Wednesday, April 3, 2013

Interest rates: dot-FED bubble?

When I read Feldstein's article at Project-Syndicate.org where he was expressing his rigorous concerns about the low long-term US public debt yields, I admit I begun to worry about yet another bubble crush this time due to manipulation by the FED. Shortly after that my concerns faded away...

On the one hand, increasing market prices of the Government issued debt securities partly depicts the continuous, though sluggish, increase of US real GDP since 2009Q3 and the decreasing public consumption and investment since 2010Q4 (US BEA). The result of this developments of the economic climate was the anchoring of the debt concerns and the subsequent increasing trends in bond prices. These trends, finally, intensified by the FED's Maturity Extension Program and Reinvestment Policy (MEP) resulting to a further decrease of the debt yields. Bernanke gave a speech a month ago concerning the low long-term interest rates. Shortly, he attributes the decrease of the long-term yields to the lower inflation expectations, to the trend of these rates in other developed economies and to lower term rates.

On the other hand, a bubble is a self-sustaining and intense positive development lacking any understructure. 

"But the FED"? You might ask... And I will add that according to the following picture the US debt securities held by the FED  has increased and MEP will continue with a pace of $45bn per month. Moreover, real rates of government debt with maturity less that 10Y are all negative. These fact that does not necessarily support the claim that the higher bond prices are nurturing a bubble. We shall see why.

In addition one might become unrest if he starts thinking of inflation and low growth especially after understanding the previous graphs. And here come the hypothesis that US economy is in a liquidity trap; in other words riskless securities equal cash. The result of a liquidity trap is an interrupted transmission mechanism of monetary policy. As you may observe in the following graph, sharp increases in public debt securities held by the FED have all been translated to excessive reserves of depository institutions. Clearly, credit institutions have failed- avoided, as a matter of fact- to transmit the increase in liquidity to credit expansion. Monetary policy cannot indeed affect the economic activity and that is way inflation is low and growth is slow regardless the tripling of the nominal money supply. 


Is there any reason to undergo this state of affairs? Absolutely yes! And I can instantaneously think of two reasons to justify my claim.

Firstly, low long-term interest rates can permit the government to acquire additional funds, without paying a high price, necessary to support aggregate demand and boost economic activity, since it is the demand that can affect the output of the economy. Besides, lower long-term borrowing cost to the government reduces any explosive momentum of the public debt that might appear.

Secondly, the arsenal of the Federal Reserve is loaded and prepared to respond when monetary tightening is required. As soon as US economy begins expanding at a brisk pace, new investment opportunities will emerge and excessive reserves will gradually shrink, increasing money supply to the broader public. At the same time diminishing excessive reserves will have served as a signal for stronger economic activity. Thenceforth, monetary authorities will have to restrain the monetary expansion dynamic by absorbing liquidity; public debt securities will be given away in exchange for cash.

Last but not least, the decreasing asset values due to increasing rates can be offset by hedging, especially since economic agents expect such a development; rates will not remain that low infinitely. 

In conclusion, when prosperity needs to be regained the least assisting factor would be a higher rate and as long as the growth is phlegmatic and as long as on the other side of the Atlantic Ocean national economies flirt with deeper recession that is how rates are supposed to be; low. I hope I have convinced you, at least to a certain degree, that not only low interest rates do not constitute a bubble but that they also are requisite.