The bond market has been buzzing this week following the publication of two papers* from staff at the Federal Reserve that could provide officials with a possible way out of their quantitative easing box.
The papers, presented at a conference this week hosted by the International Monetary Fund, suggest a lower unemployment rate of 5.5 per cent before triggering a tightening of policy, while also tolerating a higher rate of inflation of around 2.5 per cent.
It is a framework that entails the Fed keeping its key overnight rate near zero into 2017 in order to get the economy moving. Such a commitment to keeping overnight interest rates lower for longer, known as forward guidance in central bank speak, should in theory anchor long term bond yields and facilitate a taper of QE.
But will it work?
It’s no secret that policy officials are worried that their hefty money printing is stoking an almighty bubble.
Bubble like signs were on display this week with the spectacular debut of Twitter, a social media platform yet to generate a profit. Elsewhere, the S&P 500 in dollar terms eclipsed this year’s gain in Japan’s Nikkei 225, as US equities continue to defy some already weighty valuations.
It’s a similar story in areas of the credit market: this week saw the debut of a new real estate securitisation that harvests rental income and comes with a triple A stamp for the most senior slice of the deal.
The problem for the Fed has been how to gently let the air out of a growing asset price bubble at a time when a recovery in the broad economy, led by decent paying jobs and rising income, is missing in action.
This summer, the bond market looked at any reduction in the Fed’s $85bn of monthly bond purchases, dubbed the taper, as a form of policy tightening and duly sent long-term bond yields sharply higher. The ensuing sell-off in the bond market ultimately prompted the Fed in September to defy market expectations and delay the taper.
Having decided that the US economy cannot handle a 10-year bond yield north of 3 per cent, the Fed is now floating its new approach ahead of Janet Yellen assuming leadership of the central bank next year.
The big question for the Fed is whether the bond market will listen to and respect what is known as Optimal Control. Last year, Ms Yellen outlined the idea in various speeches about how the central bank can use a model to calculate the optimal path of short-term rates that over time will enable the economy to hit unemployment and inflation targets.
Given the moribund rate of inflation with further downward pressure expected from sliding US petrol prices, there is scope for the Fed to pull this off for a while. It is hard to push long-term bond yields significantly higher in the absence of inflation.
The real danger, however, is that keeping rates low for longer only stokes the formation of the ultimate asset bubble.
By December, the Fed will have already maintained its emergency zero interest rate policy for five years. After a massive expansion of its balance sheet thanks to multiple rounds of QE, all we have is a sluggish economy.
The nagging concern is that there really is no plan to arrest a low-growth economy flirting with disinflation and the absence of solid wage growth.
“I’m very sympathetic to the view that the Fed is in a monetary policy corner,” says Ian Lyngen, at CRT Capital. “There is no obvious next step if the nature of the economic data doesn’t improve.”
For all the talk of plans, Mike Tyson nailed it when he said: “Everyone has a plan ’til they get punched in the mouth.”
*Aggregate Supply in the United States: Recent Developments and Implications for the Conduct of Monetary Policy, by David Reifschneider, William W Wascher, David Wilcox (RWW), http://www.imf.org/external/np/res/seminars/2013/arc/pdf/wilcox.pdf and The Federal Reserve’s Framework for Monetary
Policy – Recent Changes and New Questions, Wlliam B English, J David Lopez-Salido, and Robert J Tetlow (ELST),http://www.imf.org/external/np/res/seminars/2013/arc/pdf/english.pdf
Get alerts on US quantitative easing when a new story is published