Masters of Universe Don’t Need Fed Hand-Holding
The last two months have been a nightmare for the Federal Reserve, which has been doing everything in its power to depress long-term interest rates. The yield on the 10-year Treasury note rose more than a full percentage point from early May to early July amid talk of the Fed first cutting its asset purchases, and then ending them by mid-2014, assuming the economy lives up to its relatively upbeat forecast.
The diagnosis for the rise in rates was “poor communication,” which Fed Chairman Ben Bernanke seems to be trying to correct. He used the Q&A session after a speech last week to attempt to coax yields down, with only a modicum of success.
The problem isn’t communication. Bernanke said the same thing at his June 19 news conference, triggering a bond market plunge, as he did last week, when he sparked a rally. If it sounded different, it was in the ear of the listener.
Rather, the problem is the underlying message. The U.S. economy is gradually improving. Just as the emergency lending facilities created at the peak of the financial crisis became superfluous, so, too, will large-scale asset purchases and an exceptionally low federal funds rate. No amount of hand-holding by Bernanke can change that reality -- or the prospect of higher rates.
Bernanke gave it another shot yesterday at his semi-annual monetary policy testimony to the House Financial Services Committee. He reiterated the key points in language a kindergartner could understand:
The Fed’s pace of asset purchases isn’t fixed. (Did anyone think it was?)
The benchmark overnight rate will stay close to zero for “the foreseeable future.”
Thresholds aren’t targets.
That’s about as clear as it gets in a world where the future is unclear. Yet short-term interest rates are holding on to some residual expectations of rate increases next year even though the majority of policy makers anticipate no change until 2015. Long-term interest rates, the focus of the Fed’s quantitative easing, have retraced only about a quarter of their losses since May. “Markets are beginning to understand our message,” Bernanke said, somewhat hopefully, in response to a question from committee Chairman Jeb Hensarling, a Republican from Texas.
They are. They just disagree with the appropriate level of interest rates.
What’s more, the “they” -- the buy-and-hold investors who were content to hide in Treasury securities earlier this year to avoid risk -- has changed. With the stock market flirting with new highs and housing percolating, investors have been selling Treasuries to bond dealers, who have a somewhat different focus. Rather than a haven, a five-year Treasury yielding 0.64 percent (May’s low yield) represents a big loss if you expect the funds rate to normalize before the note matures.
The Fed projects the neutral funds rate -- the rate that will keep the economy growing at its non-inflationary potential in perpetuity -- at 4 percent. Such a path for overnight rates implies a neutral five-year yield closer to 1.5 percent.
Andy Barr, a Republican from Kentucky, asked Bernanke about the Fed’s exit strategy. Given the adverse credit-market reaction to the possibility of tapering, how, did the Fed plan to prevent a “catastrophic spike in interest rates” when the time comes to end QE?
“By communicating, by not surprising people,” Bernanke said.
I can’t tell if the Fed chairman believes this. Under Bernanke, Fed communication has taken on a life of its own. Policy makers seem to talk as if they can send rates tumbling again. They can’t.
The Fed has come a long way from the pre-1994 era, when rate decisions were shrouded in mystery. It now communicates its objectives and what it intends to do to achieve them. It even provides economic forecasts several times a year so that financial markets can evaluate its progress toward its goals.
Communication has its limits, however. It can’t forestall a cyclical rise in interest rates or even guarantee that the increase is orderly.
Bernanke’s comments have become increasingly dovish in the wake of the bond sell-off. He’s making a concerted effort to accentuate the negatives, and uncertainty, about the outlook and the Fed’s willingness to respond to persistently low inflation and a sagging labor market.
His response to Barr’s question suggests he believes the Fed can control outcomes, and interest rates, through communication. Somehow I doubt it. I view the market’s response to talk of tapering as a taste of things to come.
The Fed will be relieved when the economy can shed its training wheels and ride on its own. Higher interest rates should be viewed as a badge of success. In fact, something would be amiss if a stronger economy didn’t usher in higher rates. Have I made myself clear?
(Caroline Baum, author of “Just What I Said,” is a Bloomberg View columnist.)
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