Rather than force upon us a yield curve that is low and flat, the Fed should leave long-term rates alone and hope for a yield curve that is low and steep – one that provides stronger incentives for lending and investment.
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Bernanke risks creating a liquidity trap
The Federal Reserve should stop trying to engineer lower long-term interest rates. Further efforts to manipulate the yield curve by driving interest rates lower runs too great a risk of leading us into a “liquidity trap” similar to the one that has plagued Japan.
Rather than force upon us a yield curve that is low and flat, the Fed should leave long-term rates alone and hope for a yield curve that is low and steep – one that provides stronger incentives for lending and investment.
The Fed, which makes its next monetary policy decision on Thursday, and other leading central banks have courageously expanded their balance sheets over the past five years since the onset of the financial crisis.
Had they not done so, a too-rapid deleveraging of our financial system would have made the recession even worse and the recovery even slower. We should applaud Ben Bernanke, Fed chairman, and his colleagues for their actions to offset the abrupt decline of private lending.
We should not be content with the current state of our economy. The Fed should aim for more rapid growth and job creation and adopt policies that pursue these goals. But what policies are those?
If low long-term interest rates encourage borrowing, would zero long-term rates encourage even more borrowing? More precisely, if the Fed suppresses the term premium entirely would we get more credit creation and economic activity?
Of course not: we would get less because zero long-term interest rates would discourage lending. There would be no reward for those willing to give up current consumption or liquidity. At the current low level of interest rates, the Fed needs to explain why suppressing the reward for lending will lead to more lending.
In his recent thoughtful remarks at Jackson Hole, Mr Bernanke explained that the Fed has been seeking to use the “portfolio balance channel” to stimulate the economy. By selling the Fed’s short-term bonds and buying more long-term ones, the Fed’s maturity extension programme both directly drives up bond prices and brings down bond yields and, at the same time, influences other investors’ portfolios in similar ways.
As the Fed hoards Treasury and agency securities, other investors are forced to replace those assets with a comparable amount of risk, and their actions should further bring down interest rates, ease financial conditions and encourage credit creation.
But the impact on other investors’ portfolios is more ambiguous. As the Fed hoards more long-term bonds and drags rates lower, some investors can and do “chase yield” with some of their portfolio by buying other risky assets, such as high-yield bonds.
Yet with each move higher in bond prices, and lower in yields, investors and lenders of all types reasonably fear the eventual reversal of this process when bond prices decline and yields rise.
Critically, as yields move lower investors can also observe the smaller opportunity cost of holding cash. So while one might think that investors will replace the bonds the Fed hoards with ones of comparable or greater risk, as the yield differential between bonds and cash is compressed investors can also choose to replace the bonds they give up with cash and other short-term cash equivalents.
The increasingly modest yields on bonds will not compensate for their potential volatility. Although cash may have a zero yield it also has zero volatility.
The Fed’s conditional commitment to hold short-term rates down for the next several years is an important way that the Fed can try to minimise investors’ fears of rates backing up soon or abruptly. But the more the Fed drags down the level of interest rates, the more attractive cash becomes on a relative basis, leading to a less-favourable portfolio rebalancing that looks just like a liquidity trap.
At Jackson Hole, Mr Bernanke candidly discussed both the benefits and the costs of the Fed’s unconventional policies, but the one cost he did not mention was the risk that holding down long-term interest rates could reduce incentives to lend to the point where leaving money “under the mattress” becomes the more attractive alternative.
The US economy is showing remarkable resilience in the face of the European crisis and the slowdown of the Chinese and other developing economies. Of course more rapid growth and job creation would be a good thing.
But it is time to face the simple truth that, as they approach zero, lower interest rates will not automatically create more credit and more economic activity but, rather, run the significant risk of perversely discouraging the lending and investment that we need.
Peter R. Fisher is senior managing director and head of fixed income at BlackRock
Rather than force upon us a yield curve that is low and flat, the Fed should leave long-term rates alone and hope for a yield curve that is low and steep – one that provides stronger incentives for lending and investment.
The Fed, which makes its next monetary policy decision on Thursday, and other leading central banks have courageously expanded their balance sheets over the past five years since the onset of the financial crisis.
More
On this story
- Gavyn Davies US monetary policy at turning point
- Money Supply Jackson Hole – Woodford
- Jackson Hole debate informs Fed decision
- Bernanke signals Fed ready to act
- Zero rates force US funds to chase income
On this topic
- Yields on US mortgage securities tumble
- Bernanke takes plunge with QE3
- Fed insists politics did not affect QE3
- John Authers Fed felt it had to act
Markets Insight
We should not be content with the current state of our economy. The Fed should aim for more rapid growth and job creation and adopt policies that pursue these goals. But what policies are those?
If low long-term interest rates encourage borrowing, would zero long-term rates encourage even more borrowing? More precisely, if the Fed suppresses the term premium entirely would we get more credit creation and economic activity?
Of course not: we would get less because zero long-term interest rates would discourage lending. There would be no reward for those willing to give up current consumption or liquidity. At the current low level of interest rates, the Fed needs to explain why suppressing the reward for lending will lead to more lending.
In his recent thoughtful remarks at Jackson Hole, Mr Bernanke explained that the Fed has been seeking to use the “portfolio balance channel” to stimulate the economy. By selling the Fed’s short-term bonds and buying more long-term ones, the Fed’s maturity extension programme both directly drives up bond prices and brings down bond yields and, at the same time, influences other investors’ portfolios in similar ways.
As the Fed hoards Treasury and agency securities, other investors are forced to replace those assets with a comparable amount of risk, and their actions should further bring down interest rates, ease financial conditions and encourage credit creation.
But the impact on other investors’ portfolios is more ambiguous. As the Fed hoards more long-term bonds and drags rates lower, some investors can and do “chase yield” with some of their portfolio by buying other risky assets, such as high-yield bonds.
Yet with each move higher in bond prices, and lower in yields, investors and lenders of all types reasonably fear the eventual reversal of this process when bond prices decline and yields rise.
Critically, as yields move lower investors can also observe the smaller opportunity cost of holding cash. So while one might think that investors will replace the bonds the Fed hoards with ones of comparable or greater risk, as the yield differential between bonds and cash is compressed investors can also choose to replace the bonds they give up with cash and other short-term cash equivalents.
The increasingly modest yields on bonds will not compensate for their potential volatility. Although cash may have a zero yield it also has zero volatility.
The Fed’s conditional commitment to hold short-term rates down for the next several years is an important way that the Fed can try to minimise investors’ fears of rates backing up soon or abruptly. But the more the Fed drags down the level of interest rates, the more attractive cash becomes on a relative basis, leading to a less-favourable portfolio rebalancing that looks just like a liquidity trap.
At Jackson Hole, Mr Bernanke candidly discussed both the benefits and the costs of the Fed’s unconventional policies, but the one cost he did not mention was the risk that holding down long-term interest rates could reduce incentives to lend to the point where leaving money “under the mattress” becomes the more attractive alternative.
The US economy is showing remarkable resilience in the face of the European crisis and the slowdown of the Chinese and other developing economies. Of course more rapid growth and job creation would be a good thing.
But it is time to face the simple truth that, as they approach zero, lower interest rates will not automatically create more credit and more economic activity but, rather, run the significant risk of perversely discouraging the lending and investment that we need.
Peter R. Fisher is senior managing director and head of fixed income at BlackRock
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