April 2nd, 2011 | By Nick SargenI just returned from a conference of the American Council of Life Insurers for CIOs and CFOs, where the above topic loomed large on the agenda. Virtually all of the attendees believed today’s record low interest-rate environment poses a major challenge for life insurance companies and other financial institutions, because it contributes to margin compression, which hurts overall profitability. And while debt service burdens of households and the federal government are being alleviated by low rates, many participants were concerned that the Federal Reserve’s policies were creating distortions in capital markets that could backfire at some point.
Against this backdrop, two prominent Wall Street economists -- Peter Hooper of Deutsche Bank and Neil Soss of Credit Suisse -- offered differing assessments about how long it would take for the Fed to alter its stance and raise interest rates. Hooper maintained that the Fed would begin to tighten monetary policy by 2013, whereas Soss contended that the Fed would keep rates low for much longer. Considering that they both served as staff members of the Board of Governors, their analyses offer interesting insights about the factors Fed officials must weigh in making decisions about the course of interest rates.
The crux of Peter Hooper’s analysis is that the Fed’s stance on monetary policy today is largely driven by its perception that inflation and inflation expectations are well contained, whereas unemployment remains unacceptably high. In this context, he believes Fed officials will continue to speak openly about the need for low interest rates, as long as the pace of economic activity remains subdued.
Behind the scenes, however, Hooper thinks Fed officials are taking note of the recent improvement in the economy, and he believes there is now a higher threshold for the Fed to embark on a third round of quantitative easing. For the Fed to undertake additional easing, in his view, would require a new bout of economic weakness and/or little progress in the way of further reductions in the unemployment rate.
Hooper’s own forecast of the economy, however, calls for a faster reduction in the unemployment rate than the consensus forecast. He notes that the unemployment rate rose much faster than expected during the 2008-09 financial crisis, as businesses cut costs aggressively to offset weaker demand. This was accompanied by an unusually large increase in labor productivity.
The essence of Hooper’s argument is that firms are now finding they cannot meet increased demand by working the existing labor force more intensively, and they are now compelled to hire more workers to meet growing demand. This faster pace of employment growth relative to overall economic growth, in effect, is payback for what happened during the depths of the financial crisis.
If his call is correct and the unemployment rate continues to decline, he believes the Fed will abstain from embarking on QE3, and that this will be an important signal for financial markets that could cause bond yields to spike later this year. By his reckoning, the Fed will begin to alter its rhetoric about the economy and interest rates next year, which would be the precursor to the Fed hiking short term interest rates.
By comparison, Neil Soss puts less emphasis on the near term forecast for the economy in formulating his views about Fed policy. He assigns much greater importance to underlying problems in the financial system and to the long-term fiscal outlook for the U.S. as the key reasons the Fed must keep interest rates abnormally low for a longer period.
Soss first observes that there is an asymmetry in the effectiveness of monetary policy in an inflationary environment than in a deflationary context. In the former case, the Fed is prepared to raise interest rates sufficiently to curb inflation pressures and will do so until the economy enters recession. At that point, inflation expectations typically recede and the Fed is free to easy monetary policy.
In contrast, in situations in which a financial crisis triggers an economic collapse and spawns the risk of deflation, it typically takes much longer for the economy to respond to an easing in monetary policy. One reason is that economic agents typically increase their demand to hold cash balances while financial institutions are more reluctant to lend to creditworthy borrowers. Another reason is that the Fed can drive nominal interest rates close to zero, but real rates could increase if market participants anticipated that prices could decline.
Soss also contends that the Fed is mindful of the high debt burdens of U.S, households and the federal government. One way of easing their debt service burdens is to keep interest rates abnormally low. As an illustration, he notes that the federal government’s interest burden is little changed since the financial crisis, even though the government’s debt outstanding has soared. He acknowledges that this situation cannot last indefinitely and that interest rates must rise at some point. However, he believes Fed officials are attempting to hold off the day of reckoning until the economy is on more solid footing.
One of the critical issues insurance companies and other bondholders confront today, therefore, is how to position portfolios for a low interest rate environment that likely to shift higher at some point. Based on discussions with CIOs and CFOs at the conference, it is clear that the most desired outcome would be one in which interest rates rise gradually – close to what happened in the period between 2003 and 2007. At the same time, it is widely recognized that the Fed’s gradualist policies then contributed to the bubble in housing, and the conference participants were concerned that current Fed policies could produce distortions in capital markets.
While there was no consensus about the future path of interest rates, my own take is that we likely have seen the lows in bond yields. Thus, we now believe 10-year treasury yields will fluctuate in range centered around 2.25%, or roughly 25 basis points above the former mid-point. In my view, the key driver of treasury yields in the second quarter will be expectations about a third round of quantitative easing. If the employment data continue to show healthy increases in nonfarm payrolls, market participants will likely bid up yields to new highs as expectations for QE3 fade. Conversely, if the economy falters or job growth slows, yields are likely retest the 2.0% floor.
Looking beyond the next few months, however, I do not believe the Fed is in a hurry to raise rates, and when it does reach that point it is likely to proceed very gradually. In this respect, I would not expect the 10 year treasury yield to breech 3% anytime soon.