Commentary on Political Economy

Tuesday, 28 July 2020

It is a recurrent injunction on investors: don't fight the Fed. This means that finance capitalists should not make contrarian bets against the monetary policy fixed by the US Federal Reserve.  In reality,  however, what is happening now is that the Fed is not fighting financial markets because it does a "Greenspan put" every time a crisis is imminent.  This is not a healthy state of affairs because (a) it leads to misallocation of capital, (b) it encourages speculation,  and so (c) leads to ever greater financial bubbles. This WSJ Editorial below says exactly that. Read carefully and act accordingly. 

Jerome Powell’s Price-Fix Is In

The Fed flirts with controlling the Treasury debt yield curve.

Every dog of a bad policy idea has its day, but bad monetary-policy ideas seem to get more than one. The latest idea whose time has come and gone and come again is yield-curve control, which is shaping up to be one of the Federal Reserve’s next party tricks.
Opinion: Potomac Watch
00:00 / 23:58
This tool would involve the Fed setting interest rates by diktat for the first time in 70 years, and Governors are warming to the idea. The Open Market Committee may discuss the policy at its meeting Tuesday, and Chairman Jerome Powell said at his June press conference and before Congress that the Fed is studying such controls.


No one should underestimate the risks this poses for the global economy. For decades the Fed has “set” short-term interest rates by expanding or contracting the money supply to guide supply and demand toward the target—via open-market operations for very short-term credit in normal times. The Fed added quantitative easing (QE) to its monetary arsenal in 2008 to influence rates, including long bond rates, but this still leaves room for markets to send signals about expectations for inflation, economic growth and the like.
Yield-curve control muzzles investors. The Fed would state its desired interest rates for government bonds at one or more maturities along the yield curve, commit to buying or selling unlimited quantities of bonds to achieve the target, and then dare global markets to test its resolve. Rising or falling rates—let alone a yield-curve inversion—no longer would be a meaningful signal. Any deviation from the declared rate would arise from speculative betting against the Fed rather than market guesses about the economy.

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Fed officials think this would be good. The Fed has fretted since the Ben Bernanke era that long-term rates often resist the central bank’s control. Operation Twist was an attempt to drag down longer-term rates by buying longer-term assets under QE. Governor Lael Brainard argues that forcing medium-term rates downward would bolster the Fed’s credibility.
Backers say the policy allows central banks to manipulate rates without expanding their balance sheets ad infinitum. This argument appealed in Japan, the Frankenstein’s lab of monetary policy, where two decades of quantitative easing left the central bank with relatively few outstanding government bonds to buy.
The Bank of Japan’s 2016 introduction of yield-curve control saw an initial flurry of central-bank asset purchases, but markets now do as they’re told without intervention. Monthly bond purchases have slowed relative to the era of “pure” QE. Australia introduced yield-curve control in March in an experiment the Fed is watching, and its central bank also needs to trade relatively little to maintain the peg.
Yet this putative blessing could quickly become a curse. Should investors decide to challenge the central bank’s interest-rate peg, authorities would be forced to expand or contract the balance sheet quickly at a time of markets’ rather than officials’ choosing. The Fed would probably win such a battle of wills, but at what cost?
The Fed last experimented with this policy in the 1940s as Washington struggled to finance World War II. Interest-rate price controls reduced the Treasury’s borrowing costs. But they introduced financial and other distortions that became harder to manage the further out of sync the official rate and market sentiment drifted.
By explicitly politicizing interest rates, the Fed also opened itself to political pressure from Treasury to maintain the policy after the war despite rising inflation. This conflict was finally resolved in the 1951 Accord when the Fed wrested back its independence from Treasury, but Fed “even keel” operations to facilitate government borrowing lingered into the 1970s.
If Mr. Powell thinks President Trump’s Twitter feed is bad for Fed independence, wait until the chairman starts manipulating rates outright. The danger will grow more acute the more indebted the federal government becomes from pandemic response and Baby Boomer entitlements.


These concerns pale against the greatest risk: The world needs a market price for the 10-year Treasury yield, and Mr. Powell is threatening to take that away.
The Fed is interested in the Japanese and Australian yield-control experiments, but there’s an important difference between those countries and the United States. Without meaning to be rude, the world cares little about the yield on a 10-year Japanese or three-year Australian bond. Everyone must care about the interest rate on 10-year U.S. Treasury notes.
Mr. Powell and his colleagues propose to fix the price on the paramount safe-haven asset in the global economy. This is true even if the Fed follows Australia’s lead and introduces price controls at maturities of only three or four years. A fixed price at one or two points on the yield curve inevitably will distort prices at every other point.
Note also that Australia’s central bank targets the rate used as the risk-free benchmark for mortgages and other loans in that economy—which is why the central bank thinks the policy works. The same logic in the U.S. would require the Fed to price-fix the benchmark 10-year Treasury sooner or later.
We don’t know what price the global economy would pay for such a policy in economic distortions or financial instability. The Fed doesn’t know either. No one should be eager to find out.

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