Monetary Policy at a Crossroads

How Now Goes the Fed?

For nearly a decade, the Federal Reserve was largely on the sidelines. After reducing interest rates to close to zero in the wake of the Great Recession, they were reduced to less powerful weapons. In this period they adopted “quantitative easing,” where the numbers are big but the effect less clear.

Now the Fed is back. They have repeatedly declared that the economy is sound and it’s time to “remove the punch bowl” before the party gets out of hand. While the U.S. economy is not booming, it’s the strongest it’s been in more than a decade and may well be gaining momentum.

Fed policy takes time to bring about the desired effects so it must act ahead of time and anticipate the future. Even so, the Fed relies on data and trailing information about the economy and so usually operates behind the curve. We ask the Fed to do the impossible — accurately foresee the future — and are disappointed, even hostile, when, as most often is the case, they err.

What are the chances that this tightening cycle will be successful and how will we judge that success? At the same time, the Fed plans to sharply trim its record four trillion dollar balance sheet.

As a conservative institution, as a committee, and as a seer, the Fed operates  with challenges and consensus as they try to steer the world’s largest economy on the narrow path of prosperity and avoid a recession.

We are on the verge of the longest expansion in history and the odds of the Fed triggering a recession soon are high. This need not be a disastrous recession and perhaps will be one that markets can shrug off with a short pause.

Nonetheless, the Fed faces difficult challenges as it tries to nurse this economy through a period of sub-par growth while avoiding calamity.


Bond Bubble

If there were a bond bubble, this is what it would look like: trillions of dollars of Eurobonds going for negative interest rates, the 10 year German bund yielding pennies and Mexico promising to pay back bonds in 100 years with an interest rate of 4 percent. More than half of the world’s government bonds are yielding less than one percent. We don’t have any experience with this kind of a world. We know it won’t last forever but we don’t know when and how it will end. We do know that we should be careful in buying bonds. None of this means that we shouldn’t buy bonds or that everyone will lose money. A good guess is that many, if not most, of these bond buyers haven’t thought through the end game and if trouble comes, it will be unexpected. There are many reasons why interest rates are so low. One is that the Great Recession was so terrifying that people still haven’t recovered. They aren’t willing to sign up for risky assets and as a consequence they have made a once safe asset one of the riskiest. As the saying goes, buyer beware.


Negative Interest Rates

Desperately Seeking Yield

Investors are perplexed and concerned about continued low interest rates.

People who think of themselves as conservative investors like to rely on guaranteed fixed interest rates. Over the last six years that hasn’t been much fun.

In early 2009, the Federal Reserve Board lowered their short-term interest rate target to close to zero and it’s remained there ever since. It seems hard to believe but as recently as early 2008, the target was 4.25 percent.

Investors’ choices in this environment are unattractive: they can accept little risk and interest rates of close to zero or take on different kinds of risk.

Many investors refuse to take on risk. In fact, by some estimates as much as $3 trillion is invested at negative interest rates. With a negative interest rate it means that the investor is paying the issuer or custodian to hold their money. They’ll get less money back than they put in.

In a world of seemingly low interest rates forever, investors will take increasingly “clever” or risky moves to get higher yields. They may not recognize the risks until it’s too late but the risks are there. Prudent assessment of risks and an overall plan are the best ways to survive this period.