VANDERBILT CAPITAL ADVISORS
The Fed’s New Policy
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Fed Chairman Greenspan offered a new paradigm for monetary policy. Tossing aside irrelevantly-behaved monetary
aggregates. Greenspan now steers by the
sextant of inflation-adjusted interest rates.
We applaud this move.
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Real short rates are currently near zero, and must rise toward their positive
“equilibrium” rate once growth improves.
The Fed Policy Guide
At the heart of the new credit market approach is
the notion that the supply and demand for credit will determine the price of
credit. Private market forces influence credit demand and supply to determine
an “equilibrium” short-term interest rate (Re in Figure 1). The actual level of short-term interest rate
(R1 ), however, is set by the central bank
and will generally be different from the equilibrium rate determined solely by
credit market forces. In this setting, monetary policy is measured by the spread
between the actual and equilibrium interest rates (R1-Re). “Unchanged monetary policy” means that
this spread does not change.
Quite apart from the direct
implication for short rates. Greenspan’s
testimony was a tour de force on the theoretical foundations of the Fed’s new
strategy. Greenspan ended any pretense
about the role of the M2 measure of the money stock in policy. The bank liability-based monetary aggregates
are unreliable indicators of liquidity in a word of increasing non-bank credit
intermediation. But the Fed still needs
a guidepost for policy, and Greenspan said that it has one: Real
interest rates relative to their equilibrium level.
If real rates are above that level, the Fed is
tight, with decelerating growth and disinflation the likely results. In contrast, if real rates are below their
equilibrium level, the Fed is easy and accelerating growth and rising inflation
are the probable outcomes. The
implications for counter-cyclical Fed policy are clear. From a starting point of high real short
rates, nominal short rates should be cut when growth cracks. Conversely, from a starting point of low or
negative real short rates, nominal short rates should be hiked when growth
prospects improve.
In this context, Mr. Greenspan explained that the
stimulative power of the current real rate structure has been depressed by the
“headwinds” of balance sheet restructuring and fiscal retrenchment. However, these headwinds are abating. Thus, the real growth and inflation outcomes associated with any given level of real short rates is
set to increase. Accordingly, what
currently is appropriately accommodative policy would in time represent
excessively easy policy. The Fed will
not stand pat to validate a passive shift to an inflationary policy
stance. As growth improves, confirming
the rehabilitated state of balance sheets, the Fed will nudge nominal short
rates up, so as to lift real short rates closer to their equilibrium
relationship to inflation, which is likely a positive spread of 50-150 basis
points.
The economics community has been highly critical of
this new guidepost for policy in the days since Mr. Greenspan first announced
it. We
want to go on record in support of real short-term interest rates as an
intermediate target for monetary policy. The primary criticisms of the guidepost are
that the equilibrium term structure of real rates is an ephemeral,
unquantifiable, unstable concept. In one
sense, this is true; real rates across the maturity spectrum oscillate
cyclically around a non-constant secular trend.
There is no one “perfect” equilibrium point. But perfection is not required for a monetary
policy guide point to be useful.
Sound economic logic and common sense explicability
are sufficient. In our view, real short
rates pass those tests, particularly in the contrast between positive and
negative real short rates:
·
Perpetually-negative real short rates would imply and indefinitely-long
positive arbitrage in favor of speculative investment in physical commodities
with borrowed cash. In the event,
inflation would not only rise, but tend to rise at an accelerating pace. This was the lesson of the late 1970s, an
experience that Greenspan vowed this week that he would not repeat.
·
Zero, not even negative, real short rates constitute a form of theft
from the tax-paying holders of short-term Treasury debt. To wit, after taxes and after inflation, the
purchasing power of the money they lend to the government declines. If maintained indefinitely, investors in
Uncle Sam’s short paper would revolt, lending their funds elsewhere, fueling
the inflationary process.
We do not want to suggest that we are in
danger of being overwhelmed by either of these developments. Nonetheless, they point up the risks of
overstaying an excessively easy monetary policy stance, “getting behind the
curve,” as in the late 1970s. Mr.
Greenspan plans to stay ahead of the curve.
By introducing the concept of an equilibrium level of real short rates,
which is higher than today’s level, Mr. Greenspan establishes a
defensible and understandable rationale for tightening once improvement in
economic growth is clearly visible. M2
would never have done that. Thus, while
the new guidepost for policy may have its flaws, it very much serves the
interest of the Fed’s anti-inflation secular bias. In the long-run the dollar denominated
capital marketswill benefit from such a stance. In the interim, of course, the pain of
tightening will have to be experienced first.
Is The Fed “Monetizing” The Federal Debt?
We have encountered this question a number of times
in recent weeks. At the most basic
level, our first response is yes: The
Fed is buying interest-paying Treasury securities (its assets), paying for them
with non-interest paying bank reserves and currency (its liabilities). The Fed’s conversion of debt into money
monetizes the economy.
There is nothing nefarious about this.
Rather, the money supply creation process is one in which the Fed
accommodates banks’ demand for reserves and the public’s demand for currency
while maintaining the purchasing power of these balances.
The “monetization question”, however, is usually
raised in the context of concerns over whether the Fed’s
stable-purchasing-power (zero inflation) objective is being compromised by the
Treasury’s need to float debt. Put
differently, is the Fed holding short rates at artificially low levels to
support the Treasury’s need to float debt.
Put differently, is the Fed holding short rates at artificially low
levels to support the Treasury’s borrowing, thereby sowing the seeds for rising
inflation? Is the Fed being forced to
purchase an ever-increasing share of Treasury issuance because the appetites of
other investors are sated? If so, then
the Fed is “monetizing” debt in the imprudent manner implicit in the question. With Mr. Greenspan announcing that the Fed’s
next move would be to tighten in pursuit of positive real short rates, any
concerns about “monetization” should be put to rest.
In fact, the recent acceleration of the Fed’s
holdings of Treasury securities is simply a reflection of strong demand for
bank reserves and particularly currency in circulation, which together comprise
the monetary base (see Figure 2).
Some of the currency demand is presumably from
abroad, where the physical dollar is increasingly used as a medium of
exchange. In any event, as the Fed’s
liabilities have expanded in its recent easy money posture, so have its assets,
particularly holdings of Treasury securities.
This policy, however, has entailed no imprudent accumulation of Treasury
securities that would sow the seeds for future inflation. Indeed, the Fed’s holding of Treasuries as a
percent of the total
stock of federal debt are small
(see Figure 3).
