The Fed's Not Pegging Bond Yields, the Yields Have the Fed Pegged

The Fed's Not Pegging Bond Yields, the Yields Have the Fed Pegged
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It was once said that monetary policy was a string – the central bank could pull on it in order to tame inflationary pressures, but it could never push it in order to halt the onrush of recession or worse. As one consequence, all sorts of dire predictions were made during the thirties about how the world might never recover. The central bank was to be shelved.

There was a great revival in theoretical interest of money and money supply in the sixties after decades of neglect. The timing was certainly appropriate, in many ways necessary given what was just then beginning to unfold. The Great Inflation was every bit as consequential if not quite as pernicious as the Great Depression had been.

In the latter’s aftermath, it became widely accepted among economists and therefore the public that there was little any monetary authority could do in times of contraction, though. Experience seemed to show that much; for however well the Federal Reserve, for example, may have performed during the twenties once the experience of Black Monday paralyzed the markets it was difficult back then to see what could have been done differently to avoid all the rest.

Alvin Hansen in the thirties gave us the idea of secular stagnation as this new set of assumptions emerged, a term which has in a limited sense come all the way back around. History being circular, or at least a series of pendulum swings back and forth, there are those who recognize the predicament but are somehow predisposed to always look upon it as a permanent condition.

We start with that condition. Former Bank of England Governor Mervyn King made his way to Washington, DC, this past weekend in order to address the IMF’s annual meeting. It was a strange sort of juxtaposition given that the organization’s last leader, Christine Lagarde, was busy at the same time preparing for her new role as head of Europe’s central bank.

The former central banker, King, was interested in talking about how much authorities have failed. The latter, Lagarde, fresh off yet another such failure in Argentina was on a whirlwind press tour (which included, for some absurd reason, a stop with CBS’s 60 Minutes news program) denying that very thing, decrying the very notion anyone anywhere would ever question central bank independence. Or central bank performance.

What King said was:

“Conventional wisdom attributes the [post-2008] stagnation largely to supply factors as the underlying growth rate of productivity appears to have fallen. But data can be interpreted only within a theory or model. And it is surprising that there has been so much resistance to the hypothesis that, not just the United States, but the world as a whole is suffering from demand-led secular stagnation.”

In other words, authorities are sure it has to be a supply side problem, R*, because all their models assume it has to be a supply side problem since they were created in order to analyze potential problems on the supply side. Central banks, it is always assumed, have the demand side covered. Therefore, any notion of other factors that might be of a cyclical nature, even those which could even stretch out for a very long period of time, far beyond the usual boundaries of recession, aren’t so much dismissed as never even considered.

The most damning criticism by King was in recognizing how stale and static theory and convention was in the wake of 2008. Right or wrong, after the Great Crash and into the Great Depression nobody sat still. Every assumption including, as noted above, those about central banks and the role of monetary policy was reassessed and then reassessed again. The tremendous failure, and the tremendous costs of failure, led to radical rethinking.

Maybe there was too much idealizing these new modern central banks in the twenties.

If anyone would know, it would be Mervyn King. He was “in the room” during all those secret conference calls calling upon coordination among all the big central banks as the crisis unfolded. Central banks, we had been told for decades, were all-powerful. Seeing it firsthand from the inside in 2008 and 2009, in 2019 King levels a startling indictment:

“No one can doubt that we are once more living through a period of political turmoil. But there has been no comparable questioning of the basic ideas underpinning economic policy. That needs to change.”

No tremendous burst of scholarship, no radical reexamination of fundamental assumptions. For Economics, 2008 was a minor and very much temporary blip. The rest of the world hasn’t been so lucky.

It has left the global economy in the same position as it had been during the latter part of the Depression era. In his famous Presidential Address to the American Economic Association in December 1967, Milton Friedman pointed out several prime examples of what passed for conventional wisdom in the thirties and forties that sound eerily as if they were spoken or written today.

In 1945, Friedman noted, noted economist EA Goldenweiser, the Federal Reserve Board’s Director of Research, told the board that its primary function moving forward would have to be to preserve the value of government bonds after it had racked up a huge deficit during WWII. As with many other prominent thinkers, he could not conceive of any way back toward higher interest rates.

“This country will have to adjust to a 2 1/2 per cent interest rate as the return on safe, long-time money, because the time has come when returns on pioneering capital can no longer be unlimited as they were in the past.”

For many, that view of the past has become prologue again. The Fed acts in 2019 because, many are now claiming, like 1945 the world cannot tolerate higher interest rates under the strain of so much debt. That’s why central banks have painted themselves into such a narrow corner. After “stimulating” with low rates for so long, we are told, they’ve “stimulated” so much debt it cannot survive being repriced by normal rates without causing massive disruption.

Hansen had said demographics and the lack of capital investment (on the supply side, of course) doomed the world to constant low growth, if not a complete lack of growth that would last long after the thirties. Goldenweiser warned that with so much government debt it would leave the US unable to ever get back off the ground.

The world did not end in the fifties as interest rates generally normalized; quite the opposite. The global economy blossomed in a way it hadn’t in decades. The baby boom boomed precisely because the economy did, and capital investment boomed which then raised the level of interest rates. The US government didn’t collapse into a failed mess of insolvencies.

What Friedman told his stunned audience in 1967 was that the central bank cannot peg either interest rates or unemployment beyond the short run, and that what had occurred between the Great Depression and that time was the pendulum had swung too far in the other direction. If the central bank was thought useless or at best secondary in 1930, by 1960 it had been revived as a powerful agent to try and control those main factors.

That’s the set of assumptions we recognize today. But they still proceed from a faulty basis. He said:

“Let the Fed set out to keep interest rates down. How will it try to do so? By buying securities. This raises their prices and lowers their yields. In the process, it also increases the quantity of reserves available to banks, hence the amount of bank credit, and, ultimately the total quantity of money. That is why central bankers in particular, and the financial community more broadly, generally believe that an increase in the quantity of money tends to lower interest rates.”

But all experience shows this is not so. As Friedman detailed, that’s only the beginning of the process rather than its end. There are feedback effects, very positive ones that in the end leave interest rates moving higher; to the extent that the initial policy actually does stimulate investment and spending, it will also mean rising incomes and liquidity preferences, maybe even the price level (inflation), all of which should combine to pressure interest rates into going only upward.

The result of successful stimulus is higher rates. As back then, today everyone including central bankers seem unaware of the multistage processing. Or they are insidiously disingenuous; they know higher interest rates would confirm their success with monetary policies but in their absence keep calling low interest rates “stimulus” so as to stave off questions about their performance.

It’s come to be known as Friedman’s interest rate fallacy. He made what were a testable set of predictions in 1967 that were about to be proved all over again by the Great Inflation:

“As an empirical matter, low interest rates are a sign that monetary policy has been tight-in the sense that the quantity of money has grown slowly; high interest rates are a sign that monetary policy has been easy-in the sense that the quantity of money has grown rapidly. The broadest facts of experience run in precisely the opposite direction from that which the financial community and academic economists have all generally taken for granted.”

It was his use of expectations theory which explained the seeming contradiction, and the mistaken impression left by conventions surrounding modern monetary policy. If, as Friedman said, the central bank expands the money supply in the manner set forth (which, if you noticed, sounded exactly like modern quantitative easing – demonstrating that it wasn’t actually a modern innovation) in order to hold down rates it would require an even larger monetary expansion in the next iteration because economic agents had already adjusted to the prior one (rational expectations).

What Friedman then said was, if your goal as a central bank was to peg an interest rate the only choice you had was to make larger and larger open market purchases, creating more and more bank reserves, in order to counteract the inflationary effects of “money printing.” You were only hurting yourself by not understanding the interest rate fallacy – the more you did to peg the interest rate, the more you did to undermine the peg.

This was in many ways the big monetary contribution toward the Great Inflation. Trying to hold government bond rates down, on the mistaken belief that it was entirely necessary, the Fed ended up (“even keel” policy) after 1965 raising the level of reserves and thereby stimulating inflationary pressures which brought with them the higher interest rates Friedman predicted.

One of the big reasons why this happened was monetary scholarship had been left to rot.

And it totally undermines the current argument about bond yields and quantitative easing as money printing. If the Federal Reserve has been acting in that same manner as Friedman described in 1967, and to begin with it sounds like they have, then the Fed would have to be buying more and more bonds in order to keep rates low.

Many now argue that’s just what’s happened. But if that was the case, inflationary pressures via rising nominal incomes and intense capital investment would have become undeniable. You print “too much” money, you get higher interest rates. Not a few tens of basis points, but, as all experience has shown, several percentage points and more.

There’s absolutely no sign of anything minimally like the next Great Inflation.

Instead, even Economists admit that our biggest problems globally are the lack of nominal income growth and capital investment. They don’t know why, falling back on that supply side R* thingy, but the channel from bond buying into inflation and higher rates isn’t behaving at all in the manner of money printing.  

Again, go back to Friedman: “low interest rates are a sign that monetary policy has been tight.”  The reason interest rates aren’t being pressured higher is that there have been no inflationary pressures because there hasn’t been rising nominal incomes nor capital investment which would’ve been stimulated if money had actually been printed at some point. The great non-inflation fallacy of our time is different than what it had been in Friedman’s; and interest rates are telling us exactly that.

Central bankers today aren’t trying to peg interest rates to a low level, the bond market is doing that for them and they are actually trying to make the case that the resulting low interest rates are somehow good. And because it really isn’t, they keep doing the same things over and over and over. No radical rethinking of the process deep down to the fundamental intellectual level.

In that view there is also the one about how the world is stuck in a low rate environment because there’s too much debt. When in fact the yields on those debt instruments are stuck at high prices because there’s too little money. Keynes had first talked about liquidity preferences which play a huge role in the paradigm. It’s only too much debt in light of too little growth.

And, if you haven’t noticed, that’s exactly how the Fed is acting right now. Monetary officials aren’t close to solving the issue, of course, but in first ending QT long before they had intended then the sudden reaction of repo auctions (which aren’t repo) whose caps have been raised substantially just this week, and now a small-scale asset purchase (don’t call it QE) on top, Jay Powell is telling you he’s pretty sure there’s a monetary shortage, too.

He doesn’t know why or where, but it doesn’t take a genius to properly interpret current money market signals. The real crux of the matter, though, is that he only needed bond market yields to warn him the system had been heading toward this state (again) for quite some time. They had signaled throughout 2017 and 2018 that globally synchronized growth was a farce, the inflationary pressures he envisioned that comported with Milton Friedman’s view of them just never materialized – all because no money had ever been printed.

That’s why rates stayed low, the curve flattened, and are now lower still with the curve inverted – at an incredibly low nominal level. The federal government doesn’t need any help at all to sell its debt. It’s perverse, sure, where the monetary reality is there are too many buyers. It gets better for everyone, including the federal government, when demand for the safest, most liquid instruments goes way down.

In the aftermath of all this renewed activity with 21st century bank reserves, it needs to be pointed out, yields, of course, haven’t budged. Not because the Fed is buying T-bills, but because of the reasons behind the Fed thinking it should buy T-bills. “The broadest facts of experience run in precisely the opposite direction from that which the financial community and academic economists have all generally taken for granted.”

Mervyn King was also right, though it’s of little comfort he’s only now talking about it. Authorities needed to do something different in the aftermath of a global panic in 2008 they had previously said was impossible. And in the absence of a recovery they all said was coming, maybe they didn’t know everything they thought they did, as King now implies. Maybe secular stagnation is just a fancy way of avoiding stating outright how officials screwed it all up and keep screwing up.

The Fed’s not pegging bond yields. Bond yields have the Fed pegged.

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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