Pimco's Tony Crescenzi reveals the most pressing items he thinks should be on Fed chairman Ben Bernanke's agenda for the year ahead.
1. Play offense
The actions taken by the Federal Reserve since the onset of the financial crisis have aimed primarily to buffer the U.S. economic and financial system against a major shock. Today, with the system more stable but economic stagnation posing a threat to the long-term health and vitality of the U.S. economy, we think monetary policy should aim to promote faster economic growth. The Fed’s mantra in 2013 therefore must be to print, print, print, thereby using coinage to nudge annual growth in nominal gross domestic product (GDP) toward 5% instead of the recent slow pace of about 4% shown in Figure 1. The Fed’s new focus on employment and its tolerance for faster inflation in the short-run announced on 12 December should advance the cause.
2. Help housing
PIMCO for the first time in seven years is expecting the U.S. housing sector to strengthen and contribute to economic growth. Although we believe the recovery is rooted in the reduction of excess supply resulting from a severe underbuilding of homes relative to population growth and demographic trends, the Federal Reserve’s interest rate policies deserve some credit. The Fed’s purchase of about $1.5 trillion (and rising) of mortgage-backed securities has helped. Yet, there’s more the Fed can do.
Bernanke mentioned three means when he spoke in New York on 20 November: regulatory, supervisory and analytical actions the Fed could take. On the regulatory front, the Fed can consider current housing conditions when it crafts rules for implementing the Dodd-Frank Wall Street Reform and Consumer Protection Act. On the supervisory front, the Fed’s army of bank supervisors can advise banks that, as Bernanke said, “tighter is not always better,” and that they should therefore seek the appropriate balance when making mortgage lending decisions. On analytics, the Fed’s legion of Ph.D.s and other knowledgeable folk can contribute ideas to other government agencies about how to improve mortgage lending.
3. Keep volatility low
Uncertainty tends to breed market volatility. The more predictable, transparent, credible and understandable the Fed’s actions, the less volatile markets are likely to be. To the extent that the Fed reduces uncertainty in the bond market, it may reduce the “term premium” in bonds – the extra yield that investors demand to compensate for uncertainty, particularly for the uncertainty that tends to surround potential changes to the federal funds rate, the benchmark rate that the Fed aims to control. In our view, the Fed has been very successful at this, which is one reason why market interest rates are so low. Figure 2 shows the decline in market volatility since the financial crisis. The Fed must ensure that its latest experimentation with communications and buying bonds also aims to keep volatility low. It’s not clear that it will. This brings us to the next to-do item.
4. Clarify the 12 December policy announcement
Starting in August 2011 the Fed conditionally promised to keep its benchmark interest rate near zero for at least two years or so, repeatedly pushing its rate guidance outward, from mid-2013 in August 2011 to mid-2015 more recently. The repeated changes have created pessimism by giving the impression the Fed lacks confidence in the vigor of the economic recovery. This is likely one reason why the Fed on 12 December scrapped its calendar approach in favor of economic thresholds. From now on, the Fed’s decision to raise the federal funds rate will depend on either the unemployment rate reaching 6.5% or inflation reaching 2.5% in the Fed’s one-to-two year forward projections.
While the calendar approach was clear and allowed the Fed to reduce uncertainty and suppress volatility, we believe the new approach is less clear. For starters, the unemployment rate is an imperfect indicator of the employment situation and can be significantly affected by changes in the size of the workforce and other factors. In addition, the Fed’s inflation tolerance is based on a forecast and its own, no less. How are investors to know day-to-day what that forecast is or how it might be evolving? We think the Fed should clarify its new policy and give investors the proper lens to view it with.
Cart data from Bureau of Labour Statistics (Unemployment) and InflationData.com (inflation - CPI-U)
5. Preserve hard-won gains
As the above shows, the Fed over several decades has won a substantial battle against inflation. We would caution against the Fed becoming complacent as a result of either its past successes or the seemingly harmless disconnect between the Fed’s massive money printing and the tameness of inflation. Inflation is a virulent, creeping, vine-like condition not easily rooted out, so the Fed should avoid allowing it to take root in the first place. Beyond inflation, there are other hard-won gains the Fed must preserve, including its success in suppressing interest rate volatility and the confidence many investors now have in the Fed’s ability to stabilize financial conditions in a time of stress. Rules-based guides to policy and transparency can help bolster confidence in the Federal Reserve as an institution.
6. Watch for bubbles
If the Fed continues with its plan to purchase $45 billion of U.S. Treasuries per month throughout 2013, Federal Reserve data indicate the Fed will own between 30% and 45% of all Treasuries outstanding, depending on the maturity. Moreover, its holdings of mortgage-backed securities will top $1 trillion at the end of 2013. The Fed’s involvement as not just a referee but also a player in the markets has implications for the ability of the markets to function properly. The usual ebbs and flows associated with the evolution of data and information can diminish, keeping prices from settling at fair value.
Market participants may come and go as a result of these price distortions, harming the functionality of markets. The Fed must be aware of its strong hand, which results from both its direct involvement in the markets and its effort via low interest rates to compel investors to move out on the risk spectrum. The longer there is a disconnect between economic performance and financial market performance, the more cautious the Fed should be.
7. Save the savers
Bernanke has made clear that he believes the benefits of low interest rates far outweigh the harm they are causing savers. There will likely come a time, however, when the Fed will have to consider the harm that low interest rates are having on savers of all kinds, such as those saving for retirement and pension funds. Savers can also be harmed by inflation and helped by faster income growth. The Fed should be mindful of the potentially deleterious impact it can have on the investments that savers help to finance: The Fed gives the government a free ride when it purchases the same amount of Treasuries that the government is selling and when it remits to the government all the income it receives from the Treasuries it owns.
This then reduces pressure on politicians to cut the budget deficit and take other actions necessary to help the U.S. reach its economic potential, stymies investment and squanders a major benefit of savings. This brings us to the next to-do item.
8. Be wary of building a bridge to nowhere
Investors for three years have taken a leap of faith expecting policymakers to take actions that would improve U.S. competitiveness and thereby promote sustainable economic growth. Dithering by politicians has forced the Fed to use nontraditional tools to bridge the gap until policymakers wake up. There is a limit to this. For markets to continue performing well, we believe investors will need to take ever larger leaps of faith and actors other than the Fed will need to perform in the theater. In the meantime, the Fed must monitor the extent to which its actions are creating moral hazard issues in Washington and potentially leading investors to a land nothing like the good and plenty they seek.
9. Speak up
Bernanke’s decision to steer clear of politically charged issues is commendable. Yet we believe his experience before, during and after the financial crisis puts him in a unique position to help shape legislation that will have a lasting influence on the financial stability of both the U.S. and the rest of the world. We hope Bernanke will speak up and more often about issues that relate to financial stability, including the implementation of Dodd-Frank, and will weigh in on how the U.S. should reform housing finance.
That issue is stuck in mud but vital to both financial stability and the economy. Bernanke can also help shape opinions about how the world can reduce risks from its interconnectedness.
10. Stay focused on the human impact
Mr. Chairman, you have said that the high level of unemployment in the U.S. is an 'enormous waste of human and economic potential' and you have noted that behind every economic statistic there is a human being. Your upbringing and your knowledge of the Great Depression no doubt enhance your ability to take decisive actions against the sort of economic stagnation that affects the lives of ordinary people. Your attention to the well-being of people is admirable and also rare in today’s rancorous political climate.
There is much more the Fed can do, in our opinion, and in today’s precarious and uncertain world, there are bound to be some surprises to address in the year ahead. We believe Fed Chairman Bernanke is up for the task.