There is no reason to think that they will not be able to do so again…..
from Ken Landon, J.P.Morgan Strategy, NY (Oct 7, 2010)
* FED – The press is now filled with breathless accounts of another “option” that the Fed may use to stoke inflation. This time, the supposed monetary magic lies with the literal targeting of yields along the US Treasury curve. Here is how today’s Washington Post describes it:
”Instead of just announcing that it will create, say, $500 billion out of thin air and buy bonds with the money, the Fed could instead announce it will target a certain interest rate and then buy Treasury bonds so that rates in the marketplace reach that level.”
(see: http://tinyurl.com/29t6qbu for full article)
The article briefly mentions Chairman Bernanke’s previous advocacy of such a policy, which he highlighted in his notorious “Helicopter Ben” speech in November 2002. Here is the key passage from that speech:
”So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure–that is, rates on government bonds of longer maturities….A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years…Of course, if operating in relatively short-dated Treasury debt proved insufficient, the Fed could also attempt to cap yields of Treasury securities at still longer maturities, say three to six years. Yet another option would be for the Fed to use its existing authority to operate in the markets for agency debt (for example, mortgage-backed securities issued by Ginnie Mae, the Government National Mortgage Association).”
(full speech can be viewed at: http://tinyurl.com/2wja)
* It is obvious from Chairman Bernanke’s own words that he is amenable to a policy that targets US Treasury rates along the entire yield curve. He has already aggressively used the Fed’s “authority to operate in the markets for agency debt.” It is not a difficult stretch of the imagination that he would also use the Fed’s authority to target long-term US Treasury rates.
In a somewhat bizarre reference in the article from the Washington Post, the journalist wrote:
”While the Fed and other central banks have experience announcing planned bond purchases and setting targets for overnight lending rates, targeting longer-term interest rates is an untested strategy that could have hard-to-predict consequences.
”‘We’re in the experimental drug phase of monetary policy,’ said John Makin, a resident scholar at the American Enterprise Institute. ‘These are all very nice ideas, but there’s no real experience to tell you what works best.’”
I say that reference is “bizarre” because there is a prominent example of the Fed literally targetting the 10Y UST rate. Between April 1942 and March 1951, the Federal Reserve explicitly set a ceiling of 2.5% on the 10Y UST. The central bank committed to buying unlimited amounts of USTs in order to control rates. The explicit rate-targetting of USTs ended with the famous Fed-Treasury Accord of 1951 that granted the central bank more leeway in implementing monetary policy.
The purpose of the 2.5% ceiling on the 10Y UST was clear. The Fed was turned into a source of financing of the government’s war spending. Here is how the San Francisco Fed described that period of time:
”During the decade before the 1951 Accord, Federal Reserve actions were dominated by considerations arising from the government’s World War II financing needs. The Treasury, faced with the need to raise funds far in excess of tax receipts in order to finance the war effort, wanted to keep interest rates on government securities at low levels. The Treasury view was supported by the Federal Reserve, and the Fed adopted an explicit policy of supporting the government bond market. Particularly during 1942 to 1945 when the government was engaging in massive borrowing, this was clearly an important consideration. As expressed by G.L. Bach, “In this period, Federal Reserve and Treasury officials agreed, with perhaps more patriotic fervor than foresight, that there must be no shortage of money to buy the weapons of war .. .”
(see: http://www.frbsf.org/publications/economics/letter/1993/el93-21.pdf )
Fast forward approximately 70 years and it is not hard to imagine the same agenda motivating a similar UST rate-targetting regime in 2010. Whether under direct political pressure or not, the Fed is part of the apparatus used by Washington to finance its massive spending (in 2009, government spending as a percentage of GDP surged to 25% from 19.4% in 2007 and an average of 19.3% during the previous 60 years). To paraphrase the San Francisco Fed, “the Treasury, faced with the need to raise funds far in excess of tax receipts in order to finance” the rapid expansion of the Federal government “wanted to keep interest rates on government securities at low levels.” The Fed is obviously doing its part to lubricate the Treasury’s current financing needs.
* Attached chart 10Y_4251.jpg shows the 10Y UST rate and the CPI rate between 1940 and 1960. Notice that between Apr 1942 and Mar 1951, the Fed successfully held the yield of the 10Y UST below 2.5%. In fact, the average yield of that period was 2.4%. The central bank was able to do so despite the fact that average CPI was 5.7%. Not only was inflation high, but it was also extremely volatile between 1942 and 1951, which is not surprising given the Fed’s commitment of aggressively monetizing debt. At one point in 1947, CPI hit 20% yoy and then, in 1949, it turned negative and fell as low as -2.9%.
* The purpose of this history lesson is to illustrate that the Fed has in fact controlled rates along the entire US Treasury curve even during a period of high and volatile inflation. Contrary to the assertion of the Washington Post and the commonly-held belief that “targeting longer-term interest rates is an untested strategy,” there is a glaring nine-year period in the mid-20th Century that shows the power of the Fed to hold long-term UST rates below a certain level *if* it makes a commitment of monetizing unlimited amounts of debt. Bernanke has talked highly of such a policy in the past.
The result of such a policy would be higher and more volatile inflation, which makes the recent plunge in TIPS yields and surge in commodities prices perfectly understandable. The Fed will soon implement aggressive policies with the stated purpose of boosting inflation. The market is in fact taking the central bank at its word and acting accordingly.
We are literally at the dawn of a new era of rising inflation. This is the context of the recent decline in the USD and erupting global tensions (i.e., the “currency wars”). The Fed was able to maintain its UST rate-targetting policy for nine full years the last time they entered this territory. There is no reason to believe that the current episode will be a quick one, which means that the USD is likely to weaken and trend to successive historic lows.
* To reiterate one of my recent themes, the “real” is preferable to the “abstract” when central banks are actively printing money and monetizing debt. Hard assets are preferable to fiat paper currencies and financial assets that are harmed by inflation. In FX, the obvious winners are the commodities currencies. Elsewhere, formerly popular assets from the 1970s will make a comeback. Farmland and precious stones, among others, may once again become popular with investors who seek to protect the value of their capital. Deeply depressed assets such as real estate should also perform well.
Kenneth Landon, Oct 7, 2010 kenneth.landon@jpmorgan.com
