (TMF).
There really is a ridiculous amount of choice (we haven't been even close to exhaustive, despite the rather long list).
While low interest rates are probably not doing a whole lot to stimulate the economy, and there are some concerns, these do, on balance, don't seem yet serious enough to hike rates now, as there is a distinct risk that higher rates would cool off the rather weak recovery. However, the economy can't live on these low rates forever.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.