The Global Debt Crisis Risk
Carlos M Pelaez
The most critical issue of the world economy is the threat to the recovery from the global recession by rising long-term interest rates driven by the fiscal imbalances and debt of many advanced countries. US debt is rated AAA because the institution that issues the debt, the US government, issues the currency or legal tender, the dollar, with which the debt is redeemed. The dollar is the reserve currency of most countries in the world, conferring to US debt what Charles Degaulle called “exorbitant privilege,” quoting his finance minister Valéry Giscard D’Estaing (Pierre-Olivier Gourinchas and Hélène Rey cited by Pelaez and Pelaez, The Global Recession Risk, 44, Globalization and the State, Vol. II, 190). The US is like the venture capitalist of the world, borrowing short-term at low rates to invest long-term in equities and direct investment with higher rates of return. The pressure on long-term interest rates eroding the US “exorbitant privilege” by threatening its credit rating originates in the deteriorating fiscal situation and the unwinding of the Fed balance sheet. The Congressional Budget Office (CBO) calculates record fiscal deficits from the President’s budget proposal of $1.5 trillion in 2010, or 10.3 percent of GDP, and $1.3 trillion in 2011, or 8.9 percent of GDP after $1.4 trillion or 9.9 percent of GDP in 2009 (http://www.cbo.gov/ftpdocs/112xx/doc11231/frontmatter.shtml ). Debt held by the public would rise from $7.3 trillion or 53 percent of GDP in 2009 to $20.3 trillion or 90 percent of GDP in 2020. Net interest would quadruple from 1.4 percent of GDP in 2010 to 4.1 percent in 2020. The Fed holds a portfolio of $1.9 trillion of long-term securities that will cause increases in long-term interest rates when it is sold to the public even using appropriate tools in an optimum exit strategy. Issuance of debt to pay for continuing high government deficits and refinancing of maturing debt together with the sale of the Fed’s portfolio will cause upward pressure on long-term interest rates with likely adverse effects on the rate of economic growth and employment. The will to restore fiscal balance by elected officials is replaced by profligacy during election processes in alternate years. Voters will eventually be more committed to fiscal parsimony.
This post provides initially analysis of important developments in bond markets, interest rates and the fiscal situation followed by an analytical narrative of the shocks of interest rates in the economic cycle. The final section focuses on the mixed signals from short-term economic indicators and the increasingly worrisome outlook.
Bond Markets and the World Debt Problem. There are signs of stress in markets of US Treasuries. The sale of $118 billion of Treasuries in the week of Mar 22 as part of expected debt issue of $1.6 trillion this year after $2.1 trillion in 2009 resulted in sharp increase of the yield of the 10-year Treasury note to 3.9 percent while the 30-year mortgage rate jumped from 5.06 to 5.13 percent (http://online.wsj.com/article/SB10001424052748704094104575144244213486742.html?KEYWORDS=Lauricella ). The yield of the 10-year note touched briefly 3.954 percent only in intraday trading on Jun 10-11, 2009 (http://online.wsj.com/mdc/public/npage/2_3051.html?mod=mdc_bnd_dtabnk&symb=UST10Y&page=bond ). Data and analysis by Bloomberg posted on Mar 22 reveal pressure on the yields of Treasury securities because of record budget deficits and expectations of increases in the ratio of debt to GDP of the US toward 100 percent or more (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=azz5FiyZHvMY ). Composite prices compiled by Bloomberg show that notes of large US private entities yield less than the Treasury equivalent security: Berkshire Hathaway note due in Feb 2012 yield -3.5 basis points (bp), Procter & Gamble’s note due on Aug 2012 yield -6 bp and Johnson & Johnson note due Aug 2012 yield -3 bp. Corporate debt is being priced at a yield or risk lower than government debt. Bloomberg also recalled the warning a week earlier by Moody’s that the US would be the AAA-rated country with second highest ratio of debt payments to government revenue: 7 percent in 2010, increasing to 11 percent in 2013. The US government borrowed $2.1 trillion in 2009 almost twice the issue of debt by investment grade companies of $1.08 trillion. Bloomberg data also show that investors demand 60 bp more in yields of Treasuries than in yields of German bunds of similar maturity while a year ago bunds yielded about 50 bp more than Treasuries. The German government deficit is projected to increase to 5.5 percent of GDP in 2010 or half of the deficit/GDP ratio of the US (http://www.imf.org/external/np/ms/2010/020810.htm ). There is temptation to short US Treasuries while going long on similar bonds of Germany and Canada. This arbitrage position is not speculation but rather a defensive strategy for maintaining wealth that would erode in value if invested in Treasuries. Fiscal profligacy is the actual speculation that excessive spending currently does not have a hard price in the future in foregone economic activity and jobs.
Some of the most prominent participants in world financial markets expressed concern about the fiscal situation. Answering questions during testimony in the House (http://www.federalreserve.gov/newsevents/testimony/bernanke20100325a.htm ), Chairman Bernanke reiterated the need for concerted, credible action moving the path of the US deficit toward a more sustainable path (http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aHNI.d7R6uVU ). William H. Gross, Managing Director of PIMCO, warned that Treasuries may not be a good investment even if the US escapes its worsening fiscal situation by issuing debt (http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2010/Rocking-Horse+Winner+April+2010+IO.htm ). The First Managing Director of the International Monetary Fund (IMF), John Lipsky, revealed the projection that average government debt of advanced countries will increase from 75 percent of GDP at year-end 2007 to 110 percent of GDP at year-end 2014. The IMF expects that with the exception of Canada and Germany all G7 countries including the US will have debt/GDP ratios above 100 percent by 2014 (http://www.imf.org/external/np/speeches/2010/032110.htm ). The fiscal effort required to attain by 2030 the average debt/GDP ratios of 60 percent before the credit crisis would require reversing the average deficit of 4 percent of GDP in 2010 to a surplus of 4 percent of GDP in 2020 and maintaining the surplus at that level for an entire decade. The initial swing from deficit to surplus in the first decades of adjustment amounts to 8 percentage points of GDP. Higher taxes will be a key ingredient in reversing fiscal excesses. There is nonzero probability of a global debt crisis likely centered in the US characterized by a risk premium on government debt.
Wealth Shocks. An analytical narrative of the recent economic cycle can shed light on events and future perspectives by the use of permanent income concepts (A Theory of the Consumption Function by Milton Friedman cited by Pelaez and Pelaez, Regulation of Banks and Finance, 219, Globalization and the State, Vol. II, 200 and cited in Friedman’s Nobel presentation (http://nobelprize.org/nobel_prizes/economics/laureates/1976/presentation-speech.html ). Decisions are made not on the basis of current income but on the expectation of what income will be over a lifetime. The calculation of the all-in costs of a medical education including tuition and foregone income during school years and in hospital residence is close to one million dollars. The student borrows the equivalent of a mortgage on a house with the expectation that the lifetime earnings will permit repayment of the loan principal and interest, providing more comfort than available alternatives. All decisions of consumption and investment by households are made on the basis of expectations of lifetime earnings. Wealth consists of physical assets such as houses, bonds and stocks, pensions and human capital such as education and training. Income, Y, is a flow that is obtained by applying a rate of return, r, to the stock of wealth, W, or Y = rW, which on division of both sides by r becomes Y/r = W. A decrease in interest rates perceived by households to be permanent can induce perceptions of permanent increases in wealth as in forever increasing house values, stocks and retirement funds.
In the first period of recovery from the shallow and short recession of 2001, the Fed lowered the policy rate or fed funds rate to 1 percent with the “forward guidance” that it would remain at low levels for as long as required. There was an additional policy of eliminating the auctions of 30-year Treasury bonds between 2001 and 2005 to lower mortgage rates. The policy of affordable housing consisted of a yearly subsidy of $211 billion per year. Fannie Mae and Freddie Mac increased their combined retained and guaranteed portfolios to $4.9 trillion in 2007 or 41.1 percent of total outstanding mortgages of $12.1 trillion and acquired or guaranteed $1.6 trillion of nonprime mortgage-backed securities (Pelaez and Pelaez, Financial Regulation after the Global Recession, 42-8, Regulation of Banks and Finance, 79-80). The combination of these policies increased house prices, stock values, bond prices and retirement funds, raising expectations of higher lifetime earnings or wealth that were eroded when the Fed raised interest rates from 1 percent to 5.25 percent between Jun 2004 and Jun 2006. The credit/dollar crisis and global recession originated in these four almost contemporaneous policies that induced highly-leveraged risky financial exposures, unsound credit and low liquidity (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4).
Expectations of lifetime income are suffering a major setback from the poor prospects of economic recovery during the next three decades because of painful fiscal adjustment by taxation in lowering debt levels to the period before the crisis. A global debt crisis would force the adjustment, resulting in costly and sudden contraction of economic activity and jobs. Expected weak economic conditions during a protracted period in the future do not augur well for returns on past, current and future prospects of investment on education and training. The fiscal effort will consist significantly of tax increases. The huge government debt will maintain high real rates of interest, increasing the burden of interest payments. Limited opportunities for entrepreneurship will restrain innovation that has driven US economic growth. Permanent unemployment or underemployment will afflict segments of the population, creating strains on safety nets.
Economic Indicators and Outlook. The National Association of Realtors (NAR) announced on Mar 23 that existing-home sales declined 0.6 percent in Feb to 5.02 million annual equivalent compared with 5.05 million in Jan but are higher by 7.0 percent over 4.69 million in Feb 2009. The inventory of unsold houses increased 9.5 percent in Feb to 3.59 million annual equivalents, which corresponds to 8.6 months at current sales. Distressed sales represented 35 percent of total sales (http://www.realtor.org/press_room/news_releases/2010/03/ehs_ease ). The housing sector may not recover soon its past dynamism of 7.1 million sales of existing homes in 2005, for decline of 30.3 percent from that peak to current levels, or even 6.2 million in 2003 (NAR cited in Pelaez and Pelaez, The Global Recession Risk, 224). The US Census Bureau announced on Mar 24 that sales of new houses in Feb 2010 stood at the seasonally adjusted annual rate of 308,000 for decline of 2.2 percent relative to Jan and 13 percent below 354,000 in Feb 2009 with the stock of unsold homes equivalent to 9.2 months of current sales (http://www.census.gov/const/newressales.pdf ). New home sales have declined from 1371 thousand in Jul 2005 to 308 thousand in Feb 2010 or by 77.5 percent (http://www.census.gov/const/newressales_200601.pdf ). Recovery of pre-crisis levels would require an increase by 4.4 times from current levels. Many workers developed skills and established small businesses during the construction boom for jobs and opportunities that may not return, illustrating the need for creating new, different jobs. On Mar 24 the US Census Bureau announced that new orders for manufactured durable goods increased by 0.5 percent in Feb for a third consecutive monthly increase, following an increase by 3.9 percent in Jan. Durable goods increased by 10.9 percent in Feb 2010 relative to a year earlier (http://www.census.gov/manufacturing/m3/adv/pdf/durgd.pdf ). The recovery is driven by manufacturing but dragged by housing. Seasonally adjusted initial jobless claims for the week of Mar 20 were 442,000, decreasing by 14,000 from 456,000 in the previous week and the four-week average declined by 11,000 to 453,700. The number of insured unemployment in the week ending on Mar 13 was 4.6 million, decreasing by 54,000 (http://www.dol.gov/opa/media/press/eta/ui/current.htm ). Claims below 350,000 as in 2007 may signal dynamic labor markets that could help to initiate the recovery of employment. The Bureau of Economic Analysis of the Department of Commerce announced on Mar 26 that GDP grew at the annual seasonally-adjusted rate of 5.6 percent in the fourth quarter of 2009 with the following contributions in percentage points (pp): 1.16 personal consumption expenditures, 4.39 gross private domestic investment decomposed in 3.79 from change in private inventories and only 0.61 from fixed investment, 0.27 net exports of goods and services and -0.26 government consumption expenditures and gross investment (http://www.bea.gov/national/nipaweb/TableView.asp?SelectedTable=2&FirstYear=2008&LastYear=2009&Freq=Qtr ). While the rate of growth is high, recovery requires more impulse from segments other than change in inventory. In the recession of the 1980s the quarterly annual percentage rate of growth of GDP was: -7.9 QII80, -0.7 QIII80, 7.6 QIV80, 8.6 QI81, -3.2 QII81, 4.9 QIII81, -4.9 QIV81, -6.4 QI82, 2.2 QII82, -1.5 QIII82 and 0.3 QIV82. During the recovery phase GDP grew at the quarterly annual percentage rate of: 5.1 QI83, 9.3 QII83, 8.1 QIII83, 8.5 QIV83, 8.0 QI84, 7.1 QII84 and thereafter at rates in excess of 3 percent. Change in private inventories was a significant contributor to the rate of GDP growth in terms of percentage points only in a few quarters: 3.5 QII83, 3.1 QIV83 and 5.1 QI84. Growth was driven by personal consumption expenditures and fixed investment. The rate of unemployment increased from 6.3 percent in January 1980 to a peak of 10.8 percent in December 1982, declining at year end to: 8.3 percent in 1983, 7.3 percent in 1984 and 7.0 percent in 1985 (http://data.bls.gov/PDQ/servlet/SurveyOutputServlet ). The recovery of full employment depends on sustained high quarterly annual rates of growth of GDP originating in demand and fixed investment. Taxation and high interest rates may flatten dynamism from the private sector.
The Fed holds a portfolio of $709 billion of Treasury notes and bonds, $1073 billion of mortgage-backed securities and $167 billion of federal agency securities for total of $1.9 trillion with excess reserve balances of $1144 billion and $100 billion in the Treasury supplementary financing account in the road to $200 billion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ). On Mar 26, the 30-year bond yielded 4.75 percent, the 10-year Treasury note 3.85 percent, the 5-year note 2.59, the 2-year 1.04 and the 3-month bill 0.13 percent (http://www.bloomberg.com/markets/rates/index.html ). This peculiar yield-curve will shift upward with unpredictable twists because of the combination of budget deficits and rising debt with the Fed’s exit of monetary stimulus. There is still time for avoiding a perverse combination of tight monetary policy with expansive fiscal policy that can restrain growth and job creation.
(Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)
Sunday, March 28, 2010
Sunday, March 21, 2010
The Financial Stability Act, Fed Policy, the Economy and the Jobs Agenda
Carlos M Pelaez
The Senate Banking Committee released the proposal for financial regulation in the form of a bill for Restoring American Financial Stability or Financial Stability Act (http://banking.senate.gov/public/ ). The most important aspects of this proposal are analyzed below: origins of the credit/dollar crisis, consumer protection, systemic risk oversight, Fed role in regulation/supervision and proprietary trading. The remainder of this post considers short-term economic indicators and Fed policy, which are more important to US welfare.
Origins of the Crisis. The intent of the Financial Act reveals the interpretation of the crisis: “to promote the financial stability of the United States by improving accountability and transparency in the financial system” (http://banking.senate.gov/public/_files/ChairmansMark31510AYO10306_xmlFinancialReformLegislationBill.pdf ). The proposals emanating from government follow Official Prudential and Systemic Regulation (OPSR) (Pelaez and Pelaez, Financial Regulation after the Global Recession, 30-4, Regulation of Banks and Finance, 217-24, International Financial Architecture, 101-60, Government Intervention in Globalization, 31-7, Globalization and the State, Vol. I, 30-43, Globalization and the State, Vol. II, 102-8). The assumed goal of OPSR is protecting depositors, investors, output and employment from failures in banking and financial markets. Financial crises are considered as the most important market failure, which is processed through “systemic risk.” The credit crisis allegedly originated in excessive risk taking by finance professionals who generated short-term profits to appropriate “irresponsible” compensation in bonuses and stock options. The failure of Lehman Bros in September 2008 affected the ability of other financial companies such as American International Group (AIG) and Citigroup to finance their positions in the market. Systemic effects paralyzed counterparty credit in multiple segments of financial markets, causing illiquidity of large companies and the collapse of their stock prices that prevented the raising of new capital. The government was forced into bailing out failing companies by equity infusions through the Troubled Assets Relief Program (TARP), which eventually restored confidence in financial markets.
Professor Alan H. Meltzer, the author of the three-volume magnum opus A History of the Federal Reserve (http://www.amazon.com/s/ref=nb_sb_noss?url=search-alias%3Dstripbooks&field-keywords=%22Alan+H+Meltzer%22 ), stated in testimony to the House Financial Services Committee on Mar 17 that the official interpretation ignores “the government’s disastrous mortgage and housing policy. Without the policies followed by Fannie Mae, Freddie Mac and the destructive changes in government housing and mortgage policies, the crisis would not have happened” (http://www.house.gov/apps/list/hearing/financialsvcs_dem/meltzer.pdf ). OPSR is based on the Nirvana fallacy. This fallacy consists of identifying imperfections in actual markets while attributing to the government omniscience in observing imperfections in markets and omnipotence in always correcting them with textbook precision for an improvement in social welfare (cited in Pelaez and Pelaez, Globalization and the State, Vol. I, 133-7, 201, Government Intervention in Globalization, 81, Regulation of Banks and Finance, 18, Financial Regulation after the Global Recession, 11). OPSR finds alleged imperfections in behavior of consumers, investors and financial markets and institutions that can be cured in all cases by errorless regulation. The New Institutional Economics (NIE) argues that both markets and regulation can fail (Oliver Williamson cited in Pelaez and Pelaez, Globalization and the State, Vol. I, 137-43). Professor Meltzer provides an interpretation closer to reality: “The market is not perfect. It is run by humans, who make mistakes. They should pay for them. But the same humans run government where they make different, often more costly mistakes for which the public pays.” On Mar 19, the former Chairman of the Board of Governors of the Federal Reserve Alan Greenspan stated at the Brookings Institution: “Another factor contributing to the surge in demand was the heavy purchases of subprime securities by Fannie Mae and Freddie Mac, the major US Government Sponsored Enterprises (GSE). Pressed by the Department of Housing and Urban Development and the Congress to expand ‘affordable housing commitments,’ they chose to meet them by investing heavily in subprime securities. The firms accounted for an estimated 40 percent of all subprime mortgage securities (almost all adjustable rate), newly purchased and retained on investor’s balance sheets during 2003 and 2004” (http://www.brookings.edu/~/media/Files/Programs/ES/BPEA/2010_spring_bpea_papers/spring2010_greenspan.pdf ). In the comments at Brookings on the Greenspan essay, Professor N. Gregory Mankiw concurs: “While neither Alan nor I would suggest that the current crisis is primarily the result of misguided housing policies, we both believe that these policies served to make a bad situation worse. We should be mindful of how imperfect the political process is” (http://gregmankiw.blogspot.com/2010/03/comments-on-alan-greenspans-crisis.html ).
The credit/dollar crisis and global recession originated in four almost contemporaneous policies that stimulated excessive construction and high real estate prices, highly-leveraged risky financial exposures, unsound credit and low liquidity (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4): (1) the interruption of auctions of the 30-year Treasury in 2001-2005 that caused purchases of mortgage-backed securities (MBS) equivalent to a reduction in mortgage rates; (2) the reduction of the fed funds rate by the Fed to 1 percent and its maintenance at that level between Jun 2003 and Jun 2004 with the implicit intention in the “forward guidance” of maintaining low rates indefinitely if required in avoiding “destructive deflation”; (3) the housing subsidy of $221 billion per year; and (4) the purchase or guarantee of $1.6 trillion of MBS by Fannie Mae and Freddie Mac. The combined stimuli mispriced risk, causing excessive risk and leverage as the public attempted to obtain higher returns on savings. The increase of the fed funds rate by 25 basis points per meeting of the Federal Open Market Committee from Jun 2004 to Jun 2006 raised the fed funds rate from 1 percent to 5.25 percent around the time that house prices peaked. The response of the Fed to the credit/dollar crisis was the reduction of the fed funds rate from 5.25 in Sep 2007 to 0 – ¼ percent in Dec 2008 without any subsequent change.
OPSR fails to balance roles of regulation and innovation in promoting financial functions. The approach of functional structural finance (FSF) of Professors Robert Merton and Zvi Bodie warns against frustrating financial innovation because of the adverse impact on the efficiency of the economy and growth (cited in Pelaez and Pelaez, Regulation of Banks and Finance, 234-6, Financial Regulation after the Global Recession, 34-7). Prudence instead of rush to taxation and regulation would be advisable to permit the adequate provision of banking and financial functions required for optimum allocation of resources that can move the economy to full employment. Financial stability has never been legislated or regulated but financial functions can be restricted by laws and regulation.
Consumer Financial Protection Bureau. The need for change here according to the Financial Stability Act is because “the economic crisis was driven by an across-the-board failure to protect consumers” (http://banking.senate.gov/public/_files/FinancialReformSummary231510FINAL.pdf ). The proposed solution is to politicize consumer credit by creating an agency inside the Fed “led by an independent director appointed by the President and confirmed by the Senate.” The result is likely to be higher interest rates and lower volumes of available credit as shown by the CARD (Credit Card Accountability, Responsibility and Disclosure) Act of May 2009 and subsequently by lower growth and employment creation. Investors will withdraw funds from financial institutions engaged in consumer credit, reducing banks’ equity capital required for lending. The consumer will be harmed instead of protected. In testimony to the House on Mar 17, Professor Anil K. Kashyap advised: “I want to reiterate the Squam Lake Working Group’s recommendation to get the Fed out of the business of consumer protection” ((http://www.house.gov/apps/list/hearing/financialsvcs_dem/kashyap.pdf http://www.squamlakeworkinggroup.org/ ). The argument may be technically correct but the alternative politicized independent agency may even be worst in practice.
Financial Stability Oversight Council. The need for this new agency according to the Financial Stability Act is “identifying, monitoring and addressing systemic risks posed by large, complex financial firms as well as products and activities that spread risk across firms.” Professor Meltzer provides criticism in his testimony of Mar 17: “Setting up an agency to prevent systemic risk without a precise, operational definition is just another way to pick the public’s purse. Systemic risk will forever remain in the eye of the viewer. Instead of shifting losses onto those that caused them, systemic risk regulation will continue to transfer cost to the taxpayers.” In criticism of appointing the Secretary of the Treasury as chairman of the systemic risk council Professor Meltzer reminds: “Treasury Secretaries are the officials who authorized all or most of the bailouts since bailouts began.” The Financial Stability Act has here also a proposal that withdraws authority from an independent, technical institution, the Federal Reserve System, to replace it with a politicized new agency that will never develop the professional expertise of the Fed. Professor Kashyap argues that: “No one thinks that it is possible, let alone responsible, to have a modern economy without a lender of last resort for financial firms. Likewise, a lender of last resort has to be able to provide liquidity on demand, and hence the central bank is the only credible lender of last resort.” The Swam Lake Working Group identifies the Fed as the location for the systemic regulator: “One regulatory organization in each country should be responsible for overseeing the health and stability of the overall financial system. We argue that the central bank should be charged with this important new responsibility” (http://www.squamlakeworkinggroup.org/ ).
Fed Role in Regulation/Supervision. Expert advice on the need of the supervisory information for monetary policy is equivocal. Professor Meltzer analyzes multiple institutional arrangements, such as the Financial Services Authority (FSA), concluding none has been effective in regulating systemic risk: “A main reason is that large permanent changes are difficult to foresee and even harder to act against in a timely way.” In compelling testimony to the House on Mar 17 Professor Kashyap concludes that “stripping the Fed of its role in bank supervision would be a step in the wrong direction” The Fed has relied on the information obtained in its supervisory functions to design and implement policy in a form of economies of scope (Ben Bernanke cited in Regulation of Banks and Finance, 100). Relocation of Fed supervision may weaken overall supervision, preventing the Fed from obtaining information for its policy decisions. There is here also the wasteful relocation of a function that has been performed technically by the Fed to a more politicized agency that has to start from scratch with higher costs to taxpayers and consumers of financial services. The case by Chairman Bernanke for maintaining the role of the Fed in regulation/supervision of banks is strong (http://www.federalreserve.gov/newsevents/speech/bernanke20100320a.htm ).
Proprietary Trading. There was not a single case of a bank that experienced problems because of proprietary trading, hedge funds or funds of private equity. Banks would become more vulnerable by restricting their diversification and diminishing their international competitiveness.
The week was rich in short-term indicators confirming the “nascent economic recovery” ((http://www.federalreserve.gov/newsevents/testimony/bernanke20100224a.htm ). Industrial production increased only 0.1 percent in Feb compared with 0.9 percent in Jan and capacity utilization was still depressed at 72.7 percent just barely up from 72.6 percent in Jan. The important change in the 12 months ending in Feb 2010 is an increase of 1.7 percent for the total index and 1.5 percent for manufacturing (http://www.federalreserve.gov/releases/g17/Current/default.htm ). Housing recovery may be slow and prolonged. In Jan 2006, housing starts in the US were at an annual rate of 2265 thousand (http://www.census.gov/const/newresconst_200701.pdf ). In Feb 2010 housing starts were at an annual rate of 575 thousand (http://www.census.gov/const/newresconst_201002.pdf ). The producer price index (PPI) declined by 0.6 percent in Feb but increased by 4.6 percent relative to a year earlier. The core PPI increased by only 0.1 percent in Feb and by 0.9 percent relative to a year earlier (http://www.bls.gov/news.release/pdf/ppi.pdf ). There are no evident immediate threats of inflation. The consumer price index (CPI) did not change in Feb and was up by 2.2 percent relative to a year earlier with 0.1 percent increase in the core CPI and 1.3 percent in a year (http://www.bls.gov/news.release/pdf/cpi.pdf ). Initial jobless claims declined by 5000 to 457,000 in the week ending Mar 13 and the four-week moving average declined by 4250 to 471,250 (http://www.dol.gov/opa/media/press/eta/ui/current.htm ). Recovery of the job creation impulse will coincide with initial jobless claims of around 350,000. The US current account deficit increased to $115.6 billion in the fourth quarter of 2009 from $102.3 billion in the prior quarter. For the entire year of 2009, the current account deficit of the US was $419.9 billion, much lower than $706.1 billion in 2008 and the lowest since 2001 (http://www.bea.gov/newsreleases/international/transactions/transnewsrelease.htm ). The current lower external imbalance of the US raises questions of whether it will increase in the expansion phase of the economy as it did before (Pelaez and Pelaez, The Global Recession Risk, Globalization and the State, Vol. II, 182-90). The currency tensions with China and the need to grow international trade in an improving but weak world economy raise the possibility of regulatory, trade and investment frictions (Pelaez and Pelaez, Government Intervention in Globalization).
The Federal Open Market Committee (FOMC) decided on Mar 16 to maintain the target range of the fed funds rate at 0 to ¼ percent, advising that economic conditions such as resource slack, restrained inflation trends and stability of inflation expectations warrant low fed funds rates for “an extended period” (http://www.federalreserve.gov/newsevents/press/monetary/20100316a.htm ). The yield curve continues to be J-shaped with percentage annual yields of: 0.16 3-months, 0.42 1-year, 1.02 2-years, 2.48 5-years, 3.70 10-years and 4.58 30-years (http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml ). There are two threats of jumps and twists of this abnormal yield curve. First, the Fed holds a portfolio of $709 billion of Treasury notes and bonds, $1066 billion of mortgage-backed securities and $167 billion of federal agency securities for total of $1.9 trillion with excess reserve balances of $1115 billion and $75 billion in the Treasury supplementary financing account in the road to $200 billion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ). Second, budget deficits are proposed by the executive at $1.5 trillion in 2010, or 10.3 percent of GDP, and $1.3 trillion in 2011, or 8.9 percent of GDP (http://cboblog.cbo.gov/?p=482 ). The budget proposal of the executive would increase the federal debt from $7.5 trillion at the end of 2009, or 54 percent of GDP, to $20.3 trillion at the end of 2020, or 90 percent of GDP. Sharp increases in long-term interest rates caused by unwinding the Fed portfolio of securities, financing budget deficits and refinancing maturing debt threaten the expansion path of the economy and recovery of full employment. Efforts resolving this immediate employment situation are far more opportune than regulatory exercises with delayed implementation. The agenda is jobs. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)
Carlos M Pelaez
The Senate Banking Committee released the proposal for financial regulation in the form of a bill for Restoring American Financial Stability or Financial Stability Act (http://banking.senate.gov/public/ ). The most important aspects of this proposal are analyzed below: origins of the credit/dollar crisis, consumer protection, systemic risk oversight, Fed role in regulation/supervision and proprietary trading. The remainder of this post considers short-term economic indicators and Fed policy, which are more important to US welfare.
Origins of the Crisis. The intent of the Financial Act reveals the interpretation of the crisis: “to promote the financial stability of the United States by improving accountability and transparency in the financial system” (http://banking.senate.gov/public/_files/ChairmansMark31510AYO10306_xmlFinancialReformLegislationBill.pdf ). The proposals emanating from government follow Official Prudential and Systemic Regulation (OPSR) (Pelaez and Pelaez, Financial Regulation after the Global Recession, 30-4, Regulation of Banks and Finance, 217-24, International Financial Architecture, 101-60, Government Intervention in Globalization, 31-7, Globalization and the State, Vol. I, 30-43, Globalization and the State, Vol. II, 102-8). The assumed goal of OPSR is protecting depositors, investors, output and employment from failures in banking and financial markets. Financial crises are considered as the most important market failure, which is processed through “systemic risk.” The credit crisis allegedly originated in excessive risk taking by finance professionals who generated short-term profits to appropriate “irresponsible” compensation in bonuses and stock options. The failure of Lehman Bros in September 2008 affected the ability of other financial companies such as American International Group (AIG) and Citigroup to finance their positions in the market. Systemic effects paralyzed counterparty credit in multiple segments of financial markets, causing illiquidity of large companies and the collapse of their stock prices that prevented the raising of new capital. The government was forced into bailing out failing companies by equity infusions through the Troubled Assets Relief Program (TARP), which eventually restored confidence in financial markets.
Professor Alan H. Meltzer, the author of the three-volume magnum opus A History of the Federal Reserve (http://www.amazon.com/s/ref=nb_sb_noss?url=search-alias%3Dstripbooks&field-keywords=%22Alan+H+Meltzer%22 ), stated in testimony to the House Financial Services Committee on Mar 17 that the official interpretation ignores “the government’s disastrous mortgage and housing policy. Without the policies followed by Fannie Mae, Freddie Mac and the destructive changes in government housing and mortgage policies, the crisis would not have happened” (http://www.house.gov/apps/list/hearing/financialsvcs_dem/meltzer.pdf ). OPSR is based on the Nirvana fallacy. This fallacy consists of identifying imperfections in actual markets while attributing to the government omniscience in observing imperfections in markets and omnipotence in always correcting them with textbook precision for an improvement in social welfare (cited in Pelaez and Pelaez, Globalization and the State, Vol. I, 133-7, 201, Government Intervention in Globalization, 81, Regulation of Banks and Finance, 18, Financial Regulation after the Global Recession, 11). OPSR finds alleged imperfections in behavior of consumers, investors and financial markets and institutions that can be cured in all cases by errorless regulation. The New Institutional Economics (NIE) argues that both markets and regulation can fail (Oliver Williamson cited in Pelaez and Pelaez, Globalization and the State, Vol. I, 137-43). Professor Meltzer provides an interpretation closer to reality: “The market is not perfect. It is run by humans, who make mistakes. They should pay for them. But the same humans run government where they make different, often more costly mistakes for which the public pays.” On Mar 19, the former Chairman of the Board of Governors of the Federal Reserve Alan Greenspan stated at the Brookings Institution: “Another factor contributing to the surge in demand was the heavy purchases of subprime securities by Fannie Mae and Freddie Mac, the major US Government Sponsored Enterprises (GSE). Pressed by the Department of Housing and Urban Development and the Congress to expand ‘affordable housing commitments,’ they chose to meet them by investing heavily in subprime securities. The firms accounted for an estimated 40 percent of all subprime mortgage securities (almost all adjustable rate), newly purchased and retained on investor’s balance sheets during 2003 and 2004” (http://www.brookings.edu/~/media/Files/Programs/ES/BPEA/2010_spring_bpea_papers/spring2010_greenspan.pdf ). In the comments at Brookings on the Greenspan essay, Professor N. Gregory Mankiw concurs: “While neither Alan nor I would suggest that the current crisis is primarily the result of misguided housing policies, we both believe that these policies served to make a bad situation worse. We should be mindful of how imperfect the political process is” (http://gregmankiw.blogspot.com/2010/03/comments-on-alan-greenspans-crisis.html ).
The credit/dollar crisis and global recession originated in four almost contemporaneous policies that stimulated excessive construction and high real estate prices, highly-leveraged risky financial exposures, unsound credit and low liquidity (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4): (1) the interruption of auctions of the 30-year Treasury in 2001-2005 that caused purchases of mortgage-backed securities (MBS) equivalent to a reduction in mortgage rates; (2) the reduction of the fed funds rate by the Fed to 1 percent and its maintenance at that level between Jun 2003 and Jun 2004 with the implicit intention in the “forward guidance” of maintaining low rates indefinitely if required in avoiding “destructive deflation”; (3) the housing subsidy of $221 billion per year; and (4) the purchase or guarantee of $1.6 trillion of MBS by Fannie Mae and Freddie Mac. The combined stimuli mispriced risk, causing excessive risk and leverage as the public attempted to obtain higher returns on savings. The increase of the fed funds rate by 25 basis points per meeting of the Federal Open Market Committee from Jun 2004 to Jun 2006 raised the fed funds rate from 1 percent to 5.25 percent around the time that house prices peaked. The response of the Fed to the credit/dollar crisis was the reduction of the fed funds rate from 5.25 in Sep 2007 to 0 – ¼ percent in Dec 2008 without any subsequent change.
OPSR fails to balance roles of regulation and innovation in promoting financial functions. The approach of functional structural finance (FSF) of Professors Robert Merton and Zvi Bodie warns against frustrating financial innovation because of the adverse impact on the efficiency of the economy and growth (cited in Pelaez and Pelaez, Regulation of Banks and Finance, 234-6, Financial Regulation after the Global Recession, 34-7). Prudence instead of rush to taxation and regulation would be advisable to permit the adequate provision of banking and financial functions required for optimum allocation of resources that can move the economy to full employment. Financial stability has never been legislated or regulated but financial functions can be restricted by laws and regulation.
Consumer Financial Protection Bureau. The need for change here according to the Financial Stability Act is because “the economic crisis was driven by an across-the-board failure to protect consumers” (http://banking.senate.gov/public/_files/FinancialReformSummary231510FINAL.pdf ). The proposed solution is to politicize consumer credit by creating an agency inside the Fed “led by an independent director appointed by the President and confirmed by the Senate.” The result is likely to be higher interest rates and lower volumes of available credit as shown by the CARD (Credit Card Accountability, Responsibility and Disclosure) Act of May 2009 and subsequently by lower growth and employment creation. Investors will withdraw funds from financial institutions engaged in consumer credit, reducing banks’ equity capital required for lending. The consumer will be harmed instead of protected. In testimony to the House on Mar 17, Professor Anil K. Kashyap advised: “I want to reiterate the Squam Lake Working Group’s recommendation to get the Fed out of the business of consumer protection” ((http://www.house.gov/apps/list/hearing/financialsvcs_dem/kashyap.pdf http://www.squamlakeworkinggroup.org/ ). The argument may be technically correct but the alternative politicized independent agency may even be worst in practice.
Financial Stability Oversight Council. The need for this new agency according to the Financial Stability Act is “identifying, monitoring and addressing systemic risks posed by large, complex financial firms as well as products and activities that spread risk across firms.” Professor Meltzer provides criticism in his testimony of Mar 17: “Setting up an agency to prevent systemic risk without a precise, operational definition is just another way to pick the public’s purse. Systemic risk will forever remain in the eye of the viewer. Instead of shifting losses onto those that caused them, systemic risk regulation will continue to transfer cost to the taxpayers.” In criticism of appointing the Secretary of the Treasury as chairman of the systemic risk council Professor Meltzer reminds: “Treasury Secretaries are the officials who authorized all or most of the bailouts since bailouts began.” The Financial Stability Act has here also a proposal that withdraws authority from an independent, technical institution, the Federal Reserve System, to replace it with a politicized new agency that will never develop the professional expertise of the Fed. Professor Kashyap argues that: “No one thinks that it is possible, let alone responsible, to have a modern economy without a lender of last resort for financial firms. Likewise, a lender of last resort has to be able to provide liquidity on demand, and hence the central bank is the only credible lender of last resort.” The Swam Lake Working Group identifies the Fed as the location for the systemic regulator: “One regulatory organization in each country should be responsible for overseeing the health and stability of the overall financial system. We argue that the central bank should be charged with this important new responsibility” (http://www.squamlakeworkinggroup.org/ ).
Fed Role in Regulation/Supervision. Expert advice on the need of the supervisory information for monetary policy is equivocal. Professor Meltzer analyzes multiple institutional arrangements, such as the Financial Services Authority (FSA), concluding none has been effective in regulating systemic risk: “A main reason is that large permanent changes are difficult to foresee and even harder to act against in a timely way.” In compelling testimony to the House on Mar 17 Professor Kashyap concludes that “stripping the Fed of its role in bank supervision would be a step in the wrong direction” The Fed has relied on the information obtained in its supervisory functions to design and implement policy in a form of economies of scope (Ben Bernanke cited in Regulation of Banks and Finance, 100). Relocation of Fed supervision may weaken overall supervision, preventing the Fed from obtaining information for its policy decisions. There is here also the wasteful relocation of a function that has been performed technically by the Fed to a more politicized agency that has to start from scratch with higher costs to taxpayers and consumers of financial services. The case by Chairman Bernanke for maintaining the role of the Fed in regulation/supervision of banks is strong (http://www.federalreserve.gov/newsevents/speech/bernanke20100320a.htm ).
Proprietary Trading. There was not a single case of a bank that experienced problems because of proprietary trading, hedge funds or funds of private equity. Banks would become more vulnerable by restricting their diversification and diminishing their international competitiveness.
The week was rich in short-term indicators confirming the “nascent economic recovery” ((http://www.federalreserve.gov/newsevents/testimony/bernanke20100224a.htm ). Industrial production increased only 0.1 percent in Feb compared with 0.9 percent in Jan and capacity utilization was still depressed at 72.7 percent just barely up from 72.6 percent in Jan. The important change in the 12 months ending in Feb 2010 is an increase of 1.7 percent for the total index and 1.5 percent for manufacturing (http://www.federalreserve.gov/releases/g17/Current/default.htm ). Housing recovery may be slow and prolonged. In Jan 2006, housing starts in the US were at an annual rate of 2265 thousand (http://www.census.gov/const/newresconst_200701.pdf ). In Feb 2010 housing starts were at an annual rate of 575 thousand (http://www.census.gov/const/newresconst_201002.pdf ). The producer price index (PPI) declined by 0.6 percent in Feb but increased by 4.6 percent relative to a year earlier. The core PPI increased by only 0.1 percent in Feb and by 0.9 percent relative to a year earlier (http://www.bls.gov/news.release/pdf/ppi.pdf ). There are no evident immediate threats of inflation. The consumer price index (CPI) did not change in Feb and was up by 2.2 percent relative to a year earlier with 0.1 percent increase in the core CPI and 1.3 percent in a year (http://www.bls.gov/news.release/pdf/cpi.pdf ). Initial jobless claims declined by 5000 to 457,000 in the week ending Mar 13 and the four-week moving average declined by 4250 to 471,250 (http://www.dol.gov/opa/media/press/eta/ui/current.htm ). Recovery of the job creation impulse will coincide with initial jobless claims of around 350,000. The US current account deficit increased to $115.6 billion in the fourth quarter of 2009 from $102.3 billion in the prior quarter. For the entire year of 2009, the current account deficit of the US was $419.9 billion, much lower than $706.1 billion in 2008 and the lowest since 2001 (http://www.bea.gov/newsreleases/international/transactions/transnewsrelease.htm ). The current lower external imbalance of the US raises questions of whether it will increase in the expansion phase of the economy as it did before (Pelaez and Pelaez, The Global Recession Risk, Globalization and the State, Vol. II, 182-90). The currency tensions with China and the need to grow international trade in an improving but weak world economy raise the possibility of regulatory, trade and investment frictions (Pelaez and Pelaez, Government Intervention in Globalization).
The Federal Open Market Committee (FOMC) decided on Mar 16 to maintain the target range of the fed funds rate at 0 to ¼ percent, advising that economic conditions such as resource slack, restrained inflation trends and stability of inflation expectations warrant low fed funds rates for “an extended period” (http://www.federalreserve.gov/newsevents/press/monetary/20100316a.htm ). The yield curve continues to be J-shaped with percentage annual yields of: 0.16 3-months, 0.42 1-year, 1.02 2-years, 2.48 5-years, 3.70 10-years and 4.58 30-years (http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml ). There are two threats of jumps and twists of this abnormal yield curve. First, the Fed holds a portfolio of $709 billion of Treasury notes and bonds, $1066 billion of mortgage-backed securities and $167 billion of federal agency securities for total of $1.9 trillion with excess reserve balances of $1115 billion and $75 billion in the Treasury supplementary financing account in the road to $200 billion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ). Second, budget deficits are proposed by the executive at $1.5 trillion in 2010, or 10.3 percent of GDP, and $1.3 trillion in 2011, or 8.9 percent of GDP (http://cboblog.cbo.gov/?p=482 ). The budget proposal of the executive would increase the federal debt from $7.5 trillion at the end of 2009, or 54 percent of GDP, to $20.3 trillion at the end of 2020, or 90 percent of GDP. Sharp increases in long-term interest rates caused by unwinding the Fed portfolio of securities, financing budget deficits and refinancing maturing debt threaten the expansion path of the economy and recovery of full employment. Efforts resolving this immediate employment situation are far more opportune than regulatory exercises with delayed implementation. The agenda is jobs. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)
Sunday, March 14, 2010
Dumping of Bond Duration and the Life Expectancy of the United States “Nascent Economic Recovery”
Carlos M Pelaez
The objective of this post is to analyze two critical threats to the longevity of the so-called “nascent economic recovery” of the United States: (1) the J-shaped yield curve; and (2) the combination of expansive fiscal and monetary policies. Rising long-term interest rates, with adverse effects on innovation, productivity, wages, investment and employment, may be driven by fiscal profligacy instead of Fed policy. The Fed is locked in $1.9 trillion holdings of long-term securities and cannot prevent the increase in the long-term segment of the yield curve caused by dumping of bond duration that will drive up all interest rates. The 10-year Treasury yield has increased from 2.86 percent on Dec 18, 2008, to 3.71 percent on Mar 12, 2010, while in the same period the 30-year Treasury yield has increased from 2.53 percent to 4.62 percent (http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield_historical_2008.shtml ) partly because of actual and expected record budget deficits and increasing public debt. The eventual unwinding of Fed holdings of securities may contribute to the rise of interest rates. Discussion below considers (I) recent releases of short-term economic indicators; (II) the J-shaped yield curve; and (III) the deteriorating fiscal environment. The concluding comments analyze the relation of private-sector borrowing costs, affecting investment, consumption, production and employment, to the interest rates on the public debt.
I, short-term indicators. The economic indicators released in the week ending on Mar 12 continue to verify the “nascent economic recovery” (http://www.federalreserve.gov/newsevents/testimony/bernanke20100224a.htm ). US exports of goods and services of $142.7 billion and imports of $180 billion resulted in a trade deficit of $37.3 billion slightly lower than the revised $39.9 billion in December. While the trade deficit increased by $0.4 billion in Jan 2010 relative to Jan 2009, exports increased by 15.1 percent and imports by 11.9 percent (http://www.census.gov/foreign-trade/Press-Release/current_press_release/ft900.pdf ). The highest deficits in trade of goods not seasonally adjusted were $18.3 billion with China and $7.2 billion with the Organization of Petroleum Exporting Countries (OPEC). Retail sales and food services increased in Feb 2010 by 0.3 percent relative to Jan and by 3.9 percent relative to Feb 2009. Retail trade sales increased by 0.3 percent in Feb 2010 relative to Jan 2010 and by 4.4 percent relative to Feb 2009 while sales of gasoline stations increased by 24.0 percent relative to Feb 2009. Total retail sales in the first two months of 2010 increased by 3.4 percent relative to the same period in 2009 while total sales excluding motor vehicles and parts increased by 3.9 percent (http://www.census.gov/retail/marts/www/marts_current.pdf ). Business inventories were unchanged in Jan 2010 relative to Dec 2009, declining by 8.6 percent relative to Jan 2009. The total business inventories/sales ratio was 1.25 at the end of Jan 2010 compared with 1.46 in Jan 2009 (http://www.census.gov/mtis/www/data/pdf/mtis_current.pdf ). The Reuters/University of Michigan consumer confidence index preliminary estimate declined to 72.5 in Mar from a final reading of 73.6 in Feb (http://www.bloomberg.com/apps/news?pid=20601068&sid=atQQZ7eI3Ylc ). Seasonally adjusted unemployment insurance claims declined by 6,000 to 468,000 in the week ending on Mar 6 and the less volatile four-week average was 475,000, increasing by 5000 from the previous week’s revised average of 470,500 (http://www.dol.gov/opa/media/press/eta/ui/current.htm ). In short, increases in sales and reductions of inventories point to continuing recovery while job creation is not yet dynamic.
II, the J-shaped yield curve. On Mar 5, 2005, the percentage yields per year of Treasury securities were: 3-months 2.76, 2-years 3.73, 5-years 4.22, 10-years 4.56 and 20-years 4.93. The difference between the 10-year note and the 3-month bill was 89 basis points. The yield curve had the upward slope typical of expansions after six months of 25 basis points increases in the target of fed funds decided in meetings of the Federal Open Market Committee (FOMC). On Mar 12, 2010, the percentage yields per year of Treasury securities were: 3-months 0.15, 2-years 0.97, 5-years 2.42, 10-years 3.71 and 30-years 4.62 (http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml ). The difference between the 20-year Treasury and the 3-month bill on Mar 5, 2005 was 217 basis points (bp) while the difference between the 30-year and the 2-year Treasury on Mar 12, 2010 was 365 bp and 447 bp relative to the 3-month bill. Part of the Fed strategy may be to encourage portfolios holding long-end Treasury notes, providing more attractive yield than the 2-year note, with the objective of containing the pressure on the long-end segment of the yield curve. The J-shaped yield curve originated in the lowering toward zero of the fed funds rate with the FOMC target of 0 to ¼ percent since Dec 2008. The pressure of probable capital losses in holding long-term Treasury securities because of the actual and expected budget deficit and public debt is stronger than the Fed encouragement by maintaining the differential yield between 2-year and 10-year Treasury notes.
The credit/dollar crisis and global recession originated in four almost contemporaneous policies that stimulated excessive construction and high real estate prices, highly-leveraged risky financial exposures, unsound credit and low liquidity: (1) the interruption of auctions of the 30-year Treasury in 2001-2005 that caused purchases of mortgage-backed securities (MBS) equivalent to a reduction in mortgage rates; (2) the reduction of the fed funds rate by the Fed to 1 percent and its maintenance at that level between Jun 2003 and Jun 2004 with the implicit intention in the “forward guidance” of maintaining low rates indefinitely if required in avoiding “destructive deflation”; (3) the housing subsidy of $221 billion per year; and (4) the purchase or guarantee of $1.6 trillion of nonprime mortgage-backed securities by Fannie Mae and Freddie Mac (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). The combined stimuli mispriced risk, causing excessively risky and highly-leveraged exposures as the public attempted to obtain higher returns on savings. The increase of the fed funds rate by 25 basis points per meeting of the FOMC from Jun 2004 to Jun 2006 raised the fed funds rate from 1 percent to 5.25 percent around the time that house prices peaked. The response of the Fed to the credit/dollar crisis was the reduction of the fed funds rate from 5.25 in Sep 2007 to 0 – ¼ percent in Dec 2008 without any subsequent change. The Fed faces an even more difficult challenge in the current environment than in 2004 because the Fed balance sheet increased by 115.7 percent from $855.1 billion in February 2008 to $1844.9 billion in February 2009 (Pelaez and Pelaez, Regulation of Banks and Finance, 225-6, Financial Regulation after the Global Recession, 158-9). The Fed balance sheet for the week ending Mar 10, 2010, lists holdings of $1029 billion of MBS, $709 billion of Treasury notes and bonds and $169 billion of Federal agency securities for a combined portfolio of long-term securities of $1.9 trillion; the balance sheet has $1188 billion of excess reserve balances deposited at the Fed and now $50 billion in the supplementary financing account that will grow to $200 billion in weekly additions of $25 billion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ).
The critical issue of monetary policy is unwinding the Fed’s portfolio of $1.9 trillion of long-term securities and returning excess reserves to banks without interest rate shocks that could cut short the life of the “nascent recovery.” The Fed has been considering and testing six policies of exiting the monetary stimulus. The paths of increasing interest rates in the two past cyclical upswings have not been without turmoil. First, stress tests of banks use parameters of the bond market crash in 1994, which started in the US by the tightening of the fed funds rate from 3.00 percent in Feb 1994 to 6.0 percent in Dec 1994 (Pelaez and Pelaez, International Financial Architecture, 114-5, The Global Recession Risk, 206-7). The yield of the US 30-year Treasury bond increased by 150 basis points, causing declines in bond prices because increases of yields of 100 basis points caused declines of prices of 13 percent, which were magnified by typical leverage of 10:1. There was an increase in 30-year mortgage rates of 200 basis points that caused the loss of most of the value in some funds of MBS. Second, the increase of fed funds targets by 25 bp during 17 consecutive meetings of the FOMC from Jun 2005 to Jun 2006 (http://www.federalreserve.gov/fomc/fundsrate.htm ) increased monthly payments of mortgages, which were originally lent and borrowed on the belief induced by Fed policy that interest rates would remain low indefinitely, maintaining real estate and asset values. The rate increase caused collapse of real estate values and mortgage defaults. There are multiple alternatives of Fed tightening of interest rates between the two extremes in 1994 and 2004-2006. A major risk is that almost any change in policy stand could trigger expectations that could cause sharp overshooting of interest rates because tightening occurs now from zero interest rates. Record budget deficits and growing federal debt toward 90 percent of GDP constitute an even more important restriction of Fed policy, which is entirely out of its control.
Third, the budget deficit and government debt. The estimated federal budget deficit by the Congressional Budget Office in the first five months of 2010 is $655 billion, which exceeds the deficit in the same period in 2009 by $65 billion (http://cboblog.cbo.gov/?p=480 ). Spending adjusted for shifts in payment dates increased by $188 billion in the first five months of the fiscal year or 14 percent. Revenue declined by 7 percent or $65 billion. The budget proposal results in record deficits of $1.5 trillion in 2010, or 10.3 percent of GDP, and $1.3 trillion in 2011, or 8.9 percent of GDP (http://cboblog.cbo.gov/?p=482 ). The budget proposal of the executive would increase the federal debt from $7.5 trillion at the end of 2009, or 54 percent of GDP, to $20.3 trillion at the end of 2020, or 90 percent of GDP.
An important release is the Fed’s Flow of Funds Accounts of the United States (http://www.federalreserve.gov/releases/z1/Current/z1.pdf ). The net worth of US households, measured as the difference between assets and liabilities, was estimated at $54.2 trillion at the end of the fourth quarter of 2009, increasing by $0.7 trillion relative to the third quarter. In 2009, household net worth of the US increased by $2.8 trillion. Domestic debt of the nonfinancial sector increased in 2009 by 3.25 percent around 2.5 percentage points less than the rate of growth in 2008. The domestic nonfinancial debt outstanding in the US was $34.7 trillion at the end of the fourth quarter of 2009 distributed as: $13.5 trillion by households, $11.0 trillion by business and $10.2 trillion by government. The growth rate of 3.25 percent of the total domestic nonfinancial debt of the US in 2009 differed significantly by components: -1.7 percent for households, -1.8 percent for business, 4.8 percent for state and local government and 22.7 percent for the federal government. The private sector reduced debt while government increased debt sharply.
For the week ending on Mar 5, 2010, the Fed provides the following percent per year rates and yields: 3-month CD 0.20, 3-month Eurodollar deposit 0.40, 2-year interest rate swap 1.08, Aaa corporate bond 5.24, Baa corporate bond 6.26, state and local bonds 4.36 and conventional mortgage 5.05 (http://www.federalreserve.gov/releases/h15/current/h15.htm ). Treasury securities provide the universal benchmark of securities because they are free of credit risk but not of price or rate risk. The same institution that issues the securities, the government, prints the money paid at redemption, that is, the government never runs out of money with which to pay the debt. Moreover, the dollar continues to be the currency used as reserves by other countries. Thus, yields of private securities are quoted as spreads relative to the yield of the Treasury security with similar maturity. The spreads over Treasury of privately-issued securities are positive because the issuers do not have the power of creating legal tender in redeeming debt. The increase in interest rates of bills and notes of the Treasury will raise all other interest rates of equivalent maturity not only in the US but also likely in other regions overseas.
The conventional analysis of anticipating the Fed’s decision on interest rate tightening because of inflation, economic recovery or improving job markets may be inapplicable in the current environment. Under the FOMC zero interest rate target and the two trillion dollar quantitative easing, the 10-year Treasury yield has increased from 2.86 percent on Dec 18, 2008, to 3.71 percent on Mar 12, 2010, while in the same period the 30-year Treasury yield has increased from 2.53 percent to 4.62 percent (http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield_historical_2008.shtml ). The rise in long-term yields may be partly pushed by the “nascent recovery” as in past expansions but will be increasingly driven by the financing of record budget deficits and refinancing of increasing maturing debt while command of resources transfers from private economic activity to government spending with likely adverse impact on future innovation, productivity, wages, investment, growth and employment. Fiscal deficits and debt/GDP ratios are commonly underestimated. Profligate fiscal attitudes need to be replaced by credible and transparent measures that reverse the budget deficit and debt/GDP ratio. Failure to reverse budget deficits and rising trends of the ratio of debt to GDP will increase long-term interest rates as investors reduce their holdings of Treasury notes and bonds in fear of decline in their prices. The Fed may attempt to maintain short-term interest rates near zero but long-term interest rates will rise as a result of dumping of bond duration. Capital budgeting decisions by the private sector will be frustrated by the inability of matching rates of cash inflows obtained from long gestation projects with equivalent long-term debt cash outflows at costs of borrowing that result in positive net present value. At some point taxes will increase and government expenditure will contract after shock waves created by the premature end of the nascent recovery without sufficient creation of new jobs for full employment. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)
Carlos M Pelaez
The objective of this post is to analyze two critical threats to the longevity of the so-called “nascent economic recovery” of the United States: (1) the J-shaped yield curve; and (2) the combination of expansive fiscal and monetary policies. Rising long-term interest rates, with adverse effects on innovation, productivity, wages, investment and employment, may be driven by fiscal profligacy instead of Fed policy. The Fed is locked in $1.9 trillion holdings of long-term securities and cannot prevent the increase in the long-term segment of the yield curve caused by dumping of bond duration that will drive up all interest rates. The 10-year Treasury yield has increased from 2.86 percent on Dec 18, 2008, to 3.71 percent on Mar 12, 2010, while in the same period the 30-year Treasury yield has increased from 2.53 percent to 4.62 percent (http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield_historical_2008.shtml ) partly because of actual and expected record budget deficits and increasing public debt. The eventual unwinding of Fed holdings of securities may contribute to the rise of interest rates. Discussion below considers (I) recent releases of short-term economic indicators; (II) the J-shaped yield curve; and (III) the deteriorating fiscal environment. The concluding comments analyze the relation of private-sector borrowing costs, affecting investment, consumption, production and employment, to the interest rates on the public debt.
I, short-term indicators. The economic indicators released in the week ending on Mar 12 continue to verify the “nascent economic recovery” (http://www.federalreserve.gov/newsevents/testimony/bernanke20100224a.htm ). US exports of goods and services of $142.7 billion and imports of $180 billion resulted in a trade deficit of $37.3 billion slightly lower than the revised $39.9 billion in December. While the trade deficit increased by $0.4 billion in Jan 2010 relative to Jan 2009, exports increased by 15.1 percent and imports by 11.9 percent (http://www.census.gov/foreign-trade/Press-Release/current_press_release/ft900.pdf ). The highest deficits in trade of goods not seasonally adjusted were $18.3 billion with China and $7.2 billion with the Organization of Petroleum Exporting Countries (OPEC). Retail sales and food services increased in Feb 2010 by 0.3 percent relative to Jan and by 3.9 percent relative to Feb 2009. Retail trade sales increased by 0.3 percent in Feb 2010 relative to Jan 2010 and by 4.4 percent relative to Feb 2009 while sales of gasoline stations increased by 24.0 percent relative to Feb 2009. Total retail sales in the first two months of 2010 increased by 3.4 percent relative to the same period in 2009 while total sales excluding motor vehicles and parts increased by 3.9 percent (http://www.census.gov/retail/marts/www/marts_current.pdf ). Business inventories were unchanged in Jan 2010 relative to Dec 2009, declining by 8.6 percent relative to Jan 2009. The total business inventories/sales ratio was 1.25 at the end of Jan 2010 compared with 1.46 in Jan 2009 (http://www.census.gov/mtis/www/data/pdf/mtis_current.pdf ). The Reuters/University of Michigan consumer confidence index preliminary estimate declined to 72.5 in Mar from a final reading of 73.6 in Feb (http://www.bloomberg.com/apps/news?pid=20601068&sid=atQQZ7eI3Ylc ). Seasonally adjusted unemployment insurance claims declined by 6,000 to 468,000 in the week ending on Mar 6 and the less volatile four-week average was 475,000, increasing by 5000 from the previous week’s revised average of 470,500 (http://www.dol.gov/opa/media/press/eta/ui/current.htm ). In short, increases in sales and reductions of inventories point to continuing recovery while job creation is not yet dynamic.
II, the J-shaped yield curve. On Mar 5, 2005, the percentage yields per year of Treasury securities were: 3-months 2.76, 2-years 3.73, 5-years 4.22, 10-years 4.56 and 20-years 4.93. The difference between the 10-year note and the 3-month bill was 89 basis points. The yield curve had the upward slope typical of expansions after six months of 25 basis points increases in the target of fed funds decided in meetings of the Federal Open Market Committee (FOMC). On Mar 12, 2010, the percentage yields per year of Treasury securities were: 3-months 0.15, 2-years 0.97, 5-years 2.42, 10-years 3.71 and 30-years 4.62 (http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml ). The difference between the 20-year Treasury and the 3-month bill on Mar 5, 2005 was 217 basis points (bp) while the difference between the 30-year and the 2-year Treasury on Mar 12, 2010 was 365 bp and 447 bp relative to the 3-month bill. Part of the Fed strategy may be to encourage portfolios holding long-end Treasury notes, providing more attractive yield than the 2-year note, with the objective of containing the pressure on the long-end segment of the yield curve. The J-shaped yield curve originated in the lowering toward zero of the fed funds rate with the FOMC target of 0 to ¼ percent since Dec 2008. The pressure of probable capital losses in holding long-term Treasury securities because of the actual and expected budget deficit and public debt is stronger than the Fed encouragement by maintaining the differential yield between 2-year and 10-year Treasury notes.
The credit/dollar crisis and global recession originated in four almost contemporaneous policies that stimulated excessive construction and high real estate prices, highly-leveraged risky financial exposures, unsound credit and low liquidity: (1) the interruption of auctions of the 30-year Treasury in 2001-2005 that caused purchases of mortgage-backed securities (MBS) equivalent to a reduction in mortgage rates; (2) the reduction of the fed funds rate by the Fed to 1 percent and its maintenance at that level between Jun 2003 and Jun 2004 with the implicit intention in the “forward guidance” of maintaining low rates indefinitely if required in avoiding “destructive deflation”; (3) the housing subsidy of $221 billion per year; and (4) the purchase or guarantee of $1.6 trillion of nonprime mortgage-backed securities by Fannie Mae and Freddie Mac (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4). The combined stimuli mispriced risk, causing excessively risky and highly-leveraged exposures as the public attempted to obtain higher returns on savings. The increase of the fed funds rate by 25 basis points per meeting of the FOMC from Jun 2004 to Jun 2006 raised the fed funds rate from 1 percent to 5.25 percent around the time that house prices peaked. The response of the Fed to the credit/dollar crisis was the reduction of the fed funds rate from 5.25 in Sep 2007 to 0 – ¼ percent in Dec 2008 without any subsequent change. The Fed faces an even more difficult challenge in the current environment than in 2004 because the Fed balance sheet increased by 115.7 percent from $855.1 billion in February 2008 to $1844.9 billion in February 2009 (Pelaez and Pelaez, Regulation of Banks and Finance, 225-6, Financial Regulation after the Global Recession, 158-9). The Fed balance sheet for the week ending Mar 10, 2010, lists holdings of $1029 billion of MBS, $709 billion of Treasury notes and bonds and $169 billion of Federal agency securities for a combined portfolio of long-term securities of $1.9 trillion; the balance sheet has $1188 billion of excess reserve balances deposited at the Fed and now $50 billion in the supplementary financing account that will grow to $200 billion in weekly additions of $25 billion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ).
The critical issue of monetary policy is unwinding the Fed’s portfolio of $1.9 trillion of long-term securities and returning excess reserves to banks without interest rate shocks that could cut short the life of the “nascent recovery.” The Fed has been considering and testing six policies of exiting the monetary stimulus. The paths of increasing interest rates in the two past cyclical upswings have not been without turmoil. First, stress tests of banks use parameters of the bond market crash in 1994, which started in the US by the tightening of the fed funds rate from 3.00 percent in Feb 1994 to 6.0 percent in Dec 1994 (Pelaez and Pelaez, International Financial Architecture, 114-5, The Global Recession Risk, 206-7). The yield of the US 30-year Treasury bond increased by 150 basis points, causing declines in bond prices because increases of yields of 100 basis points caused declines of prices of 13 percent, which were magnified by typical leverage of 10:1. There was an increase in 30-year mortgage rates of 200 basis points that caused the loss of most of the value in some funds of MBS. Second, the increase of fed funds targets by 25 bp during 17 consecutive meetings of the FOMC from Jun 2005 to Jun 2006 (http://www.federalreserve.gov/fomc/fundsrate.htm ) increased monthly payments of mortgages, which were originally lent and borrowed on the belief induced by Fed policy that interest rates would remain low indefinitely, maintaining real estate and asset values. The rate increase caused collapse of real estate values and mortgage defaults. There are multiple alternatives of Fed tightening of interest rates between the two extremes in 1994 and 2004-2006. A major risk is that almost any change in policy stand could trigger expectations that could cause sharp overshooting of interest rates because tightening occurs now from zero interest rates. Record budget deficits and growing federal debt toward 90 percent of GDP constitute an even more important restriction of Fed policy, which is entirely out of its control.
Third, the budget deficit and government debt. The estimated federal budget deficit by the Congressional Budget Office in the first five months of 2010 is $655 billion, which exceeds the deficit in the same period in 2009 by $65 billion (http://cboblog.cbo.gov/?p=480 ). Spending adjusted for shifts in payment dates increased by $188 billion in the first five months of the fiscal year or 14 percent. Revenue declined by 7 percent or $65 billion. The budget proposal results in record deficits of $1.5 trillion in 2010, or 10.3 percent of GDP, and $1.3 trillion in 2011, or 8.9 percent of GDP (http://cboblog.cbo.gov/?p=482 ). The budget proposal of the executive would increase the federal debt from $7.5 trillion at the end of 2009, or 54 percent of GDP, to $20.3 trillion at the end of 2020, or 90 percent of GDP.
An important release is the Fed’s Flow of Funds Accounts of the United States (http://www.federalreserve.gov/releases/z1/Current/z1.pdf ). The net worth of US households, measured as the difference between assets and liabilities, was estimated at $54.2 trillion at the end of the fourth quarter of 2009, increasing by $0.7 trillion relative to the third quarter. In 2009, household net worth of the US increased by $2.8 trillion. Domestic debt of the nonfinancial sector increased in 2009 by 3.25 percent around 2.5 percentage points less than the rate of growth in 2008. The domestic nonfinancial debt outstanding in the US was $34.7 trillion at the end of the fourth quarter of 2009 distributed as: $13.5 trillion by households, $11.0 trillion by business and $10.2 trillion by government. The growth rate of 3.25 percent of the total domestic nonfinancial debt of the US in 2009 differed significantly by components: -1.7 percent for households, -1.8 percent for business, 4.8 percent for state and local government and 22.7 percent for the federal government. The private sector reduced debt while government increased debt sharply.
For the week ending on Mar 5, 2010, the Fed provides the following percent per year rates and yields: 3-month CD 0.20, 3-month Eurodollar deposit 0.40, 2-year interest rate swap 1.08, Aaa corporate bond 5.24, Baa corporate bond 6.26, state and local bonds 4.36 and conventional mortgage 5.05 (http://www.federalreserve.gov/releases/h15/current/h15.htm ). Treasury securities provide the universal benchmark of securities because they are free of credit risk but not of price or rate risk. The same institution that issues the securities, the government, prints the money paid at redemption, that is, the government never runs out of money with which to pay the debt. Moreover, the dollar continues to be the currency used as reserves by other countries. Thus, yields of private securities are quoted as spreads relative to the yield of the Treasury security with similar maturity. The spreads over Treasury of privately-issued securities are positive because the issuers do not have the power of creating legal tender in redeeming debt. The increase in interest rates of bills and notes of the Treasury will raise all other interest rates of equivalent maturity not only in the US but also likely in other regions overseas.
The conventional analysis of anticipating the Fed’s decision on interest rate tightening because of inflation, economic recovery or improving job markets may be inapplicable in the current environment. Under the FOMC zero interest rate target and the two trillion dollar quantitative easing, the 10-year Treasury yield has increased from 2.86 percent on Dec 18, 2008, to 3.71 percent on Mar 12, 2010, while in the same period the 30-year Treasury yield has increased from 2.53 percent to 4.62 percent (http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield_historical_2008.shtml ). The rise in long-term yields may be partly pushed by the “nascent recovery” as in past expansions but will be increasingly driven by the financing of record budget deficits and refinancing of increasing maturing debt while command of resources transfers from private economic activity to government spending with likely adverse impact on future innovation, productivity, wages, investment, growth and employment. Fiscal deficits and debt/GDP ratios are commonly underestimated. Profligate fiscal attitudes need to be replaced by credible and transparent measures that reverse the budget deficit and debt/GDP ratio. Failure to reverse budget deficits and rising trends of the ratio of debt to GDP will increase long-term interest rates as investors reduce their holdings of Treasury notes and bonds in fear of decline in their prices. The Fed may attempt to maintain short-term interest rates near zero but long-term interest rates will rise as a result of dumping of bond duration. Capital budgeting decisions by the private sector will be frustrated by the inability of matching rates of cash inflows obtained from long gestation projects with equivalent long-term debt cash outflows at costs of borrowing that result in positive net present value. At some point taxes will increase and government expenditure will contract after shock waves created by the premature end of the nascent recovery without sufficient creation of new jobs for full employment. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)
Sunday, March 7, 2010
The Risks of Upward Jumps and Twists of the ˩-shaped Yield Curve
Carlos M Pelaez
On Jan 5, 2005, the percentage yields per year of Treasury securities were: 3-months 2.33, 2-years 3.22, 5-years 3.73, 10-years 4.29 and 20-years 4.88. The difference between the 10-year note and the 3-month bill was 89 basis points. The yield curve had the upward slope typical of expansions after six months of 25 basis points increases in the target of fed funds by the Federal Open Market Committee (FOMC). On Jan 5, 2010, the percentage yields per year of Treasury securities were: 3-months 0.15, 2-years 0.91, 5-years 2.35, 10-years 3.69 and 30-years 4.64 (http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml ). The yield curve has a sort of J shape with a near horizontal segment up to one year and then a positively sloped segment. The difference between the 10-year note and the 3-month bill is 354 basis points. The risk of future jumps and twists of the J-shaped yield curve is one of the most important aspects of monetary policy and perhaps even of the rate of growth of the economy and employment creation. The sections below analyze the origins in monetary policy of the J-shaped yield curve and its relation to the government deficit and debt and proposals for financial regulation.
I. Origins. There are three factors explaining the J-shaped yield curve. First, the Fed has lowered interest rates close to the “zero bound” in two occasions. Central banks have been aggressive in monetary policy because of the “great moderation,” or reduction in the volatility of output and inflation beginning in the 1980s and ending with the current crisis (Kenneth Rogoff cited in Pelaez and Pelaez, Regulation of Banks and Finance, 221, Globalization and the State, Vol. II, 195). Of three competing explanations, (1) structural change of the economy permitting absorption of shocks such as the oil price increases of the 1970s and 1980s, (2) macroeconomic policy and (3) luck in the form of less frequent shocks, (2) macroeconomic policy in the form of sound monetary policy may have been important in ensuring stable growth (http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2004/20040220/default.htm#fn1 ). The process of inflation targeting appeared to have provided a new paradigm for the conduct of monetary policy ensuring sustained growth of output with price stability (Pelaez and Pelaez, Regulation of Banks and Finance, 108-112, Financial Regulation after the Global Recession, 74, 84-6, International Financial Architecture, 230-7). The credit/dollar crisis and global recession originated in four almost contemporaneous policies that stimulated excessive construction and high real estate prices, highly-leveraged risky financial exposures, unsound credit and low liquidity (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4): (1) the interruption of auctions of the 30-year Treasury in 2001-2005 that caused purchases of mortgage-backed securities (MBS) equivalent to a reduction in mortgage rates; (2) the reduction of the fed funds rate by the Fed to 1 percent and its maintenance at that level between Jun 2003 and Jun 2004 with the implicit intention in the “forward guidance” of maintaining low rates indefinitely if required in avoiding “destructive deflation”; (3) the housing subsidy of $221 billion per year; and (4) the purchase or guarantee of $1.6 trillion of nonprime mortgage-backed securities by Fannie Mae and Freddie Mac. The combined stimuli mispriced risk, causing excessive risk and leverage as the public attempted to obtain higher returns on savings. The increase of the fed funds rate by 25 basis points per meeting of the Federal Open Market Committee from Jun 2004 to Jun 2006 raised the fed funds rate from 1 percent to 5.25 percent around the time that house prices peaked. The response of the Fed to the credit/dollar crisis was the reduction of the fed funds rate from 5.25 in Sep 2007 to 0 – ¼ percent in Dec 2008 without any subsequent change.
Second, the traditional tool of reducing rates was complemented by the creation of about 11 credit facilities by the Fed (Pelaez and Pelaez, Financial Regulation after the Global Recession, Table 6.3, 160-1). Abundant credit may have played a role in maintaining rates around zero in the short-dated segment of the yield curve.
Third, the Fed engaged in the policy of quantitative easing (Pelaez and Pelaez, Regulation of Banks and Finance, 224, The Global Recession Risk, 83-107). When the policy rate or fed funds rate is near the “zero bound” the Fed could expand its balance sheet by acquiring government securities, ignoring the interest rate and focusing on the volume of bank reserves (http://www.federalreserve.gov/boarddocs/speeches/2004/200401033/default.htm ). The purchase of long-term securities by the Fed could lower long-term interest rates, stimulating recovery of the economy by increasing investment. The Fed borrowed from banks by paying interest rates on excess reserves deposited by banks at the Fed and from Treasury by depositing the proceeds from the issue of short-term Treasury bills at the supplementary account of the Fed; these deposits were invested by the Fed in long-term Treasury securities, agency debt securities and MBS. The Fed balance sheet increased by 115.7 percent from $855.1 billion in February 2008 to $1844.9 billion in February 2009 (Pelaez and Pelaez, Regulation of Banks and Finance, 225-6, Financial Regulation after the Global Recession, 158-9). The Fed balance sheet for the week ending Mar 3, 2010, lists holdings of $1026 billion of MBS, $708 billion of Treasury notes and bonds and $167 billion of Federal agency securities with $1198 billion of reserve balances deposited at the Fed and now $25 billion in the supplementary financing account that will grow to $200 billion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ). At some point the Fed would sell that portfolio of about $1.8 trillion of long-term securities, causing a decrease in their prices that is equivalent to an increase in their yields. Thus, there is potential pressure on long-term interest rates by the Fed portfolio of securities.
II. Government Deficit. The Congressional Budget Office has provided preliminary analysis of the budget deficit for the next ten years that suggests pressure on US financing needs and thus rising yields of Treasury securities (http://cboblog.cbo.gov/?p=482 ). The federal government deficit in 2010 would reach $1.5 trillion or 10.3 percent of GDP and $1.3 trillion in 2011 or 8.9 percent of GDP after a deficit of 9.9 percent of GDP in 2009. The cumulative deficit between 2011 and 2020 would be $9.8 trillion. The federal debt held by the public would increase from $7.5 trillion in 2009 or 53 percent of GDP to $20.3 trillion or 90 percent of GDP. Net interest paid on the debt would quadruple, increasing from 1.4 percent of GDP in 2010 to 4.1 percent of GDP in 2020. Tax increases and rising interest rates resulting from these prodigal budgets will likely flatten the growth path of the economy and job creation, triggering more aggressive revenue and expenditure measures to avoid the projected deficits and debt levels. In the short term, knowledge of this tight fiscal situation will set pressure on all segments of the yield curve. Increases in interest rates of Treasury notes and bonds are equivalent to declines in their prices. The expectation of capital losses and the worsening fiscal situation will cause increases in the required yield of securities demanded by investors.
III. Regulatory Shock. A fragile jobless recovery is inopportune timing for regulatory shocks and attacks on financial institutions and the Fed’s regulatory/supervisory authority. The administration announced on January 14, 2010, the creation of the Financial Crisis Responsibility Fee or the Tax on Big Banks (http://www.whitehouse.gov/the-press-office/president-obama-proposes-financial-crisis-responsibility-fee-recoup-every-last-penn ). The tax is fifteen basis points of covered liabilities per year or: (0.0015) x covered liabilities. These covered liabilities are defined as assets less Tier 1 capital less FDIC-assessed deposits (and/or insurance policy reserves, as appropriate). Tier 1 capital as defined in the Basel Capital Accord, also applied to Basel II, is being reformulated in the current consultative document of the Basel Committee on Banking Supervision (BCBS) (http://www.bis.org/publ/bcbs164.pdf?noframes=1, 4) as consisting mainly of retained earnings and common shares. The remaining portion of Tier 1 capital must consist of subordinated instruments with dividends or coupons that are non-cumulative without maturity date or incentive of redemption (for soft law and the Basel accords see Pelaez and Pelaez, International Financial Architecture, 239-300, Globalization and the State Vol. II, 114-48, Government Intervention in Globalization, 145-50, Financial Regulation after the Global Recession, 54-6, Regulation of Banks and Finance, 69-70). The BCBS is calibrating the overall minimum capital ratio and the composition of Tier 1 capital as part of the impact assessment process. Retained earnings and common shares will remain as the major portion of Tier 1 capital. The assessment of the Federal Deposit Insurance Corporation (FDIC) is a fee paid by insured depository institutions on their insured deposits (http://www.fdic.gov/regulations/laws/rules/2000-5000.html#fdic2000part327.3 See Pelaez and Pelaez, Regulation of Banks and Finance, 71-8, Financial Regulation after the Global Recession, 56-8). Consider the administration’s example of a bank with $1 trillion assets, $100 billion in Tier 1 capital and $500 billion in assessed deposits. The yearly tax would be: 0.0015 x ($1000 billion - $100 billion - $500 billion) = 0.0015 x $400 billion = $600 million. This tax will be assessed only on banks with more than $50 billion in assets and the administration expects that 60 percent of the tax will be collected from the largest ten banks. The objective of the tax is collecting over time the expected net cost of the Troubled Asset Relief Program (TARP) of $117 billion. The expected revenue from the tax in the first ten years would be $90 billion so that in about 12 years the government would recover the loss from TARP. The rationale of the tax is that the largest banks that received (and repaid with interest and repurchase of warrants) capital injection from TARP benefited directly or because of improved financial markets and should pay for the losses of other TARP recipients such as car manufacturers, Fannie Mae, Freddie Mac and AIG. The CBO finds that “the costs of the proposed fee would ultimately be borne to varying degrees by an institution’s customers, employees and investors, but the precise incidence among those groups is uncertain” (http://cboblog.cbo.gov/?p=479 ). An earlier post of this blog argues that the tax would likely be borne mostly by customers because of the inelasticity of demand for credit and the current difficulty of consumers in finding credit in part because of the regulatory shock. The bank fee, Volcker rule, restriction on the size of banks, the consumer protection agency and so on are inopportune measures at the moment that only have adverse effects on the growth of the volume of financial intermediation required to finance strong and sustained economic growth motivating dynamic job creation. The general public pays for these measures in the form of higher interest rates and lower volumes of available credit as shown by the CARD (Credit Card Accountability, Responsibility and Disclosure) Act of May 2009 and subsequently by lower growth and employment creation.
The first week of March, as typical, is full of important economic reports. The short-term indicators provide more evidence of the “nascent” economic recovery. The two reports of the Institute for Supply Management (ISM) are encouraging (http://www.ism.ws/ ). While the ISM manufacturing index declined from 58.4 in Jan to 56.5 in Feb, the level is high, pointing to growth. Employment increased from 53.3 in Jan to 56.1 in Feb. The nonmanufacturing index jumped from the borderline level of 50.5 in Jan to 53.0 in Feb and employment increased from 44.6 in Jan to 48.6 in Feb but still remains at a low level. Construction spending declined 0.6 percent in Jan relative to a revised value in Dec and is still 9.3 percent below the level in Jan 2009 (http://www.census.gov/const/C30/release.pdf ). New orders for manufactured durable goods increased by 1.7 percent in Jan, 0.1 percent when excluding transportation and 1.0 percent excluding defense. New orders for all manufacturing increased by 8.8 percent relative to the level in 2009 and by 7.9 percent excluding defense or transportation (http://www.census.gov/manufacturing/m3/prel/pdf/s-i-o.pdf ). Nonfarm payroll employment declined by 36,000 in Feb and the unemployment rate remained at 9.7 percent with an unchanged 14.9 unemployed persons (http://www.bls.gov/news.release/pdf/empsit.pdf ). The number of involuntary part-time workers who cannot find other type of employment increased from 8.3 to 8.8 million. An important aspect of the employment situation is that 4 in 10 unemployed persons have remained unemployed for 27 weeks or more. Unemployed workers seldom return to the same jobs lost in the recession because they do not exist. New job creation will require a highly dynamic economy and incentives for private-sector creation of new jobs. The index of pending home sales of the National Association of Realtors (NAR) declined in Jan by 7.6 percent relative to an upwardly revised level in Dec but it stands 12.3 percent above the level in Jan 2009 (http://www.realtor.org/press_room/news_releases/2010/03/phs_down ).
Short-term indicators and the Fed’s Beige Book (http://www.federalreserve.gov/fomc/beigebook/2010/20100303/default.htm ) support the view of “a nascent economic recovery” (http://www.federalreserve.gov/newsevents/testimony/bernanke20100224a.htm ). Policy can create incentives for acceleration of the recovery by avoiding deficits, debt and regulatory shocks that could exacerbate upward jumps and twists of the J-shaped yield curve. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)
Carlos M Pelaez
On Jan 5, 2005, the percentage yields per year of Treasury securities were: 3-months 2.33, 2-years 3.22, 5-years 3.73, 10-years 4.29 and 20-years 4.88. The difference between the 10-year note and the 3-month bill was 89 basis points. The yield curve had the upward slope typical of expansions after six months of 25 basis points increases in the target of fed funds by the Federal Open Market Committee (FOMC). On Jan 5, 2010, the percentage yields per year of Treasury securities were: 3-months 0.15, 2-years 0.91, 5-years 2.35, 10-years 3.69 and 30-years 4.64 (http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/yield.shtml ). The yield curve has a sort of J shape with a near horizontal segment up to one year and then a positively sloped segment. The difference between the 10-year note and the 3-month bill is 354 basis points. The risk of future jumps and twists of the J-shaped yield curve is one of the most important aspects of monetary policy and perhaps even of the rate of growth of the economy and employment creation. The sections below analyze the origins in monetary policy of the J-shaped yield curve and its relation to the government deficit and debt and proposals for financial regulation.
I. Origins. There are three factors explaining the J-shaped yield curve. First, the Fed has lowered interest rates close to the “zero bound” in two occasions. Central banks have been aggressive in monetary policy because of the “great moderation,” or reduction in the volatility of output and inflation beginning in the 1980s and ending with the current crisis (Kenneth Rogoff cited in Pelaez and Pelaez, Regulation of Banks and Finance, 221, Globalization and the State, Vol. II, 195). Of three competing explanations, (1) structural change of the economy permitting absorption of shocks such as the oil price increases of the 1970s and 1980s, (2) macroeconomic policy and (3) luck in the form of less frequent shocks, (2) macroeconomic policy in the form of sound monetary policy may have been important in ensuring stable growth (http://www.federalreserve.gov/BOARDDOCS/SPEECHES/2004/20040220/default.htm#fn1 ). The process of inflation targeting appeared to have provided a new paradigm for the conduct of monetary policy ensuring sustained growth of output with price stability (Pelaez and Pelaez, Regulation of Banks and Finance, 108-112, Financial Regulation after the Global Recession, 74, 84-6, International Financial Architecture, 230-7). The credit/dollar crisis and global recession originated in four almost contemporaneous policies that stimulated excessive construction and high real estate prices, highly-leveraged risky financial exposures, unsound credit and low liquidity (Pelaez and Pelaez, Financial Regulation after the Global Recession, 157-66, Regulation of Banks and Finance, 217-27, International Financial Architecture, 15-18, The Global Recession Risk, 221-5, Globalization and the State Vol. II, 197-213, Government Intervention in Globalization, 182-4): (1) the interruption of auctions of the 30-year Treasury in 2001-2005 that caused purchases of mortgage-backed securities (MBS) equivalent to a reduction in mortgage rates; (2) the reduction of the fed funds rate by the Fed to 1 percent and its maintenance at that level between Jun 2003 and Jun 2004 with the implicit intention in the “forward guidance” of maintaining low rates indefinitely if required in avoiding “destructive deflation”; (3) the housing subsidy of $221 billion per year; and (4) the purchase or guarantee of $1.6 trillion of nonprime mortgage-backed securities by Fannie Mae and Freddie Mac. The combined stimuli mispriced risk, causing excessive risk and leverage as the public attempted to obtain higher returns on savings. The increase of the fed funds rate by 25 basis points per meeting of the Federal Open Market Committee from Jun 2004 to Jun 2006 raised the fed funds rate from 1 percent to 5.25 percent around the time that house prices peaked. The response of the Fed to the credit/dollar crisis was the reduction of the fed funds rate from 5.25 in Sep 2007 to 0 – ¼ percent in Dec 2008 without any subsequent change.
Second, the traditional tool of reducing rates was complemented by the creation of about 11 credit facilities by the Fed (Pelaez and Pelaez, Financial Regulation after the Global Recession, Table 6.3, 160-1). Abundant credit may have played a role in maintaining rates around zero in the short-dated segment of the yield curve.
Third, the Fed engaged in the policy of quantitative easing (Pelaez and Pelaez, Regulation of Banks and Finance, 224, The Global Recession Risk, 83-107). When the policy rate or fed funds rate is near the “zero bound” the Fed could expand its balance sheet by acquiring government securities, ignoring the interest rate and focusing on the volume of bank reserves (http://www.federalreserve.gov/boarddocs/speeches/2004/200401033/default.htm ). The purchase of long-term securities by the Fed could lower long-term interest rates, stimulating recovery of the economy by increasing investment. The Fed borrowed from banks by paying interest rates on excess reserves deposited by banks at the Fed and from Treasury by depositing the proceeds from the issue of short-term Treasury bills at the supplementary account of the Fed; these deposits were invested by the Fed in long-term Treasury securities, agency debt securities and MBS. The Fed balance sheet increased by 115.7 percent from $855.1 billion in February 2008 to $1844.9 billion in February 2009 (Pelaez and Pelaez, Regulation of Banks and Finance, 225-6, Financial Regulation after the Global Recession, 158-9). The Fed balance sheet for the week ending Mar 3, 2010, lists holdings of $1026 billion of MBS, $708 billion of Treasury notes and bonds and $167 billion of Federal agency securities with $1198 billion of reserve balances deposited at the Fed and now $25 billion in the supplementary financing account that will grow to $200 billion (http://www.federalreserve.gov/releases/h41/current/h41.htm#h41tab1 ). At some point the Fed would sell that portfolio of about $1.8 trillion of long-term securities, causing a decrease in their prices that is equivalent to an increase in their yields. Thus, there is potential pressure on long-term interest rates by the Fed portfolio of securities.
II. Government Deficit. The Congressional Budget Office has provided preliminary analysis of the budget deficit for the next ten years that suggests pressure on US financing needs and thus rising yields of Treasury securities (http://cboblog.cbo.gov/?p=482 ). The federal government deficit in 2010 would reach $1.5 trillion or 10.3 percent of GDP and $1.3 trillion in 2011 or 8.9 percent of GDP after a deficit of 9.9 percent of GDP in 2009. The cumulative deficit between 2011 and 2020 would be $9.8 trillion. The federal debt held by the public would increase from $7.5 trillion in 2009 or 53 percent of GDP to $20.3 trillion or 90 percent of GDP. Net interest paid on the debt would quadruple, increasing from 1.4 percent of GDP in 2010 to 4.1 percent of GDP in 2020. Tax increases and rising interest rates resulting from these prodigal budgets will likely flatten the growth path of the economy and job creation, triggering more aggressive revenue and expenditure measures to avoid the projected deficits and debt levels. In the short term, knowledge of this tight fiscal situation will set pressure on all segments of the yield curve. Increases in interest rates of Treasury notes and bonds are equivalent to declines in their prices. The expectation of capital losses and the worsening fiscal situation will cause increases in the required yield of securities demanded by investors.
III. Regulatory Shock. A fragile jobless recovery is inopportune timing for regulatory shocks and attacks on financial institutions and the Fed’s regulatory/supervisory authority. The administration announced on January 14, 2010, the creation of the Financial Crisis Responsibility Fee or the Tax on Big Banks (http://www.whitehouse.gov/the-press-office/president-obama-proposes-financial-crisis-responsibility-fee-recoup-every-last-penn ). The tax is fifteen basis points of covered liabilities per year or: (0.0015) x covered liabilities. These covered liabilities are defined as assets less Tier 1 capital less FDIC-assessed deposits (and/or insurance policy reserves, as appropriate). Tier 1 capital as defined in the Basel Capital Accord, also applied to Basel II, is being reformulated in the current consultative document of the Basel Committee on Banking Supervision (BCBS) (http://www.bis.org/publ/bcbs164.pdf?noframes=1, 4) as consisting mainly of retained earnings and common shares. The remaining portion of Tier 1 capital must consist of subordinated instruments with dividends or coupons that are non-cumulative without maturity date or incentive of redemption (for soft law and the Basel accords see Pelaez and Pelaez, International Financial Architecture, 239-300, Globalization and the State Vol. II, 114-48, Government Intervention in Globalization, 145-50, Financial Regulation after the Global Recession, 54-6, Regulation of Banks and Finance, 69-70). The BCBS is calibrating the overall minimum capital ratio and the composition of Tier 1 capital as part of the impact assessment process. Retained earnings and common shares will remain as the major portion of Tier 1 capital. The assessment of the Federal Deposit Insurance Corporation (FDIC) is a fee paid by insured depository institutions on their insured deposits (http://www.fdic.gov/regulations/laws/rules/2000-5000.html#fdic2000part327.3 See Pelaez and Pelaez, Regulation of Banks and Finance, 71-8, Financial Regulation after the Global Recession, 56-8). Consider the administration’s example of a bank with $1 trillion assets, $100 billion in Tier 1 capital and $500 billion in assessed deposits. The yearly tax would be: 0.0015 x ($1000 billion - $100 billion - $500 billion) = 0.0015 x $400 billion = $600 million. This tax will be assessed only on banks with more than $50 billion in assets and the administration expects that 60 percent of the tax will be collected from the largest ten banks. The objective of the tax is collecting over time the expected net cost of the Troubled Asset Relief Program (TARP) of $117 billion. The expected revenue from the tax in the first ten years would be $90 billion so that in about 12 years the government would recover the loss from TARP. The rationale of the tax is that the largest banks that received (and repaid with interest and repurchase of warrants) capital injection from TARP benefited directly or because of improved financial markets and should pay for the losses of other TARP recipients such as car manufacturers, Fannie Mae, Freddie Mac and AIG. The CBO finds that “the costs of the proposed fee would ultimately be borne to varying degrees by an institution’s customers, employees and investors, but the precise incidence among those groups is uncertain” (http://cboblog.cbo.gov/?p=479 ). An earlier post of this blog argues that the tax would likely be borne mostly by customers because of the inelasticity of demand for credit and the current difficulty of consumers in finding credit in part because of the regulatory shock. The bank fee, Volcker rule, restriction on the size of banks, the consumer protection agency and so on are inopportune measures at the moment that only have adverse effects on the growth of the volume of financial intermediation required to finance strong and sustained economic growth motivating dynamic job creation. The general public pays for these measures in the form of higher interest rates and lower volumes of available credit as shown by the CARD (Credit Card Accountability, Responsibility and Disclosure) Act of May 2009 and subsequently by lower growth and employment creation.
The first week of March, as typical, is full of important economic reports. The short-term indicators provide more evidence of the “nascent” economic recovery. The two reports of the Institute for Supply Management (ISM) are encouraging (http://www.ism.ws/ ). While the ISM manufacturing index declined from 58.4 in Jan to 56.5 in Feb, the level is high, pointing to growth. Employment increased from 53.3 in Jan to 56.1 in Feb. The nonmanufacturing index jumped from the borderline level of 50.5 in Jan to 53.0 in Feb and employment increased from 44.6 in Jan to 48.6 in Feb but still remains at a low level. Construction spending declined 0.6 percent in Jan relative to a revised value in Dec and is still 9.3 percent below the level in Jan 2009 (http://www.census.gov/const/C30/release.pdf ). New orders for manufactured durable goods increased by 1.7 percent in Jan, 0.1 percent when excluding transportation and 1.0 percent excluding defense. New orders for all manufacturing increased by 8.8 percent relative to the level in 2009 and by 7.9 percent excluding defense or transportation (http://www.census.gov/manufacturing/m3/prel/pdf/s-i-o.pdf ). Nonfarm payroll employment declined by 36,000 in Feb and the unemployment rate remained at 9.7 percent with an unchanged 14.9 unemployed persons (http://www.bls.gov/news.release/pdf/empsit.pdf ). The number of involuntary part-time workers who cannot find other type of employment increased from 8.3 to 8.8 million. An important aspect of the employment situation is that 4 in 10 unemployed persons have remained unemployed for 27 weeks or more. Unemployed workers seldom return to the same jobs lost in the recession because they do not exist. New job creation will require a highly dynamic economy and incentives for private-sector creation of new jobs. The index of pending home sales of the National Association of Realtors (NAR) declined in Jan by 7.6 percent relative to an upwardly revised level in Dec but it stands 12.3 percent above the level in Jan 2009 (http://www.realtor.org/press_room/news_releases/2010/03/phs_down ).
Short-term indicators and the Fed’s Beige Book (http://www.federalreserve.gov/fomc/beigebook/2010/20100303/default.htm ) support the view of “a nascent economic recovery” (http://www.federalreserve.gov/newsevents/testimony/bernanke20100224a.htm ). Policy can create incentives for acceleration of the recovery by avoiding deficits, debt and regulatory shocks that could exacerbate upward jumps and twists of the J-shaped yield curve. (Go to: http://www.amazon.com/Carlos-Manuel-Pel%C3%A1ez/e/B001HCUT10)
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