Friday night Chairman Bernanke delivered a speech on long-term interest rates at the Annual Monetary/Macroeconomics Conference sponsored by the San Francisco Federal Reserve. The basis of his remarks was that the Fed would continue to maintain its robust monetary accommodation because any early extraction may result in the economy slowing and thus the Fed would have to move to extend the period of aggressive Fed action. It is always important to remember that Ben Bernanke is the main ’37er in the realm of preventing an economic relapse to the deflationary impact of deleveraging. When I say that Chairman Bernanke is a ’37, it refers to the pledge the chairman made to Professor Milton Friedman at the esteemed economist’s 90th birthday party. Bernanke said the Fed made a huge mistake by tightening rates and reserve requirements in 1937 while the U.S. Treasury was instituting an austerity budget at the behest of Secretary Andrew Mellon. It has been Bernanke’s belief that the Fed’s actions coupled with a badly flawed fiscal policy sent the U.S. back into a very severe recession.
The FED will do all it can to ensure against a deflationary spiral promoting an economic downturn. There will be no mass liquidation of assets on this chairman’s watch. Risk premiums will remain low on long-term term debt as BOND VIGILANTES are forced to the sidelines. The Fed’s policy is to keep real yields either at zero or NEGATIVE preventing a Japanese period of long asset unwinding. The U.S. has carried huge debt levels as PRIVATE/PUBLIC debt reached a historic high of almost 350% as a ratio to GDP–an enormous load going into 2008. A deflationary environment forces debtors to liquidate assets as falling prices prevent a positive return on borrowed capital (i.e. Japan). The economy stalls as investment is delayed causing an even greater slowdown. This is Bernanke’s great fear, so not on his watch. There will be no repudiation of debt through default or restructuring … not in the U.S.
Today, Vice-Chair Janet Yellen delivered a speech at the National Association for Business Economics Policy Conference, “Challenges Confronting Monetary Policy.” The substance of the speech was very similar to Chairman Bernanke’s and stressed the need to continue to err on the side of aggressive FED large-scale asset purchases and the need to keep real yields very low and negative on the short-end. The problem though is that Yellen seems to believe it is not necessarily the FED‘s actions that are maintaining BONDS at such low rates of return.
“To the extent that investors are reaching for yield, I see the low interest rate environment and not the FOMC‘s asset purchases, per se, as a contributing factor. It is true that asset purchases put downward pressure on the term premium component of longer-term rates, and that discontinuing purchases would likely cause term premiums to rise. But ending purchases before observing a substantial improvement in the labor market might also create expectations that the amount of accommodation provided would not be sufficient to sustain the improvement in the economy. This weakening in the economic outlook might bring down the path of the federal funds rate ….. Moreover, a weakening of the economic environment could also create significant financial stability risks. That said, financial stability concerns, to my mind, are the most important potential cost associated with the current stance of monetary policy.”
Wow, all through the speech it is the importance of the DUAL MANDATE and the need to get unemployment down, but now Yellen maintains that financial stability costs are the greatest concern. Bottom line is that the FED will not be easing off of its current policy until its threshold of at least 6.5% unemployment rate is achieved. It is all about repairing balance sheets, both the U.S. Government’s and the private sector. Carmen Reinhart aptly called what the FED is doing FINANCIAL REPRESSION. In her paper, “The Liquidation of Government Debt,” she stated it so perfectly in the abstract: “Low nominal interest rates help reduce debt servicing costs while a high incidence of negative of negative real interest rates liquidates or erodes the real value of government debt. Thus, the financial repression is most successful in liquidating debts when accompanied by a steady dose of inflation.” Let’s at least be honest about what the low-term premiums on NOTES and BONDS really are–financial repression.
***Just a quick update: While Europe is struggling to sort out some of its problems, it is important to note that the YIELD CURVES are not sending any stress signals. The 2/10 curves in Italy and Spain have remained steep and at the highs of their recent range. Back in July 2012 when Mario Draghi made his no taboos speech and we will do whatever it takes to preserve the euro, it was the TWO-YEAR NOTES that were being sold off and pushing the curves to flatten and causing such stress in the credit markets. There has been no such action as of yet in the short-end of the curve as TWO YEAR YIELDS in Italy are 1.96% and in Spain 2.45% (back in July they went as high as 7%). Also, as I have pointed out in answer to recent blog queries, the U.S. 2/10 yield curve made its 52-week low on July 24 as the DOLLAR INDEX was making a high at 84.01–true risk-off action. While the DOLLAR INDEX is currently making six month highs there hasn’t been any drastic movements in the curve. Maybe a new dynamic is developing, but we need to see more positive pricing in risk assets for a longer time.