Tag Archives: fed funds rate

liquidity trap: what is it? are we in one?

October 18, 2010 By in Current Market Thoughts, economics, liquidity trap, Recent Market Action, Strategy, Vocabulary Tags: , , , , , , Leave a comment

liquidity trap

Over the weekend, Charles Evans, president of the Federal Reserve Bank of Chicago, said at a Fed conference in Boston that he thought the US is in a “bona fide liquidity trap.”  His prescription to cue this situation:  a second round of quantitative easing (basically, the Fed trying directly to push down longer-term interest rates) plus inflation-level targeting (promising to continue loose money policy until inflation reaches 2%).  The purpose of the second is to try to assuage fears of deflation by money market participants.

What does all this mean?

what it is

When the Fed, or any central bank, lowers short-term interest rates, the move has a whole series of effects:

–the initial move signals that the short-term direction of policy is reversing;  the money authority wants to encourage faster economic growth, not slow down inflation

–lower returns on savings instruments tied to short-term rates encourages people to spend money rather than to leave it in the bank

–lower rates on lending money tend to encourage consumers to borrow to finance consumption;  to the extent that younger people tend to be borrowers and senior citizens savers, economic power undergoes a demographic shift that puts money in the hands of those more likely to consume

–arbitrage extends the lowering of rates to longer-maturity debt instruments; lower long-term rates make company investment projects more economically attractive and thus encourage spending on capacity expansion and new hiring.

You can, in theory–and, looking at Japan over the past twenty years, in practice–envision circumstances where this process of lowering interest rates to stimulate economic activity won’t work.  That’s a liquidity trap.  The money authority lowers rates but gets no economic response.

Economists have, not always clearly, distinguished between two types of liquidity trap:

1.  deflationary, sometimes called the “zero bound” case.  The goal of accommodative money policy is to lower nominal rates until they are negative in real terms.  The idea is that once the saver realizes he is no longer even preserving his purchasing power by holding short-term deposits, he will boost his consumption and look for (riskier) investments where he can earn a positive real return.

But nominal rates can in practice only be reduced to zero.  If prices are falling (which is what deflation is), real rates stay high despite the best efforts of the money authority.  If prices are dropping by 3% a year, for example, a zero nominal rate is a 3% real rate.  As a result, savers don’t budge.

There have been instances of negative nominal interest rates–like in Hong Kong in the late 1990s, when the government there announced plans to charge a recurring fee to foreigners for holding bank deposits.  But they’re a practical impossibility.

2.  a “true” liquidity trap, or “pushing on a string.”  The idea is that a point might be reached where central bank action in pumping ever larger amounts of money into the economy would have no further positive effect.  The economy would, in a sense, be saturated with money.  The original thought was that interest rates would remain above zero but would not decline further, despite the efforts of the central bank to push them down.  But the idea can easily be expanded to include other cases where money polity is ineffective:  the transmission mechanism may break down if economic entities are frightened and want to hold precautionary balances even though they earn no economic return; or there may be enough regulatory or government policy uncertainty that it’s hard to identify viable projects to invest in.

where we are now

In the US, inflation has been running at about 1% over the past year or so.  The sharp decline in the dollar over the past several months suggests that, if anything, inflation will rise a bit as we head into 2011.  So, although policy makers and economists may fear deflation, we’re not in that situation today.  That means type #1 above doesn’t apply to us.

There’s a lot of liquidity sloshing around in the US–in the whole world, for that matter.  Several private companies have been able to borrow money at a fixed rate for fifty years or more.  Mexico, despite its history of economic meltdowns and its internal political difficulties, has recently successfully issued a hundred year fixed-rate bond.

This leaves us with breakdown in the transmission mechanism as the reason why money policy has become ineffective.

Mr. Evans of the Chicago Fed seems to think that fear of deflation is the main problem, or at least that’s what his remedy of in effect having the Fed promise to create 2% inflation suggests.  Other economists lack of enthusiastic support suggests his is a lone voice.

This leaves the possibility that attractive investment projects are hard to find.  In a recent speech, the head of the Minnesota Fed, Narayana Kocherlakota, suggested that the gating factor may be lack of skilled workers.  The sound bite the press picked up was his observation that the Fed has no ability to turn construction workers into machinery workers.  He also pointed out that Bureau of Labor Statistics data indicate the economy has about 800,000 more unfilled jobs now than it did in March 2009.

It’s also at least a logical possibility that uncertainty about medical care costs or about future taxes is at the root of companies’ reluctance to invest domestically.  Given that the Fed members are political appointees, though, I think there’s a pragmatic limit to what they’re willing to say in print.  To me, however, it’s clear the Fed thinks a dysfunctional congress and an ineffective president are the reasons the current liquidity trap persists.

I think adjustment to the new economic circumstances is already taking place.  Lack of effective regulation and supportive legislation will just mean the transition process is a longer one.

No more reversion to the mean?–Mohamed El-Erian (I)

September 16, 2010 By in Absolute vs. relative performance, Banks, Current Market Thoughts, Industry Analysis, Investment firms, Strategy Tags: , , , , , , , , , , Leave a comment

“uncertainty changing investment landscape”

The other day I was paging through some old newspapers that I never got to during August (yes, I read the business news on paper).  Sometimes it gives you a sense of perspective to read, a couple of weeks after the event, what trivial things people were thrilled or fearful about at a certain moment.  But mostly I got lazy when the weather got hot and read novels instead of news.  So I was catching up.

I ran across an article from August 2nd with the above title in the Financial Times. It was written by Mohamed El-Erian and Richard Clarida, a professor of economics at Columbia.  Mr. El-Erian is the chief executive of the mammoth bond manager Pimco and an occasional columnist for the FT; Mr. Clarida consults for Pimco.

I usually skip over what Mr. El-Erian writes.  It typically reflects the economic consensus.  Besides that, Mr. El-Erian has seldom been known to use one small word when six or eight big ones will do the same job.  He’s also the public marketing face of Pimco, so we know in advance what his investment conclusion will be namely:

–The global economic landscape will be bleak for many years to come.

–Therefore bonds, even at today’s super-expensive levels, are still a buy; stocks, which are the same price today as a decade ago and the cheapest they’ve been vs. bonds for sixty years, are still a sell.  Pimco’s only change to this mantra over the past year or so has been to kick dividend paying stocks off the approved list.

Nevertheless, I did read this piece.  Despite the fact Mr. El-Erian comes to his usual (horribly incorrect, in my opinion) conclusion about stocks and bonds, I’m glad I did.  For once, Mr. El-Erian wrote something really thought provoking.

I’m going to write about this in two posts.  Today I’ll outline what Mr. El-Erian says.  Tomorrow I’ll write about where I disagree.

the article

The article makes five points.  Four of them are different facets of the same idea–that the disinflationary era that began with the appointment of Paul Volcker as Fed chairman in the US almost thirty years ago is over.  As a result, we can no longer depend on continuingly rising bond prices and falling yields to bail us out of investment mistakes.  Investors have to rethink and retest their strategies.

That isn’t the interesting part.  Equity investors have been soulsearching about excessive leverage and unwarranted risk-taking since the collapse of the Internet bubble in 2000.  (If so, how did the financial meltdown happen?  Investors made three basic mistakes:  we assumed the banks’ accounting statements were reasonably accurate; we wildly overestimated the capabilities and appetite of the regulators to enforce banking and securities laws; and we attributed to bank managements a level of integrity and risk-management competence that most American industrialists possess but many in this industry didn’t.)

The intriguing point is Mr. El-Erian’s first, that “investing on ‘mean reversion’ will be less compelling” in the future.  He implicitly describes the (bond) investing process over the past twenty-five years as having two steps:

–determine the consensus economic forecast, and

–find securities whose valuations imply an outcome that deviates markedly from the consensus.  If the imbedded expectations are too pessimistic, buy the security; if they are too optimistic, sell it short.

Why won’t this work anymore?  In the past, a compilation of expectations from professional economists would form a bell curve, with the areas at and around the mean having very high probability.  The “tails” of the distribution, that is, the forecasts that deviate a lot from the consensus, were short and stubby, that is, highly unlikely and increasingly so the farther away from the consensus they were.

Today, the compilation of forecasts looks less like a bell with a sharp, fat peak in the middle, and more like a straight line with a small bump up in the center.  The economic situation around the world is so uncertain, and the policy actions governments may take to stabilize their countries so unpredictable, that there is, in effect, no solid macroeconomic consensus to bet against.  Not only that, but the more extreme “long tail” outcomes, both bad and good, have become much more likely.

What do you do in a world like this?  Mr El-Erian’s answer is (surprise, surprise)–buy bonds, sell stocks.  You do so because (government) bonds are liquid and default-free.  Therefore, they protect you against the world going to hell in a handbasket.  I guess this means individual investors haven’t been panicking over the past year or more but responding rationally to the current situation by dumping their stocks and embracing bonds.  I suppose that if you really wanted to secure yourself against the worst, you should also think about a cabin in the woods, stocked with freeze-dried food and near a good source of water, maybe with a bow and arrows in case you need to hunt.  Maybe people are.

I’m with Mr. El-Erian up until his conclusion, with which, to put it mildly, I disagree.  Not so surprising, since I’ve spent all my investing life on Wall Street.  The real question, the thought-provoking aspect of the article I’ve linked to above, is to be able to say why I disagree.  What’s wrong with what he’s saying?

More tomorrow.

The Fed’s Narayana Kocherlakota: FRB can’t change construction workers into manufacturing workers

August 30, 2010 By in Academic Theories, Current Market Thoughts, discount rate; Fed Funds rate, economics, Recent Market Action, Strategy Tags: , , , , , , , Leave a comment

When I updated Current Market Tactics yesterday, I mentioned the August 17th speech of the President of the Federal Reserve Bank of Minneapolis, Narayana Kocherlakota.  I thought I’d elaborate on it a bit today.

First, Mr. Kocherlakota.  He went to Princeton (1983) as an undergraduate, and got a PhD in economics at U Chicago (1987).  He taught at a number of places, the  last being Stanford and U Minnesota, before being appointed President of the Minneapolis Fed last year.

Mr. Kocherlakota says the speech contains his own views, and not necessarily those of the rest of the Fed.  But the Fed routinely uses occasions like this to provide background about its actions or to air its thoughts in a way that can’t draw Congressional ire in the way an “official” position might.

As I read it, the speech has several main points:

1.  An economic rebound is under way, although the recovery is unusually slow and accompanied by an unusually low amount of inflation.

2.  The labor market is responding only sluggishly to very stimulative money policy. How so?

The Bureau of Labor Statistics has been keeping a tally of job vacancies since December 2000.  Older, but less detailed data, are available from the Conference Board for the years 1951 onward.  Robert Shimer, an MIT-educated economist teaching at UChicago, has studied the relationship between the vacancy rate and the unemployment rate, publishing the results in an article frequently discussed by the Fed and cited in the printed version of  Mr. Kocherlakota’s speech.

Anyway, there’s a stable, inverse relationship between the unemployment rate and the vacancy rate–the higher the unemployment  rate the smaller the number or unfilled jobs and vice versa–until mid 2008.  Then the relationship breaks down.  Over the past year, for example, the number of unfilled jobs the economy has created has risen from 2.34 million (the low point, last July) to 2.94 million this June.  But the unemployment rate went up during this time, despite the extra 600 thousand extra open jobs.

The unemployment rate should have fallen to 6.3% over the past twelve months as these new jobs were filled.  Why not?  Mismatch.  ”Firms have jobs, but can’t find appropriate workers,” as Mr. Kocherlakota put it.  Mismatch can come in different forms:  a worker can live in Nevada but the job can be in Florida and the worker may be unable/unwilling to sell his house or otherwise reluctant to move; the worker may be only comfortable with pencil and paper, but the job may require computer literacy; or the worker may hope against hope that his old job will magically reappear rather than starting to retrain himself.

The headline grabber of the speech is the statement that “the Fed does not have a means to transform construction workers into manufacturing workers.”  I interpret this as being a strong statement about what it thinks is the problem.  But it could equally well be that the Fed just doesn’t want to make specific policy recommendations about, say, housing.

3.  The recent Fed decision to reinvest proceeds from mortgage-backed securities into Treasuries accidentally scared the securities markets. The reason the Fed is buying Treasuries is not that the economy is in worse shape than commonly thought, but that mortgage prepayments have been larger than anticipated (because low interest rates have prompted lots of refinancing).  Because of this the Fed’s holdings of government securities have dropped below the intended level.

4.  The Fed will likely begin to raise rates before the consensus thinks it’s appropriate. Standard economic theory says that money policy actions can have short-term real effects on an economy but that over time the economy adjusts to restore the pervious real status quo.  The way this is usually expressed is that an inappropriate drop in interest rates can temporarily boost economic activity in a country but that growth soon moderates and the country is in the same place as before, but with higher inflation.

Mr. Kocherlakota’s point is that the long-term real rate of return on cash-like securities is around 1% annually.  If the Fed holds the policy rate at effectively zero after the economy is restored to health, the economy will adjust to restore the real rate to 1%.  It can only do this through deflation–by making real prices decline by around 1% a year.  Sounds kind of wacky, until you think that this is a good description of what Japan has been doing for the past twenty years.

It seems to me the speech does several things:

–it provides an answer to critics who say that money policy is still too tight, by pointing to the large number of unfilled jobs available.  The passage of time will eventually cure the mismatch.  Government programs may speed the process up, but looser money policy will just create more unfilled vacancies.

–it implicitly criticizes the notion that more “shovel ready” projects will do any good.  Again, Japan’s experience over the past twenty years is a cautionary tale.  in 1990, a startlingly high 10% of Japan’s work force was employed in construction.  Rather than allow/force a transition to other occupations, Tokyo launched wave after wave of make-work pork barrel public construction projects.  The government also used formal and informal means to preserve the status quo in other sectors, in order to keep the unemployment rate low.  What did all this get Japan–twenty years (so far) of economic stagnation, chronic deflation, a crippling amount of government debt and a tendency to rue the day that the black ships arrived at its shores.

–it signals to academic critics that it understands the negative implications of keeping the fed funds rate at zero too long.

All in all, the speech is a lot more interesting, and revealing, than the single sound byte.

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