by Warren Mosler
Click on graph for larger image and yield curve discussion at Illusion of Prosperity.
While the Fed believes labor markets have improved sufficiently to start somehow unwinding QE, they have made it clear the data and their forecasts are not going to trigger any actual Fed rate hikes anytime soon. For one thing there is currently no sign of any kind of developing private sector credit expansion that would cause them to immediately hike rates to ‘cool down‘. In fact, at this point they are keeping rate policy arguably ‘as accommodative as possible’ to remain supportive of private credit expansion.
On the other hand, the ‘markets’ have become concerned about ‘supply side’ effects of ‘tapering‘, fearing fewer Fed purchases will mean higher term rates, and particularly higher mortgage rates, even as the Fed funds rate remains well anchored at current levels.
So what we are seeing is a ‘market determined‘ decision to hike longer term rates based mainly on supply fears and not on fears of ‘excess demand‘ driving up rates.
And adding to the volatility is the notion that should the Fed someday decide things have ‘normalized‘ and the economy no longer ‘needs‘ negative real rates, that would translate into the Fed shifting the Fed funds rate to maybe 3-4% to be at some ‘neutral’ spread to ‘inflation’ etc.
So it’s pretty much binary- we stay near zero (life-support) until it’s time to ‘normalize‘ to 3-4%.
All of this makes it rational for market indifference levels to shift a full 1% or more – turning term financing on or off- on nuances of Fed language.
All of which comes back to the fact that the term structure of risk free rates, with floating fx, is necessarily a policy decision, best left to political decision rather than market decision, because with floating fx ‘market decision’ is necessarily nothing more than forecasting reaction functions of those setting the rates. That is, the ‘feedback’ from today’s rates determined by market forces is nothing more than what markets think the Fed will vote into policy down the road.
And I see no value in paying the real price of the volatility/uncertainty we are seeing to get that kind of information.
So best to cut the highly disruptive volatility that goes with letting markets determine longer term risk free rates by having the Fed peg the entire term structure of risk free rates with, for example, a bid for the entire treasury curve at their target rate ceiling, along with an open ended securities lending facility.
That is, in my humble opinion, best for the FOMC to vote on the entire term structure of risk free rates than today’s policy of voting on just the Fed funds rate and using ‘language’ to influence the curve.
But that’s just me…