A very nice article from the very sharp Justin Lenhart on one of the three things the Federal Reserve is missing right now. The first thing the Fed misses is that, at least as long as the current interest rate configuration holds, they need an inflation rate of 4% per year not 2% per year, in order to have enough running room to fight next recession. The second thing the Fed misses is that the slope of the Phillips curve has changed, and so going for faster growth and higher employment right now is not risky but, rather, harvesting low-hanging fruit. The third thing the Fed misses is that a near-inverted yield curve is a danger sign—and yet the Fed is, as in 2006, finding reasons to pretend that "this time is different". I confess that fed thought—the governors, the bank presidents, and the staff—is quite opaque to me right now: I do not understand why they are making the analytical judgments that they are making: Justin Lahart: What the Fed Is Missing, Again: "The Federal Reserve isn’t worried about the yield curve, and it has reason why. The problem: It is pretty much the same reason it wasn’t worried about the yield curve before the financial crisis...
The yield curve—the difference between shorter and longer term Treasury yields—is important for the signals it sends about the future of the economy. The curve has gotten awfully flat lately, not a good sign for the future.... An inverted curve is a signal investors believe that the Fed’s current rate-raising efforts are going beyond what the economy can handle and overnight rates will eventually fall. Fed policy makers don’t seem to think that is the risk now.Rather, they think longer-term yields are lower than they should be because of all the bonds purchased by the Fed and other central banks to prop up their economies. They believe that has driven term premia—the extra yield investors demand for the risk of lending over a long period—negative.... In 2006, the Fed’s view of the inverted yield curve was that a global saving glut had pushed down long-term interest rates.... In the Fed’s defense, it probably was right in 2006 about the cause of low long-term rights. What it missed was that those low rates drove investors to take on more risk—in many cases risks they didn’t understand—to boost yields.
Today, evidence abounds—from super tight spreads to negative yields to high stock valuations to the popularity of structured products—that investors are willing to take on risks to capture yield. Since the financial crisis, the Fed has paid more attention to such dangers. But it appears to have a blind spot when it comes to the cause of the flattening yield curve. Ignoring the market’s message seems reckless...
#shouldread
