22/04/2011: US rates: Up, up, and away...

In economics, the moments when you can make really high conviction calls are so rare that you have to relish them. Such a moment is currently in the making with the forecast that US long-term interest rates will continue to trend higher. Moreover, since the US interest rates are the most important factor to explain what is going on in global bond markets, we can safely extend the call: global long-term interest rates will continue to trend higher.

No, it is not inflation, which will be the main driver of interest rates going higher. If you are Greek, Portuguese or Irish, then you already experienced a crash on your bond market despite rather low inflation rates. The cause being a massive deterioration of the quality of sovereign credit, with Greek government bonds already considered “junk,” and the other two countries barely faring better. However, Greece, Portugal and Ireland are, in my view, the canaries in the coalmine.

Japan’s government debt-to-GDP ratio at over 220% is almost twice as large as the Greek metric. Last week Standard & Poor's issued a negative outlook on the rating of US government debt, something the UK already experienced a couple of months ago. Even virtuous and supposedly frugal Germany’s 75% government debt-to-GDP ratio doesn’t look so sound anymore once you take the still shaky German banks, as well as the German lender-of-last-resort role for the European periphery into account.

Beside the credit quality deterioration, there is something else which should push US long-term interest rates higher and again no, it is not necessarily inflation. Central bankers are still explaining to the public that they have inflation under control, and that in the case of surging inflation expectations they would just increase interest rates.

A good economist friend of mine attended a dinner in 2008 at which Alan Greenspan was present. The former “maestro” was asked if he didn’t think that what the Fed was doing would lead to substantially higher inflation. Greenspan said that the Fed’s easy money did pose some inflationary potential down the road. But he also said: “If there is one thing central bankers know, it is how to deal with inflation. We will first try a Fed fund rate of 5%. If that does not work, we will try 10%. And if that does not work, we will try 15%. But we know what to do.”

The first doubt about such a statement is whether central bankers will have the backbones solid enough to implement such a highly unpopular policy. Not everyone is Paul Volcker, the Fed chairman who enforced such measures in the early 1980s, but we leave this as a side-remark. Lifting Fed fund rates goes hand-in-hand with reducing the amount of money in the economy. Money, measured by the monetary base, has swollen from 800 billion US dollars by mid-2008 to somewhere north of 2,600 billion US dollars by mid-2011.

Even though the Federal Reserve claims that it can fine-tune the amount of money by lifting the interest rates it pays on the reserves the banks must hold at the central bank, I doubt that a more restrictive monetary policy can be achieved without reducing at least some of this ballooning monetary base. Reducing it would mean selling a portion of the trillion US dollar treasuries that the Fed has bought over the last three years. Selling government bonds in turn means pressure for lower bond prices and therefore higher interest rates on long-term government bonds.

This is the most staggering issue about the call that interest rates on US government bonds will go higher: you don’t need at all to assume that inflation will tend higher. Such an assumption would only be a strong supplementary argument.

08/04/2011: Central bankers' job rotation

After national football coaches, central bankers must have the most second-guessed job in the world. Whatever they do — get more restrictive, expansive, or stay on the sidelines — there will always be a large number of people who criticize their actions, a number that grows as the wisdom of hindsight accumulates. Even attaining guru status, like Alan Greenspan during his near two-decade tenure as Chairman of the Federal Reserve, is no protection from becoming a vilified figure in the aftermath of a financial crisis.

Hence, it is almost banal that many criticize Jean-Claude Trichet, the European Central Bank President who just started hiking interest rates, as a super-hawk spooked by imaginary inflation threats, completely insensitive to fate of the depressed economies on the European periphery. Equally normal is that Ben Bernanke, the Chairman of the Federal Reserve who is sticking to his program of quantitative easing and shows no hurry to tighten, should feel the shotgun blasts of those who call him a mega-dove, a bird who is debasing the dollar and precipitating the US on an hyperinflationary path.

But what would happen if these two gentlemen exchanged jerseys and switched jobs? Having Ben Bernanke running the ECB and Jean-Claude Trichet the Fed might not require sending the uniforms to the tailor first. My best guess is: no more than a few stitches would be needed. It is not the person who defines the function, but the function which defines the person.

While the ECB’s single goal is to keep inflation under control, the Fed has a dual mandate; it focuses both on inflation and on economic activity/employment. Therefore it is natural that the ECB, perceiving mounting inflation expectations especially in Germany, the largest and strongest of the Eurozone economies, has started to hike. By the same token the Fed, confronted with a still extremely high unemployment rate in the US, elects to focus on stimulating the economy. This said, a deeper critique can be made of both central banks.

At the top of the macroeconomic policy game plan, the foremost objective of a central bank as lender of last resort should be to guarantee financial stability. With respect to this criterion, both central banks are currently walking with their policies on a tightrope.

The ECB, by hiking interest rates, is putting pressure on many households in the European periphery, people who have indebted themselves with adjustable-rate mortgages. Many such households could default on their debt, cascading pressure onto the banks which granted those mortgages. This in turn could deluge governments, which would need to step in if banks got into trouble.

With Portugal seeking the help of the EU after Greece and Ireland, all eyes are cast toward Spain. For the time being the public debt situation there seems under control. However, this could change radically if Spanish banks came under stress. If the ECB wants to avoid the next crisis of the euro, it will need to take this into account before hiking Eurozone interest rates too far.

The Fed does not have the problem of being the central bank of a currency area which is not optimal. However, in the US, extremely loose monetary policy has led to asset bubbles and busts already twice in the past decade, the second time bringing the global financial system to the verge of breakdown. There is no reason to believe that this time will be any different.

So both the ECB and the Fed have issues with monetary policy. However, in my view, the debate shouldn’t be about the macroeconomic goals, which are given by the institutional framework, but about the ultimate consequences of those policies on the financial stability in a still fragile environment.