The potency of the Federal Reserve’s monetary elixir has become so great that today’s propitious investors see purgatory as heaven, finding nirvana in the netherworld of stagnant economic growth and in the feasts of monetary gluttony the central bank gods provide. Heaven can wait! Such is the mantra of today’s investor, yet heaven should be seen as the restoration of economic growth and competitiveness both in the United States and throughout the developed world. Investors seem to have forgotten this, because they’ve feasted on the fruit of the central banker’s garden, becoming entranced by the allure of printing presses rolling through eternity.
The Federal Reserve attempted in June to wake unsuspecting investors from their trance by indicating it might begin to create less heavenly conditions and reduce its bond buying. Made aware of their vulnerability, investors ran for cover faster than Adam and Eve, leading to very significant market volatility.
Yet the Fed – through its current Chairman Ben Bernanke or his soon-to-be-named successor – is not about to abandon investors in the garden alone amid the many dangers that lurk. Economic growth is anything but divine, running well below the more celestial levels of 5% for nominal GDP and close to 3% for real GDP – economic growth over the past three quarters has been closer to the ground at 2.9% and 1.4%, respectively (see Figure 1).
Returning calm to the bond market
No wonder, then, that ever since the maelstrom in June Bernanke and his angels at the Federal Reserve have used their powers of persuasion to placate troubled investors. The effort for now appears to have worked, with calm returning to both the stock and bond markets, and investors again content with the way things are, ever hopeful that the future will be better and that economic growth rates will return to the days of old. The Fed needs investors to be believers in order to reflate deflated asset prices and thereby build a pearly bridge to a time when factors beyond just the Fed’s monetary elixir begin contributing to growth.
Below are the three messages that Ben Bernanke and the Federal Reserve have conveyed since June to restore calm to the financial markets, and dampen interest rate volatility, a major goal of the Federal Reserve’s activist policy regime. We believe these important takeaways have shelf life and will remain in force, influencing the bond market for quite some time.
1) Tapering is not tightening.
It is widely believed that a reduction in asset purchases will occur this coming September or perhaps a bit later, but Bernanke reiterated the analogy that the Fed will merely be letting up on the accelerator rather than braking. The current consensus is for a reduction from $85 billion per month to $60 billion–$65 billion in September.
To provide some perspective, the experts at PIMCO’s mortgage-backed securities (MBS) desk have pointed out that the expected $10 billion reduction in Agency MBS purchases – the other $10 billion–$15 billion will be from Treasuries – will be less than the reduction in MBS origination occurring as a result of the recent plunge in mortgage refinancing activity tied to the increase in mortgage rates. The net effect is that we expect the Fed will be purchasing, on a percentage basis, more Agency MBS than it did when the program began. Moreover, the Treasury Department is indicating that for the first time in three years it will soon reduce its issuance of Treasury notes, owing to this year’s sharp decline in the U.S. budget deficit. So, any cutback in Fed buying of Treasuries will be partly offset by a cutback in Treasury issuance.
Keep in mind also that even when the Fed cuts back on its buying it will still be holding trillions of dollars of securities, thereby reducing the amount of bonds that private investors can buy. Natural buyers, which include the central bank reserve managers, pension funds, insurance companies and banks, therefore will likely bid higher than otherwise for the MBS and Treasury securities that remain on the shelves. The Fed’s bond buying in itself is powerful, but there’s something more important …
2) The policy rate, the policy rate, the policy rate!
Bernanke also made clear the distinction between its asset purchase program (aka QE3) and the federal funds rate. These are two separate tools that will not move in tandem. As the Fed has emphasized, there will be considerable time between the end of asset purchases and the first hike in the policy rate. PIMCO now expects the fed funds rate to remain unchanged until early 2016, given persistently low inflation and slow growth.
3) Data, rather than a date, will determine the Fed’s next move.
When the asset purchases began in September 2012, unemployment was at 8.1%. Today, after nearly a full year of data and a 0.7-percentage-point drop in the unemployment rate, the Fed has only now become motivated to consider tapering. In other words, it takes cumulative data to make a case for the Fed to decide on a change in policy. Ultimately, it’s the data, and not simply the passage of time, that will influence the Fed’s decision-making.
These messages are resonating with investors, whose visions of the wild blue yonder are painted in green on the money the Fed will be printing for quite some time.
The manager of the pearly gates
We can’t know whether Ben Bernanke will leave the Fed for greener pastures when his term expires in January 2014, but if he does, whoever is chosen to guard the Fed’s pearly gates will be bound by a greater power: rules and the strength of the institution. Here’s what I mean:
1) The Fed operates under a congressionally charged dual mandate to promote price stability and employment. The next Fed chair (and the next and the next) will be dutifully bound by this mandate.
2) The ghosts of Bernanke, Greenspan, Volcker and the array of former FOMC participants and members who have served the Fed will be in the boardroom when the next Fed chair is sworn in. In other words, the next Fed chair will be expected to and almost certainly will aim to preserve the integrity of the Fed along with the hard-won gains it has earned over the past 30 years in upholding its dual mandate.
3) The Fed is currently operating under a rules-based approach to monetary policy, using forward guidance to communicate to markets the expected path for monetary policy. The Fed has said, for example, that QE3 will likely end when the unemployment rate is around 7.0%, and that the federal funds rate will be kept at 0%–0.25% at least until the unemployment rate reaches 6.5%. The next Fed chair will be bound by these rules. To be sure, the Fed may move the goal posts (change the thresholds), but likely only in a manner that is friendly to markets, because the inflation rate it uses to guide monetary policy is at a 50-year low. This gives the Fed room to be patient about slowing its pace of accommodation, as well as eventually withdrawing accommodation.
Therefore, the outlook for interest rates depends less on the selection of the next Fed chair than it does on the Fed’s overall approach to the policy rate, and PIMCO believes the Fed will not increase that rate until 2016. The inflation rate is also vitally important to the outlook. Investors therefore are advised to remember most of all the importance of the policy rate, the inflation rate and the above factors if market volatility increases as a result of speculation about who will be chosen to lead the Fed and the throngs of people who follow the Fed.