Tuesday, January 13, 2015

How the Federal Reserve Walked the Interest Rate Tightrope and Lost Control

Updated January 26, 2015

In it's January 2015 release of Federal Open Market Committee minutes, the Federal Reserve confirmed that it was being "patient" on raising interest rates as shown in these sentences from the press release dated January 7, 2015 :

"Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy. The Committee sees this guidance as consistent with its previous statement that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time following the end of its asset purchase program in October, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored. However, if incoming information indicates faster progress toward the Committee's employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated. Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated." (my bold)

Actually, the idea that the Federal Reserve was going to taper its purchases of Treasuries and allow interest rates to rise at some point in 2015 was the worst kept secret on Wall Street.  In fact, looking all the way back to March 2014, we see that all of the FOMC participants felt that interest rates would rise to between 0 and 3 percent during 2015 as shown here:

In general, the market took to mean that we would see nothing happen on interest rates until at least the end of April.  That said, the Federal Reserve has been quite clear that it has put an end to its abnormal monetary policy when it confirmed that it would end its asset-purchase program at its October 28 and 29, 2014 FOMC meeting, the transcript of which was released to the public on November 19, 2014.  Here are the key sentences from the press release:

"The Committee judges that there has been a substantial improvement in the outlook for the labor market since the inception of its current asset purchase program. Moreover, the Committee continues to see sufficient underlying strength in the broader economy to support ongoing progress toward maximum employment in a context of price stability. Accordingly, the Committee decided to conclude its asset purchase program this month." (my bold)

What should have happened after the Federal Reserve first announced that it was ending its asset purchase program was that interest rates should have either levelled off or started to rise in anticipation of the Fed's actions.  Let's see what really happened.

Here is a graph showing the yield on 10-year Treasuries since the beginning of June 2014:

Since mid-September 2014 (right around the time that the FOMC actually decided to end its non-conventional monetary policy), rather than rising, the yield on 10-year Treasuries has steadily fallen from a high of 2.62 percent on September 17, 2014 to its current level of 1.90 percent.  That's a drop of 0.72 percentage points or 27.5 percent.

Here is a graph showing the yield on 20-year Treasuries since the beginning of June 2014:

Since mid-September 2014, the yield on 20-year Treasuries has steadily fallen from a high of 3.12 percent on September 18, 2014 to its current level of 2.21 percent.  That's a drop of 0.91 percentage points or 29.2 percent.

Why, even in the face of rising interest rates, are bond investors are still piling into bonds, pushing yields down to multi-year lows?  There are two potential reasons:

1.) Apparently, the demand for the illusion of the safety provided by the United States dollar over-rode the desires of the Federal Reserve.  With the instability around dropping oil prices, the never-ending crisis in Europe, the problems in Russia and ongoing terrorist activities in various parts of the world, investors have decided that buying Treasuries is the one safe haven that remains.  Since demand for Treasuries is up, prices rise and yields fall in tandem.   

2.) Investors simply don't believe that the U.S. economy is as "healthy" as what the Federal Reserve would have us believe and that interest rates will remain low for the foreseeable future, particularly if low oil prices lead to a deflationary environment. 

What could be the result?  If investors are wrong and the Fed is right about the economy and does decide to really contract the growth of credit, a sudden reversal of bond prices could lead to substantial losses for investors.     

In a December 2014 speech by William Dudley, the President of the Federal Reserve Bank of New York, he notes that the Federal Reserve walks a tightrope when it comes to its interest rate policies, particularly because their policies have led them to the "zero lower bound".  Tightening too quickly can create a braking effect on the economy if credit dries up too quickly.  Tightening too slowly or too late can lead to a repetition of the problems that occurred between 2004 and 2007 when the FOMC raised the federal funds rate from 1 percent to 5.25 percent in 17 steps during which 10-year Treasury note yields barely budged as shown on this graph even though the Fed was clearly signalling that it wanted to tighten credit:

Keeping in mind that it was the lack of movement in the longer end of the yield curve that created the easy credit conditions that led to the housing bubble.  And we all know how that movie ended, don't we?

As we can see from this posting, the Federal Reserve has a history of not getting what it wants despite its ample arsenal of monetary policy experiments.  Given that it lost control of the economy in the mid-2000s, it is not out of the realm of possibility that the Federal Reserve will lose control of interest rates and the economy again, one decade later.


  1. " And we all know how that movie ended, don't we?" I don't think the movie ended. I think looking back at this time period historians will say we printed money to prop up the stock market to allow companies to do buy backs and pretend for while they were still making good profits for the shareholders but in reality we had entered a depression that who knows how long it will last.

  2. As mentioned by Anonymous above things continue to roll along and to many issues exist to address in only one article. More and more my concern is turning towards what I see as a bond bubble. Anyway you look at it I have a problem lending my hard earned money out for a long period of time based on predictions of future government deficits.

    These forecast are often formed and made on assumptions based on rosy scenarios or politically skewed to benefit those in power. Like many investors I think the bond market is a bubble ready to pop and won't touch bonds with a ten foot pole. Knowing what we know about the effect that interest rates have on the value of bonds one might deduce that the 30 year bull run on bonds will have to come to an end the moment rates are expected to go up.

    To give you a sense of what this may mean to U.S. Treasury Bond investors a 10 year treasury bond issued at a 2.82% interest rate could see a 42% loss in value from a mere 3% rise in interest rates. This means if you’d held $100,000 in these bonds prior to a 3% rise in interest rates, you would only be able to sell those bonds for $58,000 in the secondary market after the increase. Not only would bond holders be stripped of wealth if rates rise or even worse soar, but rising rates will magnify the nations debt service and rapidly impact our deficit in a negative way. The article below delves into just how big a problem this path could cause.