Notes From Underground

In quoting the great Yogi Berra, the reference could be the daily algo-driven headlines of the Greek drama. It could also be the issue of a data-dependent Fed and will rates be raised in 2015. Or it’s some very successful and knowledgeable investor bloviating about the correct valuation for the stock market.

While all these issues have been filling the pages and airwaves of the financial media, what I am primarily referring to is  a speech given by former Governor Donald Kohn at Widener University in April 2004. Titled, “Monetary Policy and Imbalances,” it is a speech that Chair Yellen OUGHT to present to all current FOMC voters. I will list several points that Fed Governor Kohn raised in 2004, warning of the ill-effects of  the FED maintaining interest rates at an ultra low level of 1 percent for too long.

1. Critics worry that a continued environment of low interest rates is giving rise to economic imbalances–excessive indebtedness, and elevated prices of houses, equities, and bonds–that in the longer run will come back to haunt us;

2. Critics of present Fed policy warn that any further buildup of debt and distortions of asset prices. Any short-term pain from a premature action by the Fed would be “compensated for by the long-run gain of avoiding severe problems in the more distant future”;

3. Low rates are justified by the Fed by an economy characterized by “considerable slack in labor markets and low and declining inflation”;

4. Low interest rates have aided businesses by reducing debt servicing costs, increasing firms’ financial resilience by paying off short-term and issuing long-term debt. “Stronger balance sheets and higher profits have induced the risk premiums they require to lend to businesses, which has further supported business spending”;

5. An assumption as to the end of the Fed’s easy money effort to remove SLACK from the economy depends upon “…. the public has reasonably accurate expectations about the size and timing of the eventual increase in interest rates and its effect on wealth and debt service…”;

6. However, “if imbalances were thought to exist–if expectations appeared unrealistic and asset prices distorted–then we would judge that the potential for a sharp correction in financial markets and associated economic instability was greater”;

6a. (In a jab at Wall Street and all those warning about growing imbalances), Kohn said: “The issue is whether this process has gone too far–that is, whether investors are failing to take adequate account of the risks of those alternative investments. Forming such a judgment requires a view on the level of asset prices that would be “appropriate” given economic fundamentals. Unfortunately, economists are not very good at this, but neither is anyone else, including Wall Street analysts.”

This is Kohn following the Greenspan doctrine of it is easier to clean-up after a BUBBLE pops rather than leaning in and preventing the bubble from growing to unsustainable proportions. In 2006, BIS economist Bill White criticized central banks that failed to lean into pro-cyclical policies and waited to clean up the financial mess with extra ordinary monetary policies. In today’s markets we are seeing a replay of the pro-cyclical nature of asset values as higher prices result in more margin borrowing with the higher priced stocks serving as the collateral for further increased margin funding;

7. In 2004, Kohn noted the role of low interest rates in pushing corporate bond rates to low rates of return  and the narrowing of credit spreads. Ultra-low interest rates increase profit margins as borrowing costs are lowered, increasing corporate profits. Lower costs for low-rated borrowers acts to increase corporate profits as percentage of GDP leading to a greater sense of security against default. The problem is that high-yield debt is mis-priced due to investor complacency. Corporate profits are presently at record highs as a percentage of GDP and a result of low wage growth and record low borrowing costs for business;

All in all, Kohn is not concerned about the fallout from any of these imbalances for when the FED actually begins raising rates it would “… occur in circumstances in which income and employment were also rising briskly, and thus adding to the resources available to consumers. And, while debt has been rising briskly, and thus adding to the resources available to consumers.” Following up on Kohn’s benign view of the potential fallout from imbalances caused by the Fed’s monetary policy we find that this fits the Janet Yellen desire to keep the present policy in place–labor market slack causes the FED to err on allowing the overheating of the markets. Yellen’s comments at the last press conference about the positive effect of rising home prices for consumer spending is deemed an imbalance to be tolerated.

In 2004, Kohn advised that the FED had a “… very high burden of proof when it comes to accepting fairly predictable short-term pain in the form of reduced risks of fluctuations in output, induced by sharp and unanticipated variations in interest rates and asset prices.” Kohn’s benign concerns about the outcomes of the financial imbalances fostered by the ultra-loose Fed monetary were rendered moot by late 2007. The critics were proven correct to an extent that they never imagined.

If I had ever been here before,

I would probably know just what to do;

Don’t you

Tags: bubble BIS, Don Kohn, Fed, FOMC, Janet Yellen

This entry was posted on June 26, 2015 at 3:36 am and is filed under Fed. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.