Something is rotten in the state of U.S. monetary policy. This Wednesday will likely mark the beginning of the first rate-hiking cycle since the last one began nearly 12 ago. The “yield curve” depicts the yield of each bond from the shortest to the longest maturities. In robust economic times, the curve is upward sloping reflecting investors’ expectations of higher income in exchange for taking on the added risk of holding bonds for longer periods of time.
Back in June 2004, the difference between the ten-year and two-year Treasury notes was 190 basis points (bps), or one-hundredths of a percentage point. Today, that spread is 123 bps.
Starting points also must be taken into consideration. The fed funds rate at the point of the last lift-off was 1.0 percent compared to today’s zero. During the last tightening campaign, the Fed had to raise rates by a quarter of a percentage point four times to arrive at today’s spread. The current differential suggests that tightening in other forms has already begun.
The Lindsey Group’s Peter Boockvar recently documented the other prominent differences between then and now. In the four quarters through 2004’s second quarter, gross domestic product growth averaged 4.25 percent vs. 2.2-percent now. The unemployment rate was 5.6 percent vs 5 percent today and the factory sector was still squarely in expansion mode compared to today’s slump to contraction territory. Meanwhile, housing starts are running at about half their mid-2004 pace. And the consumer is a shadow of its former self: at 2.9-percent, today’s year-over-year rate of retail sales growth, netting out autos, gasoline and building materials, is half of what it was back then.
The powerhouse of the U.S. economy was then and remains consumption. The anemic level of retail sales would thus be confusing given the price of gasoline being below $2 a gallon for most Americans were it not for the one critical factor. According to a new Harvard study, a record number of renters are spending more than 30 percent of their incomes to lease the roof over their head; that amounts to nearly half of all renters. Meanwhile, the percentage of home sales that go to first-time buyers remains depressed at 31 percent, far from a normal market’s 40-percent level.
Housing is more burdensome than it has ever been for middle-income Americans. It’s no wonder they have less residual to spend on life’s little non-necessities. Inflation, it must be noted, is also running below the level Fed officials have traditionally deemed appropriate. And commodity prices’ continued declines have decimated millions of workers’ incomes and exacted tremendous damage on exporting nations’ economies. Finally, the strong dollar acts as a further depressant on U.S. exporters and emerging markets.
The last several months have also witnessed not only an acute rise in financial market volatility but a meltdown in the riskier corners of the credit markets. Couple this with the traditional evaporation of liquidity as yearend approaches and logic demands to know why policymakers would dare risk raising interest rates.
And yet, the financial markets have nearly fully priced in a rate hike today. Any lingering doubts were extinguished in the wake of Chair Yellen’s stating she stands ready to withstand a double dissent from two of the governors on the Federal Open Market Committee. Fed District president dissents have become common in their prevalence in recent years. But there have only been four governor dissents since 1995.
A double dissent would be remarkable, historically speaking, revealing a deep level of discord among Committee members. So why chance it?
Perhaps it’s the complete unknown that’s driving the insistence of lift-off. The mechanics of raising rates is complex against a backdrop of an atrophied fed funds rate market. Enter the repurchase, or repo market, the overnight market in which banks and other financial institutions pledge securities collateral in exchange for cash. Today’s repo rate has effectively replaced yesteryear’s fed funds rate.
Ensuring the smooth functioning of the repo market is thus critical to the successful implementation of a rate hike. The sheer size of the Fed’s balance sheet given its $3.4 trillion in purchases of Treasurys and other securities presents a convenient solution to the potential for an insufficient supply of collateral.
The expansion of its ‘reverse repo facility,’ which absorbs liquidity via money markets funds, would accomplish the task of ensuring market functionality. So too, though, would the sale of Treasurys off the Fed’s balance sheet; this maneuver would also soak up cash while simultaneously supplying collateral to a market starved for it.
The crucial difference is at the core of why the Fed is acting against every grain of its traditional modus operandi. Raising the cap of the reverse repo facility does not release collateral from the Fed’s balance sheet. The immense size is thus preserved.
The program is currently capped at $300 billion per day. This figure is a pittance of the potential demand from the $2-trillion plus in yield-starved institutional reserves sitting on bank balance sheets. Policymakers have gone to great lengths to ensure that a raised cap could be subsequently lowered. All things considered, it would be quite the feat to force that big of a genie back into its bottle, ensuring the balance sheet would not shrink.
By June 2006, which marked the close of the last tightening cycle, the fed funds rate had risen to 5.25 percent. Today’s markets are barely pricing in two more quarter-percent hikes in the New Year. Unless the economy is poised to become the longest in postwar history, chances are what little tightening can be accomplished will be quickly reversed as recession descends.
As for the Fed’s balance sheet, what if the maintenance of its current size becomes critical to the smooth functioning of overnight rate markets? Looking back in years to come, some may conclude that the Fed never intended to initiate a cycle per se but rather to make a calculated move to effect long term monetary policy by proxy.