Saturday, February 28, 2015

Is the Fed Targeting Bond Yields? Mr. Dudley's Conundrum

In the history of ideas, it is always fascinating to observe how certain notions gain traction and overcome opposition. Max Planck famously wrote, "A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die, and a new generation grows up that is familiar with it." I've always found it a touch optimistic to assume that some form of objective truth always emerges victorious in the marketplace of ideas. We know that isn't the case, with discredited opinions often showing surprising and alarming resilience. Finance and economics are no exceptions to this phenomenon. For example, German hyperinflation is often cited as having led to Hitler's ascent to power, when in reality, it was deflation that brought the Nazis to power, as Matt O' Brien and Lars Christensen point out

Sometimes marketing is important. Certain phrases seem to capture the public imagination, helping ideas spread, for better or worse. I'm often irked by the phrase "Lehman moment", which people often use casually to mean a tipping point in a crisis. Lehman, of course, filed for bankruptcy on Sep 15, 2008. While a massive event, it was just one of many in a significant chain of financial panic. I remember sitting with a fellow junior analyst on Sep 10 or so discussing the momentousness of Fannie and Freddie being put into conservatorship. The failure of the first TARP bill on Sep 29, 2008 also seems to be relatively forgotten in public memory, although that event coincides more closely with the real panic phase of the crisis (The S&P 500 was down about 3% in the 10 trading days between Lehman and the bill failure; it was down about 26% in the 10 trading days after the TARP bill failure). (See chart and data here - hardly conclusive, but worth noting).

But I suspect the real reason I find the phrase "Lehman moment" so chafing is because people often conflate the financial panic with the economic plunge, and ignore a slow Fed response to the crisis. It is surely too much to expect any institution to react perfectly to a crisis given the "fog of war", but I think it's still important to highlight the Fed's missteps. I've done so in a previous post, highlighting how Rick Mishkin's concerns were ignored by his FOMC colleagues

Funnily, most criticism of Fed seems to be encapsulated in another popular phrase, "too low for too long" (TLFTL). TLFTL is of course is the notion that the Fed contributed to financial instability by pursuing an overly accommodating monetary policy prior to the crisis. I don't have a strong view on the matter, seeing arguments in both directions, but it's clear that current Fed policy-makers harbour worries about TLFTL. The Fed has made hawkish noises well in advance of any rate rises, leading to the infamous Taper Tantrum. And more recently, New York Fed President Bill Dudley made the following remarks in a speech:

"One significant conundrum in financial markets currently is the recent decline of forward short-term rates at long time horizons to extremely low levels - for example, the 1-year nominal rate, 9 years forward is about 3 percent currently...If such compression in expected forward short-term rates were to persist even after the FOMC begins to raise short-term interest rates, then, all else equal, it would be appropriate to choose a more aggressive path of monetary policy normalization as compared to a scenario in which forward short-term rates rose significantly, pushing bond yields significantly higher."

Let me note that (a) the context of this speech was a generally nuanced discussion of the real interest rate; (b) the speech is generally quite dovish in not wanting to adhere to a strict Taylor rule that would demand a higher Fed funds rate, and (c) Dudley's views do not, of course, represent the FOMC. But I found myself confused: Is the Fed now targeting long-term bond yields? The use of the word "conundrum" seems deliberate. Naturally, this brought to mind Greenspan's use of the word in testimony to Congress describing falling long-term rates despite an increase in the Fed funds rate. Greenspan and Bernanke seemed content before the crisis to explain away the conundrum with the "global savings glut" hypothesis. Post-crisis, however, Dudley, seems much less eager to use that argument. Dudley seems to be saying "The conundrum is back, but this time we'll act differently. TLFTL won't happen again." 

Oddly, research by Daniel Thornton of the St. Louis Fed suggests that the relationship between Fed Funds and long-term yields had broken down by the 1980s. I must confess I don't have the econometric chops to evaluate this research fully. And even more importantly, perhaps I'm over-analyzing this. After all, policy-makers aren't known for inventive language, so Dudley might just be reverting to a familiar phrase. But if Thornton is right, it's disturbing for Dudley to focus on long-term bond yields. If the Fed is swayed by the price action of long-term bonds, combined with a lingering institutional sense of TLFTL guilt, I would be deeply concerned for the global economy and financial markets. I would also expect such a course of action to backfire spectacularly since long-term bond yields would probably decline if the Fed was too hasty in raising rates. But some bad ideas never seem to die - and as we've seen, some of those bad ideas can have painful repercussions for a very long time.

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