Explaining the Stir over Recent “Fed-Speak” (American Century)

Friday, March 23rd, 2012

Explaining the Stir over Recent “Fed-Speak”

by Robert Gahagan, Senior Vice President, Senior Portfolio Manager, American Century Investments
and John Eichel Investment Writer

March 20, 2012

The official statement from the Federal Reserve’s March 13 interest rate policy committee meeting was relatively ho-hum (no significant changes from January’s statement), but other recent Fed communications have raised more of a stir. In particular, we explain what “fiscal cliff” and “sterilized QE” mean, and help put them into context. It’s all part of a mixed, uncertain economic outlook in which slower mid-year growth, like last year, can’t be ruled out, but higher inflation by next year is also a possibility.

The U.S. Federal Reserve (“the Fed”—the U.S. central bank) announced no immediate significant changes or tweaks in U.S. monetary policy after its latest Fed Open Market Committee (FOMC) meeting on March 13. The Committee voted to keep the federal funds rate target for short-term interest rates at a historically low 0–0.25% (where it’s been since December 2008), continuing, as it did in January, to say that it “anticipates that economic conditions…are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.”

The Committee also voted to continue “Operation Twist”-related selling of short-term U.S. Treasury securities and purchases of long-term Treasury securities. This strategy is intended to rebalance and refocus the Fed’s balance sheet toward longer maturities, designed to help keep long-term interest rates (such as home mortgage rates) low (see “Our Take on the Fed’s 50-Year Anniversary Revival of ‘Operation Twist,’” American Century Investments Blog, posted September 26, 2011).

Swirling Speculation about Inflation Risks

But the lack of change in the Fed’s last policy statement doesn’t mean that all is quiet and calm at the central bank. Despite the mostly status-quo nature of the statement, speculation has been swirling in the background among economists and other market participants and observers (and, reportedly within the Fed itself) regarding the Fed’s next policy moves or announcements.

Much of the speculation has centered on the accuracy of the Fed’s economic assessments and projections, especially its ability to accurately assess inflation risks. Up to this point, the Fed’s front-line position has left no doubt that the majority of its key current policy-makers remain much more concerned about the sustainability of the post-Great Recession economic recovery than about inflation, as demonstrated by the Fed’s continued extremely accommodative monetary strategies.

Uncertainties about the Actual Strength of the U.S. Economy

But some Fed critics (and governors within the Fed) think that the economic recovery is significantly stronger and more sustainable than the Fed is stating. They argue that the Fed is risking higher inflation and the formation of new speculative asset bubbles (like subprime mortgages and housing, before the Great Recession, or the Tech Bubble in the late 1990s) by continuing such a sustained period of unprecedented monetary accommodation.

One of the trillion-dollar questions of 2012-13 is whether the Fed will further stimulate the recovering U.S. economy (with more measures beyond the low federal funds rate target), or if it will have to scale back the accommodation to address the potentially inflation-fueling/bubble-building momentum of nearly five-straight years of unprecedented accommodative policy moves (dating back to 2007). Or, will it somehow have to both stimulate growth and contain inflation?

Busy Weeks for Fed Communications

Some of the speculation has been fueled by the Fed itself, from its recent statements and speeches, and also from selective releases of information via the central bank’s unofficial (but widely acknowledged) mouthpiece at the Wall Street Journal (WSJ), veteran Fed beat writer Jon Hilsenrath.

The two weeks just prior to the latest FOMC meeting—the weeks beginning February 27 and March 5—were particularly intriguing from a recent Fed communications standpoint. On February 29 and March 1, Fed Chairman Ben Bernanke gave his semiannual monetary policy report to the Congress (what used to be called Humphrey-Hawkins testimony), appearing before the House Financial Services Committee on February 29, and before the Senate Banking, Housing, and Urban Affairs Committee on March 1.

The Approaching “Fiscal Cliff”

Among the biggest attention-grabbers from those legislatively mandated Bernanke appearances was a fiscal-policy warning to Congress, outlining what could happen early next year if Congress continues to waffle and stall on budgetary matters.

Bernanke doesn’t typically highlight fiscal policy (government spending and programs to aid the economy), in his remarks, but in this case he pointedly warned that the U.S. economy faces a potential “massive fiscal cliff” on January 1, 2013 if President George W. Bush-era tax cuts, President Obama’s payroll tax cut, and extended unemployment benefits are all allowed to expire at that time, and $1.2 trillion in automatic mandatory across-the-board spending cuts agreed to last August are allowed to kick in.

As reported by the WSJ and the Congressional newspaper, The Hill, Bernanke warned: “Under current law, on January 1, 2013, there’s going to be a massive fiscal cliff of large spending cuts and tax increases. I hope that Congress will look at that and figure out ways to achieve the same long-run fiscal improvement without having it all happen at one date.”

An Argument to Remain Accommodative

Bernanke warned that allowing tax cuts to expire and trimming fiscal spending could slow economic growth. “You … have to protect the recovery in the near term,” he said. The idea that the recovery might be threatened by the fiscal cliff helped put downward pressure on U.S. stock indices on February 29, according to financial media reports that day.

Because of its potential economic impact, the possible fiscal cliff has been cited by some analysts in defense of the Fed’s continued accommodative policies, adding it to the list of significant headwinds facing the economy this year, which include the weak housing market, high unemployment, tight consumer credit conditions, high gas prices, and unsettled conditions in Europe and the Middle East.

Considering QE3

With short-term U.S. interest rates effectively at 0% for over three years, the Fed hasn’t had much maneuvering room in terms of making monetary policy more accommodative. One alternative that the Fed has pursued pretty aggressively over that period has been quantitative easing (QE—buying U.S. government securities to increase liquidity in the financial system and to keep long-term interest rates low).

We have already seen two recent waves of Fed QE in the U.S. (QE1, from 2008-2010, and QE2, from 2010-11) and a third is being considered, depending on the direction of economic data in 2012. (There’s a favorite saying of economists and analysts that “the decision to execute QE is data-dependent.”)

The primary data that QE depends on are economic growth signals and short-term interest rates—if the economy appears to be in recession or sliding in that direction, and short-term interest rates are too low to cut further, QE may be (and has been) called for.

The Case for “Sterilized QE”

But one of the risks of QE is inflation—adding liquidity and keeping interest rates low can eventually create demand pressures that can push up prices. It can also devalue the dollar relative to other currencies, which is also inflationary. As we mentioned earlier, the Fed now finds itself in a position where it’s still considering another round of QE (QE3) because of economic uncertainties, but it doesn’t want to trigger more potential inflation pressures.

The result: so-called “sterilized QE”—a form of QE described by Hilsenrath in the WSJ on March 7 (in what many speculated was a Fed-planted article) as follows: “The Fed would print new money to buy long-term mortgage or Treasury bonds but effectively tie up that money by borrowing it back for short periods at low rates…employing new market tools they have designed to better manage cash sloshing around in the financial system. Transactions like those… are called ‘reverse repos.’ A related program called ‘term deposits’ also ties up short-term money held by banks.”

Later in the article, Hilsenrath also provided this clarification: “The Fed hasn’t literally printed more money, but it has electronically credited the accounts of banks and investors with new money when it purchased their bonds under quantitative easing.”

Basically, “sterilized QE” is QE with more liquidity controls. We can elaborate on its details in future updates if it looks like it will actually be implemented—we should get more clues from the April and June FOMC meetings. For now, the Fed appears to be just letting us know what options it is considering.

Another interesting thing about this Hilsenrath article was its timing—it appeared the day after the U.S. stock market’s worst performance day of the year (when the S&P 500 dropped over 1.5%, and was down 2.2% over a two-day period), raising speculation that it was timed to help boost the market and confidence (which it apparently did—the S&P 500 rallied 3.9% over the next five sessions). This, along with the “fiscal cliff” example, show how closely tuned the markets are to what the Fed is saying and how they’re tracking what its intentions are.

The Continued Case for Inflation Protection

What’s the lesson for investors from all of this? We suggest being prepared for several different economic and market scenarios in 2012. In other words, stay diversified. If the Fed—with all of its research tools and economic brainpower at its disposal—is uncertain about the economic outlook, we all should tread lightly.

As the President and Chief Executive Officer of American Century Investments, Jonathan Thomas, has been writing to fund shareholders in our shareholder reports this year: “More market volatility appears likely in 2012…as uncertainties regarding European debt, economic strength, government budget deficits, and the U.S. presidential election sway investors. We believe strongly in adhering to a disciplined, diversified, long-term investment approach during volatile periods.”

We also believe in striving for inflation protection. Both the Fed and its critics appear to be giving serious consideration to the longer-term inflation implications of the past nearly five-straight years of accommodative monetary policies, and we suggest investors should too. To serve investors’ needs, American Century Investments offers a suite of funds that aim to provide various forms of inflation protection, utilizing holdings that include commodity and precious metal-linked securities, foreign securities and currencies, and inflation-linked bonds.

American Century Investments^® offers a wide variety of stock, bond and asset allocation funds. Visit americancentury.com for more information: Individual Investors | U.S Investment Professionals

Download a PDF of this post.

The opinions expressed are those of Robert V. Gahagan and the fixed income portfolio management team at American Century Investments, and are no guarantee of the future performance of any American Century Investments portfolio. This information is not intended to serve as investment advice; it is for educational purposes only.

Generally, as interest rates rise, bond prices fall. The opposite is true when interest rates decline.

Diversification does not assure a profit, nor does it protect against loss of principal.

Copyright © American Century Investments

Tags: American Century, American Century Investments, Economic Outlook, Federal Funds Rate, Gahagan, Home Mortgage Rates, Inflation Risks, Interest Rate Policy, Investment Writer, Maturities, Open Market Committee, Policy Committee, Portfolio Manager, Qe, Rate Target, S Central, Senior Vice President, Term Interest, Treasury Securities, U S Treasury
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No QE3 – Yippee!

Thursday, March 15th, 2012

No QE3 … Yippee!

March 13, 2012

by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

Key Points

• The Fed made no major changes to its policy statement and announced a continuation of Operation Twist, but did not hint at or announce further quantitative easing.
• The Fed’s assessment of the economy did improve somewhat.
• Richmond Fed President Lacker’s dissent and Dallas Fed President Fisher’s pronouncements ring true.

In the policy statement released at the conclusion of its latest meeting, the Federal Reserve upgraded its assessment of the economy, noting improvement in labor conditions, and did not suggest imminent additional monetary easing, while keeping the fed funds rate in the 0-0.25% range it’s been in since the end of 2008. Key in the statement released by the Federal Open Market Committee (FOMC): “Labor market conditions have improved further; the unemployment rate has declined notably in recent months but remains elevated.”

Lacker dissents … again

There was one dissenter, Richmond Fed Bank President Jeffrey Lacker, who did so for the second consecutive time and who “does not anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate through late 2014.”

As for financial conditions, “strains in global financial markets have eased, though they continue to pose significant downside risks to the economic outlook.” The Fed made no change to what’s become the key sentence in its statements, noting that conditions would probably warrant “exceptionally low” short-term interest rates at least through 2014.

The Fed also subtly upgraded its assessment of the investment environment. Business investment spending is said to have “continued to advance,” whereas in its January 25 statement the FOMC said it “has slowed.”

Addressing energy prices

There wasn’t much new in the Fed’s statement other than addressing the short-term inflationary implications of the recent spike in energy prices. Inflation “has been subdued in recent months although prices of crude oil and gasoline have increased lately.” The increase in oil prices “will push up inflation temporarily, but the committee anticipates that subsequently inflation will run at or below the rate that it judges most consistent with its dual mandate.”

Operation Twist continues, but no QE3

“The Committee also decided to continue its program to extend the average maturity of its holdings of securities as announced in September.” In other words, “Operation Twist” is ongoing, but there was no mention of extending it beyond its scheduled June expiration. That will likely be discussed and detailed at the next FOMC meeting in late April.

For those who’d been expecting a third round of quantitative easing (QE3)—and we were not among them—the reasoning is likely already noted above: the economy has not only picked up its pace of growth, but the unemployment rate has also begun to ease meaningfully. Remember, both price stability (inflation) and resource utilization (maximum employment) are the Fed’s mandates. With recent conflicting data on both, and the rarity of the Fed changing course amid conflicting signals, QE3 was unlikely in our opinion.

Personally, I disagree with the many who feel the only prop under this very strong market has been quantitative easing. I do believe the economy has entered the second phase of the recovery (the expansion phase) in which jobs will be more plentiful, small businesses will be greater participants, and even housing will be a positive contributor. The market’s recent strength—and importantly, its surge immediately after the Fed’s announcement into today’s close—supports this view.

Fisher speaks the truth

The subject of QE3 was likely discussed and debated, but we’ll have to wait until the minutes of the meeting are released in three weeks to get any details. I share the view of Richard Fisher, President of the Dallas Fed, who’s publicly said that economic conditions are improving and the underlying trend of inflation is “converging on the Fed’s 2% target.” Key to Fisher’s perspective is that the liquidity injected into the financial system via QE1 and QE2 hasn’t traveled into the real economy, but instead sits on banks’ balance sheets, invested in financial assets, parked in cash—or even parked at the Fed itself.

Why keep treating a recovering patient like it remains in the operating room? Fisher recently said, somewhat bluntly, that he sees “no need to administer additional doses unless the patient goes into postoperative decline.” He went on to suggest that if incoming data continues to show accelerating improvement in the economy, “the markets should begin preparing themselves for the good Dr. Fed to wean them from their dependency rather than administer further dosage.” Hear, hear.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Tags: Bank President, Charles Schwab, Chief Investment Strategist, Consecutive Time, Dallas Fed, Dissents, Downside Risks, Fed Funds Rate, Fed President, Federal Funds Rate, Federal Open Market Committee, Global Financial Markets, Investment Environment, Jeffrey Lacker, Key Sentence, Liz Ann, Open Market Committee, Richmond Fed, Senior Vice President, Unemployment Rate
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The Economy and Bond Market Radar (January 30, 2012)

Sunday, January 29th, 2012

The Economy and Bond Market Radar (January 30, 2012)

Long-term Treasury yields fell sharply this week as once again the schizophrenic market gyrates up one week and down the next, which is what we have experienced since mid-November.

The Federal Reserve surprised the market this week with a news release that details the “central tendency” of thinking from Fed officials on the direction of federal fund rates. What surprised the market was the Fed’s statement that current economic conditions “are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.” That is well beyond current expectations and was a catalyst for appreciation.

Easy monetary policy on a global basis and a reduction in risk perception in Europe has allowed bonds to rally, not only here in the U.S. but also in Europe. As can be seen in the chart below, Italian 10-year bond yields have rallied significantly from more than 7 percent to below 6 percent in less than three weeks.

Strengths

• The Federal Reserve guided the market to expect continued easy monetary policy for roughly the next three years.
• Durable goods orders rose 3 percent in December as manufacturing indicators are signaling a rebound in activity.
• In another indicator that global manufacturing is improving, eurozone composite PMI rose back into expansion territory.

Weaknesses

• Fourth quarter GDP rose 2.8 percent. While this was the best quarterly showing since the second quarter of 2010, it did trail expectations of at least 3 percent growth.
• New home sales fell 2.2 percent in December and only 302,000 new homes were sold during 2011, the worst performance since 1963.
• The Conference Board index of leading economic indicators index (LEI) rose 0.4 percent but was short of expectations.

Opportunities

• The Federal Reserve is in no hurry to raise rates and appears very comfortable with the current inflation situation. This means the Fed is likely to maintain a very easy monetary policy for some time.

Threats

• If the weekly oscillating trading pattern over the past couple of months is any indication of market direction, bonds could see a modest sell-off next week.

Tags: Board Index, Bond Market, Bond Yields, Central Tendency, Durable Goods Orders, Economic Conditions, Economic Indicators Index, Fed Officials, Federal Funds Rate, Federal Reserve, Global Basis, Index Of Leading Economic Indicators, Leading Economic Indicators, Leading Economic Indicators Index, Market Radar, Monetary Policy, Quarter Gdp, Risk Perception, Schizophrenic Market, Treasury Yields
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Journey to the Center of the (Fed’s) Mind (Sonders)

Friday, January 27th, 2012

Liz Ann Sonders
Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.

January 25, 2012

Key Points

• The Federal Reserve opted to keep short-term interest rates on the floor and extended the period of time during which rates are likely to remain near zero.
• Newly published forecasts show slightly better growth, a bit less inflation and a lower unemployment rate.
• Fed Chairman Ben Bernanke got hit with a lot of questions about the risks of extending zero-rate policy for 2 ½ more years.

First, the statement

The Federal Reserve was more explicit in its statement today, which accompanied the finale of the Federal Open Market Committee’s (FOMC) two-day meeting today.

“…the Committee decided today to keep the target range for the federal funds rate at 0 to ¼ percent and currently anticipates that economic conditions—including low rates of resource utilization and a subdued outlook for inflation over the medium run—are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.”

The reference to 2014 was an extension of the Fed’s previous pledge to keep rates low at least until mid-2013. Although several Fed officials have said even further easing (read: quantitative easing round three, or QE3) is needed to revive hiring and housing, there was one notable dissent today: “Voting against the action was Jeffrey M. Lacker [Richmond Federal Reserve Bank President], who preferred to omit the description of the time period over which economic conditions are likely to warrant exceptionally low levels of the federal funds rate.”

The Fed did say it would continue its “Operation Twist” program, which has been extending the average maturity of its $2.6 trillion securities portfolio.

Frankly, I have reservations about the two-and-a-half year span during which the Fed expects to keep short rates effectively pegged at zero. Much can and will likely happen between now and then, be it economic conditions and/or inflation trends. Given that the Fed has often been criticized in the past for being behind the curve, it almost guarantees it will do it again by this effective promise. And, it can also be seen as yet another hit to savers and retirees.

As noted by High Frequency Economics, “they are now too cautious, expecting only ‘modest’ growth as far as the eye can see. We see no mention of the sustained surge in bank business lending, the rebound in survey data, the upturn in every housing indicator and only a tangential reference to the plunge in the pace of layoffs. The markets face two dangers if these emerging trends persist. First, the Fed might have to renege on its ‘promise’—the word ‘likely,’ after all, is not a solemn vow—or, second, they might tighten by reversing QE, while sticking to zero rates. Either way, fingers get burned in the markets.”

Second, the forecasts

Shortly after the release of the FOMC statement, the Committee released expectations of the five Fed board members and 12 district bank presidents. Of these 17 Fed officials, nine expect short-term interest rates to remain below 1% by the end of 2014, while six expect rates to remain at zero into 2015. The Fed also lowered its estimates for growth and inflation this year, a move consistent with its statement as noted above.

These projections are new for the Fed—it’s the first time in FOMC history that it’s explicitly laying out its forecast for growth, inflation and rates. Assuming an increase in rates sometime in late 2013 or 2014, it would be the first rate hike since June 2006. Think about that: as noted below, there are two Committee members that think the first hike should come in 2016—if that’s the case, it would mean a full decade of no rate hikes.

There was no unanimity with regard to the pace at which the Fed should raise rates:

• Three officials believe they should begin rising this year.
• Another three believe they should begin moving higher next year.
• Five say they should go up in 2014.
• Four say 2015.
• And two even believe the first hike shouldn’t come until 2016!

By the way, the Fed

It’s estimated that US economic growth, as measured by real gross domestic product, will be between 2.2% and 2.7% (from the fourth quarter of 2011 through the fourth quarter of this year). For 2013, US growth is forecasted to be between 2.8% and 3.2%. (The forecasts are calculated using a “central tendency forecast,” which excludes the three lowest and highest projections.)

As for inflation, it’s projected to drop below the Fed’s newly stated goal of 2%, with the majority of officials expecting inflation in a range between 1.4% and 2.0% through 2014. These are marginally lower inflation projections than those published last November.

And, in keeping with the recent traction seen in job growth, the Fed’s forecasts for the unemployment rate have also ticked down and now sit at between 8.2% and 8.5% for 2012, 7.4% and 8.1% for 2013 and 6.7% and 7.6% for 2015. These forecasts are below the prior forecasts published last November.

(For a more detailed look at the Fed officials’ economic projections, see the full chart in today’s Fed release.)

Third, the press conference

My friend Steve Liesman, from CNBC, asked the first question, and it was a good one. He essentially wanted to know whether the Fed was doubting the economic improvement that’s been seen in the past few months. Bernanke did acknowledge improvement in some areas, but “mixed results” in others; specifically: “We continue to see headwinds emanating from Europe, coming from the slowing global economy.” He also said, “I don’t think we’re ready to declare that we’ve entered a new, stronger phase at this point. We’ll continue to look at the data.”

There were additional questions that got to this subject. One asked whether there was risk of a backlash from the Fed’s new information, particularly by hurting confidence by suggesting the economy is weaker than people think. Bernanke’s response: “Those considerations are outweighed by the need to maintain accommodative conditions,” so it’s attractive for companies to invest and hire, and for people to buy houses.

Bernanke did address the fact that the individual forecasts don’t have names attached to them. He indicated that they aren’t disclosing the identities for a reason—to ensure discussion at meetings and to depersonalize monetary policy.

Bernanke did not escape politics in the questioning, and was asked about the hostility toward the Fed during many of the Republican debates. In particular, he attempted to fight back against the criticism that Fed policy is crushing savers and retirees: “The savers in our economy are dependent on a healthy economy in order to get adequate returns.”

Finally, the Chairman was asked about his confidence in the Fed’s forecasting abilities. At least he was honest when he replied, “Our ability to forecast three and four years out is obviously very limited. Nevertheless we have to make a best guess, a provisional plan,” much like companies do. “It’s certainly possible we will be either too optimistic or too pessimistic,” which suggests the Fed may have to adjust to the realities of the actual data.

We think that’s a real possibility.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Tags: Bank President, Ben Bernanke, Charles Schwab, Chief Investment Strategist, Fed Chairman, Fed Officials, Federal Funds Rate, Federal Open Market Committee, Federal Reserve Bank, Journey To The Center, Lacker, Liz Ann, Open Market Committee, Qe3, Resource Utilization, Senior Vice President, Target Range, Twist Program, Unemployment Rate, Zero Rate Policy
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Fixed Income in 2011: The Year of Opposites (Tucker)

Wednesday, December 21st, 2011

by Matt Tucker, Fixed Income,  iShares

Expectations of rising interest rates. Fears of massive municipal bond defaults. Heading in to 2011, those were the two strong trends that investors expected would shape the fixed income market. But as we know now, 2011 turned out to be almost the opposite of expectations.

At the end of 2010, investors were positioning their portfolios to respond to rising interest rates. To hedge rising interest rates in the first three quarters of the year, investors turned to fixed income ETFs, moving into short duration funds or investing in leveraged and inverse funds. Leveraged and inverse fixed income funds almost doubled in size by September¹.

But contrary to expectations, rising interest rates never materialized. The Federal Reserve kept its benchmark Funds rate near 0% and in August communicated for the first time that it intended to keep rates between 0% and 0.25% until 2013.

This was an unprecedented move on the part of the Fed. Previously they had communicated changes in the Fed Funds rate, as well as their view on the economic outlook and the likely path the Fed Funds rate would take in the future. Never before had they indicated to the market that they would maintain a target Rate for a specific period of time.

In September, the Fed once again took action to keep interest rates low, unveiling “Operation Twist.” The Fed said it would sell shorter-term Treasuries from its own portfolio and use proceeds from the sales to buy long-term Treasuries – a move designed to lower long-term interest rates.

The net result of these actions, illustrated in the chart below, was that US Treasury rates actually declined over the course of year. Short end Treasury rates remained low because they are primarily driven by the Federal Funds rate, which remained at 0%. Longer maturity Treasuries actually moved lower in yield, driven by the Fed actions as well as by increased investor concern over European sovereign default risk.

At the start of 2011, there was also a great deal of fear about the health of the US municipal bond market. Numerous states were facing budget deficits and cities were grappling with everything from falling tax revenue to rising pension costs. Wall Street analysts meanwhile were predicting that municipal defaults would be large in both size and quantity, with some fringe analysts even predicting that defaults could total hundreds of billions of dollars.

Well, it’s nearly one year later. While a few high-profile defaults and bankruptcies were announced — like the Jefferson County bankruptcy — wide-scale defaults never materialized.

According to S&P, municipal defaults in 2011 are down 69% compared to the same period in 2010. Year-to-date monetary defaults in the S&P Municipal Index total roughly $750 million, representing less than 0.5% of the index. This compares with 2010 defaults of $2.4 billion.

Despite the dire predictions, most municipalities have a number of tools at their disposal – like raising taxes, cutting spending or laying off government workers — to help them make timely payments on their debt and to avoid defaults.

What’s the lesson learned from 2011? Diversification and liquidity are key, especially in volatile markets. All markets rise and fall, and the fixed income markets are no exception. Having a diversified portfolio can help to insulate your holdings, while being in liquid investment vehicles allow you to make timely, tactical investment decisions based on changing market environments.

Footnotes: 1 Source: Investment Company Institute: Estimated Long-Term Mutual Fund Flows report data as of 11/22/2011

Diversification may not protect against market risk. Liquidity of investments is not guaranteed.

Bonds and bond funds will decrease in value as interest rates rise.

Tags: Economic Outlook, Fed Funds Rate, Federal Funds Rate, Federal Reserve, Fixed Income Market, Investor Concern, Matt Tucker, Maturity, Municipal Bond, Opposites, Period Of Time, Portfolios, Rising Interest Rates, Target Rate, Term Interest, Three Quarters, Treasuries, Treasury Rates, Unprecedented Move, Unveiling
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3 Drivers, 2 Months, 1 Gold Rally?

Sunday, November 6th, 2011

3 Drivers, 2 Months, 1 Gold Rally?

By Frank Holmes, CEO and Chief Investment Officer, U.S. Global Investors

Federal Reserve Chairman Ben Bernanke announced this week that the Federal funds rate will stay near zero for now. He reasoned that the “low rates of resource utilization and a subdued outlook for inflation over the medium run” would likely “warrant exceptionally low levels for the federal funds rate at least through mid-2013.”

This will likely translate to the real interest rate (which is the rate of interest an investor can receive on a U.S. Treasury bill after allowing for inflation) remaining negative for at least another year and a half.

For gold investors, a low-to-negative interest rate has been associated with a powerful historical trend. Going back four decades, gold has experienced positive higher year-over-year returns whenever the real interest rate tipped below 2 percent.  And the lower the rates drop, the stronger gold tends to perform.

Marc Faber, editor of the Gloom Boom & Doom Report, believes the Fed will keep rates near zero even longer than 2013. In his November commentary, he points to the opinion of Chicago Federal Reserve Bank President Charles Evans, who wants the Fed to “commit itself to keep short-term rates at zero until the unemployment rate falls below 7 percent or the outlook for inflation over the medium term goes above 3 percent.” If Evans has his way, Dr. Faber extrapolates that rates could “stay at zero for five or even 10 years (and negative in real terms).” Based on Dr. Doom’s prediction, one could infer that gold could continue its bull run for several years to come.

This rate-cutting trend is not only an American phenomenon, as other countries have been slashing their interest rates. In surprise moves, the central banks of Europe, Brazil, Indonesia and Turkey have all recently cut rates. This week, the European Central Bank surprised markets when it cut its key interest rate by 0.25 percent. Brazil has cut rates twice over the past two months, and Turkey cut its benchmark interest rate a few months back as part of an unorthodox move to keep its economy from overheating.

Many investors follow the Fed’s decisions, but to see countries’ rate changes in action over the years, The Wall Street Journal put together an interesting interactive showing how countries around the world have increased or decreased their interest rates over the past several years. Check it out now.

The other strong action central banks have been taking is loading up on gold. In “Perfect Storm Creates Tidal Wave of Gold Demand,” we discussed how the trend of gold buying by central banks in the East has been increasing while the Western central banks have ceased selling their gold. Now Turkey’s central bank is trying to manage liquidity in the banking system by allowing banks to keep up to 10 percent of their required reserves against lira liabilities in gold.

Bloomberg News reported that if Turkish banks fully allocate that 10 percent, it will free up $3.1 billion in liquidity.

This has followed a similar move by Turkey’s central bank to allow private banks to hold an increased percentage of their reserves against foreign-currency liabilities. Since that change, 21.6 tons of gold were added. According to Bloomberg News, another 55 tons of gold could be added after the new adjustment goes into effect on November 11. This would bring the total gold reserves in the Turkish central bank to a value of $10 billion.

‘Tis the Season for Gold
Combine the central bank purchases of gold with the fact that we are now entering the strongest months of the year for gold. The chart from Bank of America Merrill Lynch (BofA) below shows how gold and gold equities have performed on an average monthly basis over the past 10 years. While the spot gold price has differed from the S&P/TSX Composite Index of gold equities during the first 10 months of the year, their historical pattern is very similar during the last two months. November has historically been the strongest month of the year for gold equities, with mining stocks increasing 8.1 percent.

Combined with equity valuations at historically low levels, BofA believes, “gold equities could follow the historical pattern in late 2011.”

The argument for a rally in gold and gold equities this time of year is strengthened when we compare the seasonal patterns over different time frames. I often show gold’s historical patterns when I present my Goldwatcher Presentation to emphasize how strong these last months of the year have been over every time period.

The 5-year pattern has strayed from the longer-term historical patterns, particularly before the October timeframe. For the past five years, the gold price has started the year weak, and then moved considerably higher than its 15- and 30-year historical average from February through September.

However, over the 5-, 15- and 30-year patterns, the trends in November and December have mimicked each other.

BofA says a key driver of this late-year gold trend has been increased jewelry demand for the Christmas buying season. We agree wholeheartedly, as the gift giving season around Christmas drives many consumers to purchase gold jewelry for their loved ones. And despite consumer sentiment remaining near a record low, the National Retail Federation anticipates holiday sales rising a modest 2.8 percent this November and December.

In India and China, people are especially amorous of the metal and buy gold out of love. It is customary in most developing countries to give gold as a gift to friends and relatives for birthdays, weddings and to celebrate religious holidays. And this time of year, gift giving in the form of gold is especially strong in India. Indians recently celebrated Diwali, which spurs gold buying during a five-day celebration of good over evil, light over darkness, and knowledge over ignorance (Read the Frank Talk post on Diwali).Diwali is followed by the main Indian wedding season where many Indians will be buying golden gifts for the bride and the groom. In China, 2012 is the “Year of the Dragon” and retailers expect to sell gifts in the form of gold dragon jewelry, pendants, statues and coins.

Gold investors should remember that volatility swings both ways. If you look at 10 years of data, gold bullion has had 10 percent price swings about 7 percent of the time. These ten percent swings are more common for gold equities, as the NYSE Arca Gold BUGS Index has had 10 percent swings over 20 trading days about a third of the time.

With three drivers—1) negative real interest rates propelling investors to seek gold for it’s perceived “safe haven” qualities, 2) the Love Trade in full bloom, and 3) central banks increasing their holdings in the yellow metal—happening over the next two months, gold is one commodity that could benefit.

Tags: American Phenomenon, Brazil, Central Banks, Charles Evans, Chicago Federal Reserve Bank, Chief Investment Officer, Dr Doom, Federal Funds Rate, Federal Reserve Bank, Federal Reserve Chairman, Federal Reserve Chairman Ben Bernanke, Frank Holmes, Gold, Gold Investors, Gold Rally, India, Marc Faber, Negative Interest, Outlook, Real Interest Rate, Treasury Bill, U S Global Investors, U S Treasury, Unemployment Rate
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FOMC Engages in ‘Operation Twist,’ Another Unconventional Step

Thursday, September 22nd, 2011

This post is a guest contribution by Asha Bangalore, vice president and economist at The Northern Trust  Company.

The Fed left the federal funds rate unchanged, as expected, at 0.0-0.25%. The much awaited action called “Operation Twist” was part of the policy announcement. It was not an unanimous vote, three Fed Presidents — Richard Fisher of Dallas, Narayana Kocherlakota of Minneapolis and Charles Plosser of Philadelphia – who are concerned about inflation dissented. These three Fed officials opposed the FOMC’s August 9, 2011, decision that included an assurance of holding short-term interest rates near zero until mid-2013.

As per today’s announcement, the Fed will purchase $400 billion of Treasury securities with maturities of 6-30 years and finance this operation with sales of an equal amount of Treasuries with three years or less left on them. Operation Twist will not increase the current size of the Fed’s balance sheet. It is unlike the $600 billion program (known as QE2) which increased the size of the balance sheet to around $2.8 trillion and ended in June 2011. The objective of Operation Twist is to lift economic activity, that has slowed in the first-half of the year, by bringing about lower interest rates for home mortgages and business investment outlays. The FOMC included a surprise package – it will now reinvest early payment of mortgage securities back in debt issued by Fannie Mae and Freddie Mac.

The Fed continues to believe that “there are significant downside risks to the economic outlook, including strains in global financial markets.” The reference to global financial markets is new in the September statement and reflects the ongoing debt crisis in Euroland. The Fed anticipates a deceleration of inflation in the months ahead and continues to maintain that longer-term inflation expectations are stable.

In the Fed’s opinion, the rearrangement of it current portfolio “should put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative.” However, if the unemployment rate fails to register a significant improvement, households who were not able to obtain a mortgage at already historically low rates (see Chart 1) are unlikely to pass strict underwriting standards that are in place now. The likely limited benefit of Operation Twist is the subject of the U.S. Economic Outlook of September 9, 2011. If this forecast is accurate and economic growth remains lackluster, Chairman Bernanke would most likely embark on QE3 in the early part of 2012.

Source: Asha Bangalore, Northern Trust – Daily Economic Commentary, September 21, 2011.

Tags: Charles Plosser, Debt Crisis, Downside Risks, Economic Outlook, Fannie Mae, Fannie Mae And Freddie Mac, Fed Officials, Federal Funds Rate, Global Financial Markets, Home Mortgages, Inflation Expectations, Mortgage Securities, Narayana, Northern Trust Company, Outlook, Policy Announcement, Qe2, Surprise Package, Term Inflation, Treasury Securities, Unanimous Vote
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Fed Signals Intention to Complete Asset Purchases

Thursday, April 28th, 2011

This post (with the exception of the two video clips at the end) is a guest contribution by Asha Bangalore, vice president and economist at The Northern Trust  Company.

Today’s post-FOMC meeting analysis has two components: policy statement and Chairman Bernanke’s press conference. Starting with the policy statement, the Fed held the federal funds rate unchanged at the narrow band of 0 to ¼ percent. There were no dissents, although in recent speeches, Fed Presidents Plosser and Fisher (both voting members) had voiced their concern about imminent inflationary pressures.

The Fed’s views about the economy shows a minor difference from the March 15 policy statement. The first sentence of the today’s policy statement describes the economic recovery as “proceeding at a moderate pace.” The March statement upgraded the economic recovery to be on “firmer footing” from the January 2011 statement which simply noted that the “economic recovery is continuing.”

The Fed’s take on spending components of GDP was left intact, with housing sector continuing to be depicted as “depressed” and household expenditures and equipment and software outlays as expanding The Fed indicated that “inflation has picked up in recent months” but continues to view higher prices of energy and other commodities as “transitory.” Rhetoric about closely tracking inflation and inflation expectations was retained in today’s statement.

The policy statement settled the uncertainty about whether the Fed will complete the $600 billion purchase of Treasury securities, referred to as QE2, by noting that it “will complete” these planned purchases.

There was no change to the Fed’s near term outlook for monetary policy as the phrase “low levels for federal funds rate for an extended period” continues to be part of the policy statement.

The much awaited first press conference of Chairman Bernanke after an FOMC meeting revealed that the Fed plans to reinvest maturing securities and maintain the size of the balance sheet. Effectively, the amount of monetary policy easing will be unchanged after the completion of the $600 billion purchase. The Fed’s balance sheet as of April 20 stood at $2.67 trillion (see Chart 1). The Fed has purchased $548 billion of the $600 billion target so far.

The looming question at the present time is the course of monetary policy if oil prices continue to advance. Chairman indicated that the Fed expects oil prices to stabilize and trend down. In the event that this does not occur, Chairman Bernanke noted that the evolution of inflation expectations would be the Fed’s guide to monetary policy action. He went on to add that if inflation expectations fail to be stable and well anchored (which is the case at present) the Fed will have to take action. The five and 10-year break-evens obtained from Treasury inflation-protected securities are currently at levels seen prior to the onset of the financial crisis (see Chart 2). Markets will be tracking these levels closely in the days and months ahead.

Chairman Bernanke responded to a question about the meaning of the phrase “extended period” by noting that it would imply the Fed is unlikely to take any action for a “couple of meetings.” June 21-22, August 9 and September 20 are dates of the next three meetings of the FOMC .

There are many unanswered questions about the Fed’s exit strategy such as the actions it is likely to take to tighten monetary policy when economic conditions improve and inflation is a threat. Chairman Bernanke pointed out that the early step would be to stop reinvesting all or some part of maturing securities. In other words, if maturing securities are not replaced, the action would be akin to open market sale of securities, the action the Fed typically takes to tighten monetary policy.

The Fed also made available its latest forecast of real GDP growth, inflation, and unemployment rate today. The Fed has lowered projections of real GDP growth for 2011 and raised estimates of the unemployment rate, overall inflation, and core inflation for 2011 compared with the predictions published in January 2011.

In the two clips below, Fed Chairman Ben Bernanke takes questions on yesterday’s FOMC decision, the fate of QE2 and the Federal Reserve’s plan for dealing with creeping inflation.

Part 1

Source: CNBC, April 27, 2011.

Part 2

Source: CNBC, April 27, 2011.

Source: Asha Bangalore, Northern Trust – Daily Global Commentary, April 27, 2011.

Tags: Asset Purchases, Commodities, Dissents, Economic Recovery, Economist, Federal Funds Rate, Fomc Meeting, Footing, Household Expenditures, Inflation Expectations, Inflationary Pressures, Moderate Pace, Monetary Policy, Northern Trust Company, Outlays, Qe2, Rhetoric, Term Outlook, Treasury Securities, Voting Members
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Focus on Japan Overshadows Fed Decision

Friday, March 18th, 2011

Focus on Japan Overshadows Fed Decision

by Brad Sorensen, CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research
March 15, 2011

Key points

• To no one’s surprise, the Fed kept interest rates at near zero and maintained its scheduled purchases of Treasury securities (also known as quantitative easing, or QE2).
• We’re growing more concerned that the Fed is keeping interest rates low for too long, leading to potential problems down the road.
• With the market currently reacting to the tragedy in Japan and the ensuing market volatility, it’s important to avoid acting hastily.

With the world’s attention squarely on developments in Japan, The Federal Open Market Committee (FOMC) again held the line on its current monetary policy. The federal funds rate was held at the record low rate of 0-0.25%, while the FOMC members reiterated their intention to complete their previously announced purchase program of $600 billion in longer-term Treasuries (also known as quantitative easing or QE2) by the end of the second quarter.

With global uncertainty continuing due to the Japanese situation and continuing global tension in the Middle East and North Africa, the FOMC members felt it prudent to hold the line as they continue to assess the impact on the economies of the troubled areas.

The FOMC upgraded its view of the US economy, saying it’s on “firmer footing.” In order to attempt to strengthen the pace of the recovery, and especially the labor market, the FOMC members maintained their extremely easy monetary stance.

They noted this was possible due to still-stable inflation and expectations, despite the recent run-up in oil prices, which they believe is “transitory.” They also noted continued “elevated unemployment,” but with a slight upgrade, noting that the labor market is “improving gradually.”

The Fed’s dual mandate—maximum employment and price stability—stands in contrast to the single mandate of the European Central Bank of low inflation. One consequence of these diverging monetary policies has been continued weakening of the US dollar. According to the Fed, the dollar hit a record low on a real trade-weighted basis in February.

Although a weaker dollar can be a positive factor because it makes US goods more attractive to foreigners, thereby helping American exports, there are also possible detrimental effects. It can have the opposite effect on American imports, and because we import many more goods than we export, higher prices for American consumers can result.

Also, global confidence in the US currency can start to be compromised, which may make some transactions more expensive for the United States. However, it’s important to note that the dollar is still viewed as a “safe” asset. This has been reinforced by the flight to the dollar as concern over the nuclear situation in Japan has grown.

Also concerning to us is the asset inflation we’ve seen coinciding with QE2. While Fed Chairman Ben Bernanke has taken credit for boosting stock prices thanks to the easing program, he has flatly denied any role in the recent surge in commodity prices. We think it’s unlikely that the continued flood of dollars in the market has had nothing to do with at least part of the run in commodities lately.

Unfortunately, Bernanke’s largely right when he implies there’s not a lot that he and the Fed can do about commodity price inflation. If the Fed were to implement a monetary-policy tightening process that’s too rapid, it could run the risk of pushing the United States back into recession. As such, the Fed probably can’t have a huge short-term impact on commodities.

While we agree with the Fed that inflation (especially at the core level) remains quite tame to this point, we continue to be concerned that the Fed is keeping interest rates too low for too long—sewing the seeds for inflation down the road.

Although current world events probably preclude the Fed from deviating from its current course, we’ve been advocating for some time that the financial emergency that justified such extreme monetary measures is long past, and slowly returning to a more normal policy would be a prudent course of action.

We remain concerned that another asset bubble may be brewing, much like what occurred the past two times the Fed was overly accommodative. Finally, while inflation isn’t a problem right now, with so much money sloshing around, we fear it could accelerate relatively quickly.

Although we believe that the Fed has the tools to fight inflation should it become a significant problem, we worry that the Fed’s waiting so long could portend that once it starts tightening monetary policy, the changes might have to be more severe.

The ongoing tragedy in Japan throws another wrench in the Fed’s decision-making process. We’ve seen investors unnerved by reports of a possible nuclear meltdown, pushing the Japanese market down more than 15% in two days, while riskier assets of all sorts have also sold off.

Potentially helping the Fed’s oil-induced inflation problem, we’ve seen the price of oil drop precipitously because Japan is the world’s third largest importer of oil. As Japan emerges from the disaster, oil demand may be dampened.

We hasten to note that we don’t believe the current events warrant an extension of the QE program because we believe the US economy is strong enough at this point to go without that support.

We urge investors not to overreact to the rising fear in the market. We have no ability to know how the situation in Japan will develop over the next days, weeks and months, but we’re relatively sure that the Japanese people and economy will get through this disaster.

It’s important to note that Tokyo remains largely economically intact and that the Bank of Japan is committed to providing ample liquidity to financial markets.

We’ll continue to watch the ports to see how imports and exports are affected and how quickly they can get back up to speed. We believe it will be relatively quickly because Japan is very dependent on both for economic stability and many multinational companies have a large vested interest in making sure that their goods can be transported freely.

Even in an environment when some investors act out of fear, remaining calm is key to long-term investing success. Too often we’ve seen investors react in panic only to regret it later on.

Although we don’t know what’s going to happen in the short term, we acknowledge that more bad news coming out from Japan or the Middle East could dip markets lower and scare off investors until the volatility subsides a bit.

However, it’s important to have a disciplined strategy for what you’re looking for to get back into the market. The best time could be when things are still a bit uncomfortable and uncertain. Waiting for certainty will almost surely mean missing a large market move upward.

Importantly, we want to emphasize that stock investing is a long-term endeavor and we remain optimistic on the markets. The US stock market was overdue for a pullback, which should help correct some concerning sentiment indicators, indicating overly optimistic investors—a contrarian signal. The United States continues to post strong economic numbers, employment is growing and skyrocketing commodity costs are starting to come off the boil.

In the long term, Japan will solve the nuclear-plant concerns and rebuild what’s has been destroyed.

We can’t be sure what will happen with the markets in the very near term, but history has shown that making fear-based decisions is rarely beneficial to investors. One of the keys to long-term investing success is remaining calm during times of uncertainty.

Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative (or “informational”) purposes only and not intended to be reflective of results you can expect to achieve.

Copyright (c) Charles Schwab & Co.

Tags: Commodities, Currency, Decision Focus, Dual Mandate, Federal Funds Rate, Federal Open Market Committee, Fomc, Footing, Market Volatility, Maximum Employment, Monetary Policy, Monetary Stance, North Africa, oil, Oil Prices, Open Market Committee, Price Stability, Qe2, Sector Analysis, Stable Inflation, Treasuries, Treasury Securities, Troubled Areas
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When Even John Taylor Says Bernanke’s Interpretation Of The Taylor Rule Is Wrong

Thursday, March 3rd, 2011

Something funny transpired over the the past two years in the Fed’s interpretation of the critical Taylor rule, which Bernanke refers to in every testimony before Congress or the Senate:  John Taylor, the creator of the rule, and Zero Hedge’s nomination for Fed chairman (inasmuch as we need a Federal Reserve) said Bernanke is wrong in his interpretation of the rule, and if he had a proper interpretation the Fed Chairman should already be hiking rate. Yet leave it to Bernanke to believe he knows better what the rule is supposed to mean….than even its creator. From the WSJ: “Stanford University professor John Taylor, an outspoken critic of the Federal Reserve in recent years, has a new complaint: He says Fed Chairman Ben Bernanke is misrepresenting Mr. Taylor’s eponymous rule on interest rates.” A brief reminder on the Taylor rule, which has been presented numerous times on Zero Hedge before: “The Taylor Rule offers a simple formula that economists often use as a guide for the appropriate level of the federal funds rate. The formula provides changes in interest rates depending on the level of inflation and the output gap, which is the difference between actual gross domestic product and the economy’s potential output. Depending on how you define the rule (for instance if you give the output gap a lot of weight in the formula or just a little, or if you use a projected inflation rate or actual inflation) you can come up with different interpretations of whether interest rates should be high, low or even negative in a theoretical world.” And an odd dilemma appears when one uses the original version of the Taylor rule as presented in 1993 or its 1999 revision: they provide totally different results: the first one says the Fed is wrong, the second one validates QE. Yet here is Taylor himself: “I did not propose or prefer an alternative rule in that 1999 paper, and it is hard to see how one could interpret the paper that way.” So is the entire US monetary policy based on a rule derivative that is not even endorsed by its creator? The answer is a resounding yes.

From the WSJ:

Mr. Bernanke said Tuesday that the Taylor Rule suggested that short-term interest rates, if they could be, should be pushed way below zero. That, in turn, helped to justify the Fed’s $600 billion bond-buying program, he said.

When Sen. Pat Toomey, Republican from Pennsylvania, challenged him on whether Mr. Taylor himself believed that, Mr. Bernanke asserted even Mr. Taylor has come up with variations of his own rule. The one he originally formulated in 1993 doesn’t support the Fed’s current policy, but Taylor’s revision to it in 1999 does support the Fed’s current policy, Mr. Bernanke said.

“There’s no particular reason to pick the one that he picked in 1993. In fact, he preferred a different one in 1999 which, if you use that one, gives you a much different answer,” Mr. Bernanke said in an exchange Tuesday with Sen. Toomey.

Taylor’s 1999 paper (read it here) does point to alternate versions of his rule. But Mr. Taylor says he never stood behind any alternatives to his original 1993 rule. Instead he says he was citing alternatives that others proposed, including the Fed. The 1993 version of the rule calls for a federal funds rate of around 1%, not close to zero as it is now. He charges Mr. Bernanke with misrepresenting his preferences.

“I did not propose or prefer an alternative rule in that 1999 paper, and it is hard to see how one could interpret the paper that way,” Mr. Taylor says in a blog post today.

WSJ’s Hilsenrath explains why this is such a material issue:

If this were just two academics feuding over a formula, it wouldn’t be very interesting. But it’s more than that. Mr. Bernanke is the Fed chairman. Mr. Taylor is one of the most influential voices in monetary economics and he’s saying the Fed chairman is distorting his views to justify a controversial policy.

“It is important to correct the record because the ‘others have suggested’ rule has a much larger coefficient on the GDP gap and is therefore more likely to generate negative interest rates and be used to rationalize discretionary actions such as quantitative easing,” he says on his blog.

And below is the full transcript of the exchange between Bernanke and Toomey:

MR. BERNANKE: I think that many of the monetary or nominal indicators that somebody like Milton Friedman would look at did suggest the need for a monetary stimulus. For example, nominal GDP has grown very slowly. Growth in the money supply is in fact — I’m not talking about the reserves held by banks which are basically idle — but if you look at M1 and M2, those have grown pretty slowly. The Taylor Rule suggests that we should be, in some sense, way below zero in our interest rate, and therefore we need some method other than just normal interest rate changes to —

SEN. TOOMEY: Do you know if Mr. Taylor believes that?

MR. BERNANKE: Well, there are different versions of the Taylor Rule, and there’s no particular reason to pick the one that he picked in 1993. In fact, he preferred a different one in 1999 which, if you use that one, gives you a much different answer.
SEN. TOOMEY: My understanding is that his view of his own rule is that it would call for a higher Fed funds rate than what we have now.

MR. BERNANKE: There are, again, many ways of looking at that rule, and I think that ones that look at history, ones that are justified by modeling analysis, many of them suggest that we should be well below zero. And I just would disagree that that’s the only way to look at it. But anyway, so I think there are some — there is some basis for doing that.

Which begs the question: is the broken US monetary system so institutionalized that the only person willing to speak up against the faulty usage and interpretation of a rule, is its own creator? What would happen should the Fed follow the Taylor-endorsed rule is that QE2 would immediately have to be ended. But of course this will never happen: after all it is now clear the Fed’s policy was never to actually control inflation or maximize unemployment: the whole point was always just to get stocks as high as possible. And when the bubble pops, which it will, it will be time to point fingers, and we are confident that the Fed will resort to blaming Taylor himself. Luckily by then there will be no Fed, as the monetary system will have finally reverted back to its one sustainable form, backed by either precious metals or some other non-dilutable instrument.

The fiat experiment has taken enough casualties.

Tags: Ben Bernanke, Dilemma, Economists, Eponymous, Fed Chairman, Federal Funds Rate, Federal Reserve, Gap, Gross Domestic Product, Inflation Rate, Mr Taylor, Original Version, Output Gap, Outspoken Critic, Professor John Taylor, Proper Interpretation, Qe, Stanford University Professor, Taylor Rule, Wsj
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