The Federal Reserve meeting minutes stimulated lots of discussion in the media and blogosphere. Cumberland’s Chief Monetary Economist, Robert Eisenbeis, discussed this in his recent note. Here are some quick points from our desk.
Markets are/were reacting to the Fed’s confusing communication. Members of the FOMC (Federal Open Market Committee) are sending a mixed message. They divide along the lines of those, on the one hand, who advocate persisting in a stimulative course until the unemployment rate gets to something between 5% and 6% (and staying on this course for years), and those, on the other hand, who want to stop quantitative easing as rapidly as possible and get to some other, more neutral regime.
Both sides, and those in the middle gradations, argue persuasively. Each policymaker’s view is based on decades of experience with research about the implementation of monetary policy. The players on this monetary stage are serious observers of the roles of central banks. Both sides of the policymaker cohort add to the public debate, which in itself is massively divided.
Among financial-market agents, media personalities, investment advisors, economists and other skilled market observers, there is also an intense divide. Their views range similarly widely. The result is increased volatility in markets. We are witnessing a rapid response to every nuance and every change in point of view in every speech, conversation, or published argument. The added volatility rapidly moves market prices, as it did in the Treasury market selloff last week and in the stock market bounce a day later.
Which One?
A fundamental issue, as yet unresolved, is whether tapering is tightening or easing. In our view, it can be either. Fed purchases of federally backed securities could be reduced to an amount somewhat smaller than $85 billion per month. At the same time, the creation of net new federally backed securities might occur at a rate that falls faster than the reduction in the Fed's purchases. Therefore, the central bank purchases as a percentage of the newly created paper would increase proportionally. Under such circumstances tapering would be easing.
Yet the reverse might also hold. Suppose the federal government were to create new federally backed securities at a rate that was slowing rapidly. That is the case today because the deficit is shrinking. Suppose the Fed's tapering was also decelerating and then quickly fell to zero. The Fed would no longer be a purchaser influencing the pricing of federally backed securities, and in this case rapid tapering would amount to tightening.
Some in the Fed have pointed out that the size of the balance sheet is only part of the issue. The focus should also be on the composition of the Fed’s balance sheet and, additionally, on how that composition integrates with the US banking system.
The Fed is the storage warehouse of the entire banking system’s excess reserves. The Fed created those reserves through quantitative easing. Now it is in the throes of a debate as to how much interest it should pay on those excess reserves.
Here, Again, We Have Division
In the Fed there are those who argue that the rate should be lowered or maybe go to zero. It is currently 0.25%. Others argue that the rate should be raised or that the amount of required reserves should be changed, thereby changing the excess reserves composition. All sides of this debate are passionately argued by skilled agents in monetary economics.
In addition, other questions remain. What should the composition of the balance sheet be on the asset side? Should the Fed own long-term, intermediate-term, or short-term securities? What mix, what composition? How should the Fed change that composition over time? Again, the issue is being thoughtfully and forcefully debated in the public domain.
Janet Yellen’s task, among others as new Fed chair, is to unify the Fed's communication strategy and outline a policy that will be representative and depended upon by agents in the marketplace. She has been working at this for some time. She has a lot of experience with this issue of central bank communications. It is about to become her show.
We ask, seek, hope and anticipate that the members of the FOMC and the soon-to-be-appointed additional personalities on the Board of Governors will coalesce to achieve a communications strategy that is clearer. Markets need to know the direction the Fed will pursue and be able to depend on it. Once they do, decisions can be made about investments and the structuring and deployment of capital in ways that will enable the economy to resume a faster growth rate. We cannot expect agents in the marketplace, established economic enterprises, or those in the entrepreneurial arena to make decisions of a long-term nature when they have to navigate confusing messages from the Fed.
At Cumberland We Hold The Following View
We believe the short-term interest rate will be kept low for a long period of time, which we measure in years, not months. We do not expect the Fed to shock the economy by any action that would cause another recession. Some members of the Fed are already worrying about that possibility. There is evidence of deflationary and/or disinflationary forces at work now. That evidence has raised the eyebrows of some policymakers and commentators. We are among those who worry about this issue. We do not think Japanese-style deflation will happen but we worry that it could happen.
The bond market has to confront a very mixed bag of issues. If the short-term interest rate is going to be anchored near zero, it is not likely that the long-term interest rate is going to shoot up to some wild figure. We have seen reports stating that the 10-year or even 30-year Treasury yield will go to 6%. We do not believe it. It is not going to happen soon. It won't happen when the short-term interest rate is anchored near zero.
Our view remains that some bonds are attractive. They need to be hedged so that interest-rate risk and volatility are dampened. Structuring barbells – that is, portfolios in which the maturities of some bond issues are shorter-term for defensive purposes and others are longer-term – is needed. We select only bonds in the categories where credit is good and where the worry about payment risk is minimal. We do not buy Detroit, Puerto Rico, or Jefferson County. We stay away from certain cities in California and elsewhere.
Credit characteristics are critically important to examine. At the same time, there are great bargains in the tax-free municipal bond space because the tax-free interest rate on the highest-quality bonds is above the taxable interest rate in the long end of the Treasury curve. That absurdity persists for a variety of structural reasons. It cannot last forever, but while it does, it presents great bargains to a skilled bond buyer.
Let’s get back to the tapering, tightening or easing discussion.
Philadelphia Federal Reserve Bank president Charles Plosser has outlined the issue of acceleration and what it means with regard to quantitative easing. He used the metaphor of an automobile in a speech he gave last year. He described what it is like to have to change speed in the area of monetary policy. We utilized a similar metaphorical automobile in our discussion of tapering versus tightening. We call readers’ attention to the piece we released on November 17. We also would like to call readers’ attention to President Plosser's very thoughtful discussion.
The key element to think about is not the size or make of the automobile but how we drive it. The key element is the speed at which monetary policy is altered and reapplied and what that policy is relative to other economic factors. The issue is complex and multidimensional. That is one of the reasons there are such diverse views among policymakers and commentators.
What Plosser did in his Feb. 2012 speech was to characterize what might happen if the Fed were to continue in the policy mode it had adopted at the time. Plosser dissented during several FOMC meetings because he disagreed with the policies in place. We suggest readers take a look at Plosser’s outline, because they can look back now on the views of someone who has been consistent in his arguments about monetary policy. Take a look at the last half of his speech. Review what has happened since he dissented and ask whether or not his warnings were prescient. In our view, he called attention to serious questions and has subsequently been validated by events.
Respect The Hawks
That does not mean the next three years will be as easy to accurately forecast as the last three years have been. What it does mean is that respect has to be given to the hawkish position at the Fed and to the warnings that are issued by hawks. On the other side, one could also examine speeches from dovish colleagues of President Plosser. They would argue that the labor-market recovery is weaker than desired or expected. One could look at the forecasts being issued by FOMC members. One could also notice how they have repeatedly forecast economic outcomes only to later revise their forecasts downward.
The labor market is not robust. Coincidentally, we might be flirting with disinflation or deflation. Falling prices and weak labor markets are the stuff that turns the Phillips curve upside down. When confronted with both trends, does tapering mean easing, tightening, or something else? In our view, we are in uncharted waters with the extraordinary monetary policy evolving at the Fed. No one knows how this will play itself out.
Meanwhile, there is work to do and life continues. We remain fully invested. And we wish all a happy Thanksgiving as we celebrate our great American tradition.
David R. Kotok, Chairman and Chief Investment Officer