Tag Archives: zero lower bound

Revised: The End of Forward Guidance

In December 2012, The Federal Reserve declared “it would not raise interest rates until America’s unemployment rate dropped to at least 6.5%, so long as inflation remained below 2.5%.”  This declaration represents one of the Fed’s most unique policy tools for impacting economic conditions at the zero lower bound: forward guidance.

Forward guidance is merely a promise of future monetary policy in order to impact current economic activity.  Today, the Fed employs forward guidance by promising to keep interest rates low until a 6.5% unemployment rate is reached.  Doing so allows investors to understand when and how future interest rates will change, thereby reducing uncertainty and encouraging investment today.  This heightened level of investment increase economic output and accelerate economic recovery.

Forward guidance is not a new tool.  At the onset of the lost decade in the 1990’s, the Bank of Japan promised to keep interest rates at zero “until deflationary concerns subside.”  In the United States, just a few years after the NASDAQ crashed, the Fed cut interest rates to 1% in 2003 and pledged to keep rates at this level “for a considerable period.”  While forward guidance has certainly evolved since the Great Recession (from vague statements about time to concrete thresholds determining policy changes), the zero lower bound necessitates its use even today.  Because the Fed is unable to lower short-term interest rates to their necessary, negative value, it has no choice but to alter long-term rates in an effort to stimulate today’s economy.

While forward guidance seems to have been an effective (though painfully slow) policy tool in the last 6 years, recent debate has me worried about its legitimacy.  As the unemployment rate nears the 6.5% threshold targeted by the Federal Reserve, there is talk (and concern) about hikes in interest rates.  In my opinion, once a 6.5% unemployment rate is achieved, the Fed should raise interest rates per it’s promise.  However an intriguingly titled Wall Street Journal article caught my eye recently.  With the title “Grand Central: As Unemployment Falls, Fed Doves Pivot to Low Inflation Concern,” this article had me worried that the Fed will not keep its promise to raise interest rates once 6.5% unemployment is achieved.

The article notes that some Fed doves are concerned about low levels of inflation.  In 2012, the Fed targeted an annual inflation rate of 2%, but in reality has only generated average inflation of 1.3% (uncertainty about the effects of Quantitative Easing has resulted in more conservative stimulus).  As shown in the graph below, this discrepancy in rates has caused a large discrepancy between predicted and actual price levels.  Many doves support the continuation of low interest rates (even after unemployment reaches 6.5%) so as to boost short-term inflation above 2% and bring actual price levels in line with predicted price levels.

Screen shot 2014-03-24 at 12.00.01 PM

I have two concerns about continually low interest rates.  The first relates to the motivation for boosting inflation.  I certainly agree that inflation can be helpful in the face of the zero lower bound by allowing for negative real interest rates.  However, once the Fed reaches its 6.5% unemployment target, its has achieved its goals.  Accordingly there should be no further need for large economic stimulus.  At least, this would be the case if the Fed stayed committed to its December 2012 promise.

The issue of commitment brings me to my second and more important concern about continually low interest rates: failing to raise interest rates undermines forward guidance, thereby challenging the trustworthiness of the Fed and potentially eliminating a useful policy tool.  In my opinion, if the Fed does not alter the direction of interest rates after reaching a 6.5% unemployment rate (as many doves are suggesting), it is completely disregarding the forward guidance promises made in 2012.  Granted, while these promises were qualified by terms like “necessary” and “sufficient,” the Fed did commit to a policy change once unemployment reaches 6.5%.  If the Fed does not change its policy after reaching this threshold, my trust in the Fed will be destroyed.  If private investors (whose decisions depend of trusting the Fed’s promises) think like me, they will also lose trust in the Fed.  Should private investors lose trust in the Fed, forward guidance will be eliminated as a policy tool entirely, making economic stimulus at the zero lower bound extremely difficult.

Ultimately, forward guidance is a tricky tool as it locks the Fed into a single, long-term strategy.  Deviation from this strategy (which might occur very soon) undermines the Fed’s trustworthiness and eliminates forward guidance as a policy tool entirely.  In this way, effective forward guidance requires consensus as to the long-term strategy of central banks.  But today, this consensus simply does not exist, and there is frequent debate as to which metrics the Fed should target.  Some believe inflation should be the Fed’s key goal; others are more focused on unemployment and still others are focused on financial stability.  In my opinion, this type of debate will always exist.  And I think this debate should exist.  The Federal Reserve would be foolish to not reassess its long-term strategies given changes in the economic environment.  Like a successful business, an effective central bank should not commit to a single strategy, but rather should address each economic situation individually to respond optimally.

For this reason, I believe forward guidance, while powerful, is a foolish economic tool.  In order to preserve private investors’ trust, forward guidance locks the Fed into a single long-term strategy, inhibiting its ability to respond to unanticipated changes in economic conditions.  Unfortunately, given the zero lower bound, forward guidance has become necessary (as short term interest rates of 0% do not provide sufficient stimulus).  Therefore, in order to eliminate forward guidance as a policy tool, I believe addressing the zero lower bound should be a key priority of central banks.  So long as the zero lower bound exists and forward guidance remains necessary, the Fed cannot do its job as well as possible.

(Revised) Owning Bonds Despite a Bearish Perspective

During the financial crisis, the Federal Reserve (Fed) cut the federal funds rate from above 5% to below 1% and has not raised rates since.

fredgraph_effectivefedfunds

As seen above, the grey shaded area represents the recent financial crisis. After reaching the zero lower bound (ZLB) in late 2008, the federal funds rate target has remained at 0.00-0.25%. With interest rates unable to go any lower due to the ZLB, the only way interest rates can move is upwards. The only question is – when will the Fed decide to raise rates?

Although I have been bearish on bond prices for some time, I have not traded on this perspective because I did not know when rates would rise. I am bearish on bond prices because bond yields and bond prices have an inverse relationship (ex. when interest rates rise, bond prices fall). As the economy improves, the moment that interest rates rise (and bond prices subsequently fall) approaches. Following the march FOMC meeting, I have come to believe that rates will rise in 2015. According to the Wall Street Journal, “If you expect lower returns from an asset class than it has provided historically, such as lower returns from bonds, then the math, and probably logic, would tell you to lighten up on bonds”. In order to lighten up on bonds, I would need to sell any bonds that I own. However, I do not own any bonds so I have considered shorting bonds instead through an exchange-traded fund (ETF) such as ProShares UltraShort Lehman 20+ Year Treasury.

Although this investment logic might be right, I have made a mistake by not having any exposure to bonds in the first place. According to the Wall Street Journal, “To be clear, the solution is not to eliminate bonds from your portfolio because they will still provide the very important diversifying benefit of cushioning your portfolio if the market should pull back”. Diversification is an important part of asset allocation that helps reduce the variance of expected returns through decreasing (and potentially eliminating) unsystematic risk from one’s portfolio. In a well-diversified portfolio, only systematic risk remains. On the one hand, systematic risk is correlated among all securities (i.e. macroeconomic news). On the other hand, unsystematic risk is uncorrelated among all securities (i.e. industry or company specific news). Traditionally, stock prices and bond prices have demonstrated a negative correlation. Adding bonds to my portfolio, which consists entirely of large cap U.S. equities, would offer me meaningful benefits through diversification. Recently, irregularities in the relationship between stock prices and bond prices (i.e. a positive correlation) due to quantitative easing might lead one to think that the benefits of diversification are lessened or eliminated. According to Burton Malkiel, “But note that even though correlations between markets have risen, they are still far from perfectly correlated, and broad diversification will still tend to reduce the volatility of a portfolio” (212). Although Malkiel was not referring to quantitative easing, he makes a useful point. As long as two securities are less than perfectly correlated (i.e. less than 1), then there will be benefits from diversification. With my portfolio consisting entirely of large cap U.S. equities, I could reduce the variance of my portfolio’s expected returns through diversification.

Despite my bearish view on bond prices, there are still ways for me to purchase bonds and gain the benefits of diversification. My bearish view on bonds is due to interest-rate risk. In this case, increasing interest rates will push down bond prices. If I wanted to still purchase bonds in order to diversify, then I could purchase bonds with short maturities. The shorter the maturity of a bond, the less it is subject to interest rate risk. This can be seen in the yield curve, which has a positive slope as maturities increase (and the credit rating remains fixed). Although the prices of short term bonds will still fall as rates rise, there will still be benefits from diversification.

As I attempt to adjust my portfolio’s asset allocation, I will consider both diversification and my bearish perspective on bonds. On the one hand, I will purchase bonds with short maturities. On the other hand, I will sell (i.e. sell short) bonds with long maturities. As a small investor, I will use ETFs in order to implement my strategy because it is more cost effective.

Electronic Money: Revisited

Professor Miles Kimball of the University of Michigan has proven to be a strong advocate of eliminating paper money and having all monetary transactions be electronic. His main reason for this is that it is a way to eliminate the Zero Lower Bound or ZLB. This can be seen on his blog, Confessions of a Supply-Side Liberal. His also contributed an article to Slate, which brought up similar points. Professor Kimball’s main reason for electronic money is indeed the elimination of the ZLB on nominal interest rates in the short-term. This only exists with paper money because paper money collects zero interest. If banks offered negative interest rates on savings, then people would hold onto cash because zero interest is better than a negative rate. Professor Kimball believes that these negative interest rates are integral to helping the economy recover because they promote investment and consumption, which are parts of GDP, or output.

There is an article in the Wall Street Journal about the elimination of cash, but from a legal standpoint. The article makes light of the fact that crime has gone down dramatically since the 1990’s. It attributes this to the decrease in the use of cash. Cash is crucial to illegal transactions due to the fact that it is not as traceable as electronic money. It is completely anonymous. The article also mentions that payments, such as welfare would be a lot easier if they were made electronically.

With regards to all of this, and one of my previous blogs posts. I am still unsure about the elimination of paper money. Negative interest rates would promote investments. They would promote consumption by creating an incentive against saving. Money in the bank would decrease everyday, so it would make more sense, economical, to spend. One downside is that nobody would want to loan money at a negative interest rate. It would be like the creditor is paying the borrower to borrow money. Positive interest rates create the incentive for a creditor lend money since he or she will be paid more in return.

From a legal standpoint, I think the argument in favor of electronic money is more valid. The credit and debit card purchases are very easily traced. The card company, bank, and/or government can know the exact amount of money transferred and exactly to whom it was going. Black market transactions would be a lot more difficult to make. Somebody buying illegal drugs, such as cocaine, would not be able to make the purchase. What would the dealer do? Use Square? The government would see a Square transaction for a large amount of money, and be able to investigate the transaction.

The End of Forward Guidance

In December 2012, The Federal Reserve declared “it would not raise interest rates until America’s unemployment rate dropped to at least 6.5%, so long as inflation remained below 2.5%.”  This declaration represents one of the Fed’s most powerful tools for impacting economic conditions at the zero lower bound: forward guidance.

Forward guidance describes a promise of future monetary policy in order to impact current economic activity.  Today, the Fed employs forward guidance by promising to keep interest rates low until a 6.5% unemployment rate is reached.  Doing so increases investor confidence because investors know that interest rates will not increase until unemployment hits 6.5%.  With a good estimate of future interest rates, investors feel safer making investments now.  In turn, this heightened level of investment increase economic output and accelerate economic recovery.

Forward guidance is not a new tool.  In the 1990’s the Bank of Japan promised to keep interest rates at zero “until deflationary concerns subside.”  In the United States, the Fed cut interest rates to 1% in 2003 and pledged to keep rates at this level “for a considerable period.”  While forward guidance has certainly evolved since the Great Recession (from vague statements about time to concrete thresholds determining policy decisions), the zero lower bound necessitates its use even today.  Unable to lower short-term interest rates to their necessary, negative rate, forward guidance allows the Fed to impact long-term rates and long-term risk tolerance in an effort to stimulate the economy.

That said, recent debate has me worried about the legitimacy of forward guidance.  As the unemployment rate nears the 6.5% threshold targeted by the Federal Reserve, there is talk (and concern) about hikes in interest rates.  In my opinion, once this 6.5% unemployment is achieved, the Fed should raise interest rates and keep its promise.  However an intriguingly titled Wall Street Journal article caught my eye this morning.  With the title “Grand Central: As Unemployment Falls, Fed Doves Pivot to Low Inflation Concern,” this article had me concerned as to whether the Fed will actually keep its promise to raise interest rates once 6.5% unemployment is reached.

The article notes that some Fed doves are concerned about low inflation rates.  In 2012, the Fed targeted an annual inflation rate of 2%, but in reality has only generated inflation of 1.3%.  As shown in the graph below, this discrepancy in rates has caused a discrepancy between predicted price levels and actual price levels.  Many doves support the continuation of low interest rates so as to boost short-term inflation above 2% and bring actual price levels in line with predicted price levels.

Screen shot 2014-03-24 at 12.00.01 PM

Personally, I have two issues with this decision.  The first relates to the motivation for boosting inflation to match actual and predicted price levels.  I agree that inflation can be helpful in the face of the zero lower bound by allowing for negative real interest rates and increased economic investment.  That said, once the Fed reaches its 6.5% unemployment target, its goals have been met, and there should be no further need for large economic stimulus.  At least, this would be the case if the Fed stayed committed to its December 2012 promises.

Which brings me to my second and more important issue with this decision: it undermines forward guidance, thereby challenging the trustworthiness of the Fed and potentially eliminating a powerful policy tool.  In my opinion, if the Fed does not alter the direction of interest rates after reaching a 6.5% unemployment rate (as many doves are suggesting), it is completely disregarding the forward guidance promises made in 2012.  Granted, while these promises were qualified by terms like “necessary” and “sufficient,” the Fed did commit to a policy change at 6.5%.  If the Fed does not change its policy after reaching this threshold, my trust in the Fed will be destroyed.  If private investors (whose decisions depend of trusting the Fed’s promises) are like me, they will also lose trust in the Fed, thereby eliminating forward guidance as policy tool.

Ultimately, forward guidance is a tricky tool as it locks the Fed into a single, long-term strategy.  Deviation from this strategy (which might occur very soon) undermines the Fed’s trustworthiness and eliminates forward guidance as a policy tool entirely.  In this way, effective forward guidance requires consensus as to the goals of central banks.  Today, there is frequent debate as to which metrics the Fed should target.  Some believe inflation should be the Fed’s key goal; others are more focused on unemployment and still others are focused on financial stability.  In my opinion, there will always be debate as to which metrics the Fed should target.  And I think there should be.  The Fed should not pick a single goal, but rather should address each economic situation individual to respond optimally.

For this reason, I believe forward guidance, while powerful, is a ridiculous economic tool.  It locks the Fed into a long-term strategy and inhibits its ability to respond to unanticipated changes in economic conditions.  Interestingly, the elimination of the zero lower bound would eliminate the need for forward guidance.  As such, I believe that addressing the zero lower bound should be a key priority for the Federal Reserve, as the Fed’s current need to use forward guidance hinders its ability to do its job well.

 

The Fed’s Dual Mandate: Easier Said Than Done

One of the more interesting news stories I have been following has been regarding the Federal Reserve. Following the financial crisis in 2008, the Federal Reserve has played a significant (maybe even revolutionary) role in financial markets.

After cutting the Fed Funds rate to unprecedented lows of 0.00%-0.25% (where it still remains today), the Fed made a bold decision to enter uncharted territory (as if cutting interest rates to zero wasn’t bold enough). On the one hand, interest rate targeting through the Fed Funds rate is considered conventional monetary policy because it is a normal tool the Fed uses. On the other hand, quantitative easy (QE) is appropriately considered unconventional monetary policy. The consequences of QE, let alone prolonged QE, are unknown (causing many to assume the worst).

QE was a desperate attempt to lower long-term interest rates through purchases of long duration Treasuries. By keeping both short and long-term interest rates low and flattening the yield curve, the Fed hoped to stimulate the economy.

The Fed plays a vital role in not only the U.S. economy, but the global economy. For example, the threat of tapering caused a significant capital outflow from emerging markets. In any case, the Fed has a dual mandate in the U.S., which requires it to minimize unemployment and control inflation. According to the Wall Street Journal, “The Labor Department said the unemployment rate fell to 6.7% from 7%, though the decline was largely the result of people leaving the workforce.” This new bit of data today shows that the unemployment rate is finally coming down, however, we should remain cautious as part of the improvement was due to people leaving the labor force (which somewhat distorts the improvement).

Although the unemployment rate is moving closer to the Fed’s threshold of 6.5%, the other half of the Fed’s mandate (inflation) is below target and even creating concern about whether deflation is looming. With interest rates at the zero lower bound and the Fed inserting massive amounts of liquidity through QE, I thought we would be experiencing an inflationary spike (after all, I’ve been taught that an increased money supply and low interest rates tend to cause inflation). Thus, the possibility of deflation comes as a surprise and is extremely troubling as it is without a doubt worse than inflation. For example, Japan was stuck in a deflationary environment for a very long time and is only just beginning to escape.

This makes me wonder about the Fed’s decision to taper QE. The Fed announced it will reduce its monthly bond purchases to $75 billion from $85 billion. The Fed also signaled its intent to continue reducing its bond purchases by $10 billion at each subsequent meeting.

According to the Wall Street Journal, “The bond buying will be slowly reduced as long as the economy sticks to the Fed’s projection of gradually quickening growth, declining unemployment and a slight uptick of inflation from near 1% to the Fed’s 2% target.

Considering the decline in UE to 6.7% and stubbornly low inflation, is this the right thing for the Fed to be doing? I believe that tapering is the right decision (as long as the Fed keeps interest rates low as they promised).

It is important for financial markets to understand that the Fed’s decision to taper was based on positive economic data. And future decisions by the Fed will also be data dependent. However, reaching the Fed’s threshold of 6.5% UE will NOT automatically trigger a Fed decision. In other words, the Fed’s decision going forward will be both an art and a science. 

With UE nearing the Fed’s threshold of 6.5%, but inflation below target, the Fed is put in an interesting position. An increasingly important tool for the Fed is its forward guidance. Forward guidance directly impacts expectations, which are immediately priced into financial markets. For example, when the Fed hinted it was ready to taper during the summer, the markets quickly priced that in (ex. the yield on 10 year treasuries spiked). Then the Fed surprised when it decided not to taper.

In order to promote stability in the financial markets, the Fed must clearly outline its future plans. One thing the Fed has tried to clearly express is that it will keep interest rates very low for an indefinite period of time. This makes sense as long as inflation is below target and unemployment is above the Fed’s threshold.

The Fed’s recent decision to taper was received well by financial markets. I believe this happened for two reasons. First, tapering was already priced in over the summer. Second, the Fed’s decision to taper was based on strong economic data. On the one hand, tapering reduces liquidity. On the other hand, tapering is symbolic of an improving overall economy. All eyes will be on the next FOMC meeting.