September 18th, 2012 | By Nick Sargen
In his Jackson Hole speech, Fed Chairman Bernanke paved the way for additional monetary stimulus by arguing that unemployment is unacceptably high above 8%, while inflation at 2% is within the Fed’s tolerance band. One of the main challenges he faced, however, was to convince skeptics that monetary policy could be effective when interest rates were near zero.
A former colleague of Bernanke’s, Professor Michael Woodford of Columbia University, was invited to the conference to make the case in a paper entitled “Methods of Policy Accommodation at the Interest-Rate Lower Bound.” In this paper, Woodford argued that the Fed needed to change its forward guidance to make it clear that it would continue to purchase financial assets until the unemployment rate fell to an acceptable level – widely regarded to be below 7%. Moreover, Woodford argued the Fed’s message should indicate it would not raise interest rates in the meantime even if the economy strengthened.
How significant is this change in policy stance? According to John Makin of the American Enterprise Institute, it amounts to “an extraordinary upgrade in the intensity of the Fed’s effort to ignite higher growth and reduce unemployment.” Makin offers the following assessment:
“The new ‘conditional’ approach – call it CA – to monetary policy aims at enabling the Fed to affect real variables like the unemployment rate by pre committing it to further action if goals are not met and pre committing it maintains a highly accommodative policy stance (zero interest rates and QE) even after the economy starts to improve.”
In this regard, the FOMC announcement included a statement that the Fed would extend the period of ultra low interest rates to mid 2015, which coincides with the Fed’s forecast of when unemployment is expected to be below 7%.
Prior to the Fed’s announcement, I thought the news of a third round of quantitative easing was largely priced into financial markets and would therefore have little impact. However, I did not foresee the change in tactic in which the Fed’s commitment to further bond purchases is unlimited until unemployment falls to an acceptable level. Consequently, the announcement had a much greater impact on markets than I anticipated: Equity investors greeted the news enthusiastically, as the U.S. stock market surged to its highest level since December 2007, boosting the YTD increase to nearly 15%. At the same time credit spreads narrowed, especially for mortgage backed securities.
Investors also responded by increasing their long-term inflation expectations. The ten year break-even inflation expectation for TIPs, for example, increased by 30 basis points to 2.6%, and the yield on the long bond rose above 3.0%. At the same time, prices of gold and other commodities surged, while the U.S. dollar weakened against most currencies.
Fed officials undoubtedly are pleased with the markets’ response, as it indicates the policy action has had its intended impact. Nonetheless, it remains to be seen whether the new approach to quantitative easing will have much effect on the economy. With short-term interest rates at zero and banks sitting on substantial excess reserves, the transmission mechanism is primarily through the financial markets, especially the stock market and mortgage market.
My own take is that the wealth effect will have only a marginal effect on the economy, but the latest action will make it more difficult for the Fed to tighten policy once the economy improves. The reason: Investors will likely shed bonds once interest rates begin to rise, but the Fed will then have to decide whether to temper the rise purchasing bonds or allow yields to rise to their equilibrium values.
While equity investors are happy with the Fed’s decision, the investment environment has become more challenging for fixed income investors. Monetary policy has moved in a new direction where the Fed is willing to risk higher inflation to combat high unemployment. I am not concerned about an imminent rise in inflation with the global economy weak and resources far from being fully deployed. But I am concerned the Fed’s policy will widen the disparity between market prices and their equilibrium values. Credit spreads, for example, appear too narrow from a long-term perspective; yet, they could compress further as long as the Fed maintains its buying program.
Recognizing this, we are maintaining overweight positions in high yield and commercial mortgage-backed securities. However, we believe investment-grade credits are more vulnerable if interest rates were to increase, and we are in the process of scaling back positions. We plan to deploy the proceeds into U.S. treasuries, which offer greater liquidity than corporate bonds, and to trade these positions actively.