The Smart and Thoughtful Gavyn Davies Is Gloomy About the Fed
Gavyn Davies:
Fed’s exit will be gradual and difficult: The first question is whether the exit will be gradual or abrupt. The chairman’s personal preference is very well known: it should be gradual, and extremely well flagged in advance. But Mr Bernanke might not be in office after next January, and there are others on the FOMC who could have different ideas. Furthermore, economic and market circumstances could change. In 1994, GDP growth and inflation both rose markedly, and the Fed slammed on the brakes without any warning. The resulting 3 per cent rise in the Fed funds rate delivered a major shock…. [T]he consequences for a complacent financial system were extremely severe (remember Orange County and the Mexican debt crisis?) Bond traders who were around at the time still have nightmares about it…
I guess it really depends how one defines "major shock". A shock, yes. An unexpected shock, yes--the sudden rise in the quantity of long-term bonds as the duration of mortagage-backed securities lengthened much more than any of us had forecast was not pleasant. But by the standards of 2008's fall in the GDP growth rate from 2.5%/year to -4.5%/year, the fall in 2005's growth rate from 4%/year to 2%/year was little more than static electricity:
Gavyn:
Consequently, when Mr Greenspan had his next opportunity to tighten policy from 2004 onwards, he reassured the market that this would happen at a “measured pace”, or in an extremely gradual manner. The result was that the housing and credit bubbles were allowed to build almost directly under the eyes of the Fed.
I genuinely do not see this. Yes, the Fed tightened less quickly after 2003 than after 1993 (although in the end it tightened by more), but the unemployment rate fell less quickly after 2003 than after 1993 as well, The reaction function looks much the same:
Gavyn:
[T]he chairman also seems determined to extend forward guidance not only to the balance sheet and short rates, but to long term rates as well, so that there is less chance of a 1994-style bond market debacle. This willingness to offer guidance on long term bond yields is taking the Fed into territory which most central banks have traditionally avoided…. Bernanke highlighted the fact that the term premium in long-term bonds (green line in the graph below) has recently turned negative, which means that lenders are willing to offer their money for lengthy periods for lower returns than they expect to get from lending for shorter periods, and then rolling over the loans at later dates…. Why is the Fed chairman going out of his way to warn the market that bond yields may well be higher than they currently expect?… [T]he politics surrounding the Fed may make the exit asymmetrical compared to the initial build-up of QE.
When the Fed was purchasing assets from 2009-13, it was helping to finance the budget deficit…. It was hard for politicians not to like this…. In contrast, during the exit, all of these forces will operate in reverse. The Fed could be making losses…. [T]he politics of paying less money to the Treasury and more to the banks will be very difficult. Under political pressure, the Fed is more likely to slow the exit process in order to hold bond yields down and protect its own balance sheet against losses. That is the main reason why the exit looks so much harder than the entry.
I disagree: the politics will not be difficult at all. Ben Bernanke (or his successor) will simply say that the Federal Reserve earned more than $400 billion for the Treasury since Greenspan's retirement, that now market fluctuations mean that it has to give, but that the Federal Reserve is still highly profitable.
