Recently,
the eyes of the financial world were turned to the Federal Reserve to see what
treat they were going to pull out of their "bag'o'tricks" to combat
the looming slowdown in the United States. While those of us who live on
Main Street always assume that decisions made by the Federal Open Market Committee (FOMC) are always unanimous, such is rarely the case. Even
rarer, are central bankers that are relatively outspoken about why they voted
against the proposals that the majority of their fellow Federal Reserve
District Bank Presidents voted for. It is also quite unusual that the
mainstream media covers these viewpoints in more than a cursory fashion.
Operation
Twist seems to have stirred dissenting central bankers into action. On
September 27th, 2011, Richard W. Fisher, President and CEO of the Federal
Reserve Bank of Dallas, took the time to address the reasons why he was one of
3 bankers out of 10 to vote against “Twist”. Here for our illumination
are some of his comments and an explanation of why he is not a fan of "The
Twist". Interestingly enough, Mr. Fisher was also a dissenting voter
when it came to QE2 and the August announcement that the Fed was going to hold
interest rates exceptionally low through mid-2013.
As
you may have read in the mainstream media coverage of Operation Twist, the Fed
has breathed new life into the corpse of the first experiment with “Twist” back
in February of 1961. In Twist One, the Federal Reserve sold part of its
portfolio of short-term Treasuries and invested the proceeds into longer-term
Treasuries in an attempt to lower long-term rates to promote investment and
raise short-term rates in an attempt to stabilize the U.S. dollar.
Back
to Mr. Fisher. He opens his remarks with the following:
"After
meeting for two days last week, the committee announced that its outlook for
the economy was less sanguine than it had previously anticipated. It foresaw “significant
downside risks to the economic outlook, including strains in global financial
markets.” Realizing that resolution of the European situation depends on
European authorities, we focused on policy alternatives that might bolster the
U.S. economy. The committee decided that it would “purchase, by the end of
June 2012, $400 billion of Treasury securities with remaining maturities of 6
years to 30 years and ... sell an equal amount of Treasury securities with
remaining maturities of 3 years or less. This program,” the committee stated, “should put
downward pressure on longer-term interest rates and help make broader financial
conditions more accommodative.” In addition, the FOMC also reaffirmed the
expectation it expressed at the August meeting, “that economic conditions … are
likely to warrant exceptionally low levels for the federal funds rate”―the
interest rate we set for overnight interbank lending―“at least through
mid-2013.”"
(my bold)
Operation
Twist is an attempt by the Federal Reserve to drive down longer term interest
rates thereby driving down the cost of capital to businesses. This will
ostensibly create an economic expansion that results in the creation of much
needed jobs for America. As well (and even more importantly from what I
can see), this could result in a slight increase in short-term rates as the Fed
unloads a portion of its short-term securities for longer term issues. Here's
one key sentence in Mr. Fisher's remarks that I find rather scary:
"Implicitly,
the program may also lift short-term rates, albeit mildly given the expectation
that rates at the short end will remain at “exceptionally low levels” through
mid-2013, perhaps providing some relief to money market funds that, in
searching for yields sufficient to cover their costs, have been invested in
foreign bank paper now considered by many analysts to be somewhat toxic." (my bold)
Somewhat
toxic foreign bank paper? Is Mr. Fisher using central banker-speak to tell investors
that have been fleeing the volatile stock markets and parking their funds in
cash/money market funds that their principal is at risk because the managers of
these funds have been investing in shaky foreign banks? I'd say that foreign
bank paper, particularly from some European countries, is more closely akin to
toilet paper than it is to anything that has any value....and perhaps, toilet paper
is more valuable since it does have a softness factor that the printed page
simply does not possess when used for certain purposes!
Why
is Mr. Fisher not a proponent of “Twist”? In his remarks, he notes that
the effects of Twist One were rather minute. The 1961 version resulted in
a pitifully small 15 basis point drop in long-term Treasury yields and a 2 to 4 basis point
reduction in corporate bond yields. By comparison, a study by two
economists at Northwestern University estimated that the much-touted QE2
lowered Treasury yields by only 20 basis points and corporate bond yields by
only 7 to 12 basis points, hardly the result the Federal Reserve was likely
anticipating last November when they announced QE2. With this data in
mind, Mr. Fisher goes on to say that there are "...suspicions among our
critics that the FOMC is influenced too heavily by the financial interests that
make more money (i.e. commissions) from trading than from lending to
job-creating businesses." No sh$t Sherlock!
Mr.
Fisher outlines four reasons why he dissented as follows:
1.) “Twist”
would provide those mortals who live on Main Street an excuse to stuff their
cash further under their mattresses for fear that an announcement about the
implementation of “Twist” would signal that the Fed had reached the point of
desperation and that the economy was in far worse shape than was publicly
known. As well, driving down the yields on savings could result in
further erosion of the real value of their dollars.
2.) If
“Twist” were implemented, the ability of banks to earn money on the spread
between what they pay on short-term deposits and lend for longer terms would be
under pressure as long-term rates drop to meet rising short-term rates (i.e. a
flatter yield curve). Poor, sad, pitiful banks!
3.) If
“Twist” were implemented, American pension funds would be under greater
pressure since their returns would be well below what they need to ensure that
their reserves meet their obligations. This would force Corporate America
to invest their profits propping up their employee's pension plans rather than
investing in expansion....or their executive stock options. (my addition -
sorry)
4.)
Expanding the holdings of the Federal Reserve's longer term Treasury debt could
result in capital losses to the Fed when interest rates are eventually forced
upwards by market forces as (or if/when) the economy strengthens. This
could put the Fed into a bind when the economy dictates that they need to
tighten because the very act of raising interest rates will reduce the value of
their holdings.
Mr.
Fisher concludes by resurrecting the ghost of 1970's style stagflation. As
a self-admitted inflation hawk, Mr. Fisher is most concerned that a program of
temporarily allowing inflation as a means of creating economic expansion and
reducing debt overhang, is a danger to all Americans. He quotes from Paul Volcker, Chairman of the Federal Reserve
from 1979 to 1987, who spent his tenure combating inflation:
"...The
siren song is both alluring and predictable. Economic circumstances and the
limitations on orthodox policies are indeed frustrating. After all, if 1 or 2
percent inflation is O.K. and has not raised inflationary expectations — as the
Fed and most central banks believe — why not 3 or 4 or even more? Let’s try to
get business to jump the gun and invest now in the expectation of higher prices
later, and raise housing prices (presumably commodities and gold, too) and
maybe wages will follow. If the dollar is weakened, that’s a good thing; it
might even help close the trade deficit. And of course, as soon as the economy
expands sufficiently, we will promptly return to price stability...What we
know, or should know, from the past is that once inflation becomes anticipated
and ingrained — as it eventually would — then the stimulating effects are lost.
Once an independent central bank does not simply tolerate a low level of
inflation as consistent with “stability,” but invokes inflation as a policy, it
becomes very difficult to eliminate...”
I
find Mr. Fisher's remarks most interesting and, surprisingly enough, he
presents a very cogent argument for why he voted against his fellow FOMC
members and perhaps why we should all be concerned about the Hail Mary
implementation of the Fed’s latest experiment. I should also note that Charles Plosser, President of the Federal Reserve
Bank of Philadelphia, announced his reasons for voting against Twist. Here is a quote from Mr. Plosser's speech to the
Villanova School of Business:
"I
dissented from these decisions because I believe that they will do little to
improve the near- term prospects for economic growth or employment and they do
pose risks. Policy actions should never be considered free and should be
evaluated based on the costs and benefits....We also need to ensure that Fed
policy remains credible. In my view, the actions taken in August and September
tend to undermine the Fed’s credibility by giving the impression that we think
such policies can have a major impact on the speed of the recovery. It is my
assessment that they will not. We should not take certain actions simply
because we can. To address our economic ills we must apply the appropriate
remedies. A doctor who misdiagnoses a disease and prescribes the wrong medicine
can make the patient worse. The ills we currently face are not readily resolved
through ever more accommodative monetary policy. If we act as if the Fed has
the ability to solve all our economic problems, the credibility of the
institution is undermined. The loss of that credibility and confidence could be
costly to the economy because it will make it much harder for the Fed to implement
effective monetary policy in the future.” (my bold)
Exactly.
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