Washington As the Federal Reserve prepares to meet next week, policy makers are under conflicting pressure to do more to stimulate the economy and to swear off quantitative easing. And that's just from inside the Fed.
In congressional testimony last week, Fed chief Ben Bernanke refused to tip his hand. His prepared remarks highlighted both positive and negative trends in the US economy - a profitable business sector at home and nasty headwinds from Europe - suggesting he's not ready to pull the trigger just yet.
Not so other members of his policy committee, who are itching to do something. (Exactly what to do is secondary.) Following a June 1 report that showed the US economy adding a paltry 69,000 jobs in May, Boston Fed President Eric Rosengren, currently a non-voting member, recommended additional purchases of long-term securities and offsetting sales of short-term bills and notes. The current maturity extension program, a reprisal of Operation Twist in 1961, ends this month.
"If you were looking for something that would promote growth but didn't have an impact on our balance sheet, then certainly extending the maturity extension program would be a viable way forward," Rosengren said in a June 1 interview.
He's right about the effect on the balance sheet. He's on shakier ground when it comes to promoting growth.
The New York Fed maintains a recession probability indicator based on the slope of the yield curve: specifically, the difference between the monthly average yield on the Treasury's three-month bill and 10-year note. While recession odds one year from now are still low - about 8 per cent - the risk increases as the spread narrows. An inverted curve, with short-term rates higher than long-term rates, is a harbinger of recession. At what point, one wonders, do lower long-term rates stop promoting growth and start promoting recession?
The yield curve serves as an inducement for banks to create credit. Banks borrow short, lend long and pocket the difference. At least they used to before they got creative. The wider the spread, the greater the incentive to increase their earning assets.
When the banking system is impaired, as it was in the early 1990s following the savings and loan crisis and again after the 2008 financial crisis, it takes an unusually wide spread for a longer period of time to achieve the same result.
If policy makers believe the economy suffers from what they call a lack of aggregate demand, there is no point in shuffling the deck chairs. The Fed should expand its balance sheet - increase the money supply - by outright purchases of Treasuries of all maturities.
I'm not advocating more QE. I'm just saying it's a mistake to equate a change in the makeup of the Fed's portfolio, which is tantamount to doing nothing, with an increase.
In fact, it might even do some harm. All it took was a lousy employment report and news that Spain's banks were in the ICU to slice the yield on the 10-year Treasury note to a record low of 1.43 per cent on June 1, a 30-basis-point decline for the week. The market accomplished in a matter of days what the Fed couldn't in nine months and $400 billion of curve-twisting operations.
I suspect we are two events away from a 1 per cent yield on the 10-year note and a flatter curve. All it would take is another weak employment report and a Greek exit from the euro zone to send investors rushing for the safety and security of US Treasuries. And no, those buyers aren't expecting to earn a positive return during the next 10 years.
In the old days, the spread provided a timely reading on the economy's health by juxtaposing a Fed-pegged short-term rate with a market-determined long-term rate. The market rate served as a kind of check on Fed policy.. Why would the Fed want to compromise a good compass and reduce the incentive for banks to lend?
The argument for additional curve-twisting rests on the idea that lowering long-term Treasury yields brings down mortgage rates and helps the ailing housing sector. Freddie Mac's 30-year commitment rate fell to a record low of 3.67 per cent last week. It's not the rate that's deterring home purchases; it's the lenders, having wisely determined that a good credit score and a 20 per cent down payment are important after all. Not to mention potential buyers' fears that home prices may fall further.
If Bernanke isn't convinced of the need for more QE just yet and twisting the yield curve is cosmetic, what else could the Fed do at the conclusion of the June 19-20 meeting? More talk therapy.
The Fed has already pledged to hold the federal funds rate at near-zero at least through the end of 2014. Some policy makers favour providing more explicit guidance, absent outright action, on when the Fed will start to raise rates and under what circumstances.
While reiterating that monetary policy is "no panacea," Bernanke made clear last week that the Fed is ready to do whatever it takes to protect the financial system and economy from renewed stress. If the outcome of the Greek election tomorrow raises the probability of Greece reneging on its obligations, the ensuing chaos could prompt central banks to announce some sort of coordinated intervention to ensure the adequate provision of liquidity to the markets.
Under the circumstances, US long-term interest rates would plunge and the yield curve would flatten. Who knows? One of these days, the Fed may actually have to start twisting the curve in the opposite direction. Operation Steeper Curve, anyone?