U.S. monetary policy may need to be tightened sufficiently to offset the downward tug on interest rates from robust official capital inflows, New York Federal Reserve Bank President Timothy Geithner said on Thursday.
Asian central banks have been huge buyers of U.S. government debt in recent years, which analysts say helps explain why long-term bond yields have largely failed to react to a long series of short-term interest rate hikes by the Fed.
Geithner said the downward pressure on bond yields has made financial conditions easier than they would be without the foreign buying.
“Policy would have to act to offset these effects in order to achieve the same impact on the future path of demand and inflation,” said Geithner. “To do otherwise would run the risk that monetary policy would be too accommodative.”
As vice chairman of the Fed’s policy-setting committee, Geithner always votes on interest rates.
Asian countries, especially China and Japan, hold huge amounts of foreign exchange reserves, mostly U.S. dollar-denominated assets.
Geithner said the move toward increased flexibility in the foreign-exchange policies of countries with more rigid currency regimes may not be smooth and gradual but is welcome nonetheless.
“It won’t necessarily be smooth and gradual but it’s probably healthy for the financial system as a whole,” Geithner said in a question and answer session.
Geithner also reiterated his concern about the gaping U.S. external deficit.
He said if the current account gap remained close to 7 percent of gross domestic product, the net U.S. international investment position would “deteriorate sharply.”
He said the conditions did not fully exist for a gradual adjustment to such imbalances, and low interest rates may have lulled the country into a false sense of security about its own ability to sustain prolonged deficits.
“This phenomenon (of foreign buying) can act to mask or offset the effects of high levels of present and expected future government borrowing on interest rates, perhaps contributing to a false sense of reassurance that we can continue to run large budget deficits without risk of crowding out private investment and damaging future growth.”
Geithner appeared skeptical of conventional explanations for persistent deficits, saying that low U.S. savings and increased productivity only went so far.
“The present magnitude of the U.S. external imbalances seems difficult to reconcile with plausible estimates of future productivity and potential output growth,” he said.
The FED finally figured out foreign treasury buying was influencing US long term interest rates. Bear in mind that I do not think it has had as much impact as others do, but no doubt it has been a factor.
Click on the following link for the full text of NY Fed President Geithner speech:
U.S. Monetary Policy in the Global Financial Environment .
On that note, the Mish telepathic thought lines are now open.
Wow! I am being flooded with questions.
In just three seconds flat I have at least a half dozen distinct questions.
Hmmm I see I have 8 questions, all being asked hundreds of times.
Here they are:
- Is the FED that stupid to just be figuring this out?
- Who is really responsible for what is happening?
- Who is the intended audience of the FED’s message?
- Are we locking the gates after the horses left the barn?
- Why Now?
- What direction is the FED looking?
- If FED is looking North what direction is the economy headed?
- What are the implications?
Let’s attempt to answer them one by one.
1)Is the FED that stupid to just be figuring this out?
Although that is certainly possible, a more likely explanation is that the trade deficits and capital inflows are now the most important thing on their minds (for reasons I will explain in just a bit). But there are other possibilities including a “test” of Bernanke. At the heart of the matter and more to the point is a FED full of Hubris that thinks it can create bubbles and deal with any consequence that arise when they pop. On the surface Bernanke is inheriting an economy that seems to be running on all 4 cylinders, where inflation seems to be low, where interest rates seem to be near neutral, and where job growth seems to be reasonably steady enough. Beneath the surface is a completely different story. Whether or not the FED actually believes what they are saying is now no longer of relevance. The FED long ago lost control of credit expansion has succeeded at blowing one bigger bubble after another. The housing bubble is the bubble of last resort and whether or not the FED recognizes what is actually happening at this point in time is simply irrelevant.
2) Who is really responsible for what is happening?
This question is easy enough to answer: The FED was blowing serially bigger and bigger bubbles in conjunction with a president and Congress that long ago lost any semblance of fiscal responsibility. Add in corporate greed and you have a lethal bubble topping mix.
3) Who is the intended audience of the FED’s message?
This one is much harder to answer. On the assumption that the FED is not completely brain dead, they see the abyss the US is staring in to. In that case the target audience is corporations, banks, and lending institutions in an attempt to rein in merger mania, IPOs, stock buybacks, spinoffs, leveraged buyouts, and junk bond silliness. Indeed corporations are now (and have been for at least a year) going to the junk bond market to take on debt just for the purpose of stock buybacks. If the FED has a rational thought in their heads it would be to prevent companies from squandering the cash on their balance sheets in the foolish endeavors mentioned above. If corporations squander that cash (and because of pension obligations corporate balance sheets are not as good as they look), then not only will the FED be dealing with a housing bust, they will be dealing with corporate balance sheets as messy as they looked in 2000.
4) Are we locking the gates after the horses left the barn?
Yes. It should be obvious that at least 2/3 of the horses have escape. Still it is better late than never. Perhaps one horse can still be saved: corporate balance sheets. The consumer horse and the housing horse are both beyond redemption.
5) Why Now?
The real question here is “Why not earlier”? Looking back at 2001-2003 when the FED was slashing interest rates like mad, it is entirely likely the FED was attempting to preserve the banking system itself. Banks lent tons of money to “dotcoms” that were imploding left and right as well as to places like Argentina that were defaulting. Banks were likely technically insolvent. Interest rates were slashed and held at absurdly low levels to attempt to bail out banks. This was done on purpose not caring what the aftermath might be. It turns out the aftermath was a housing bubble of enormous proportion, skyrocketing consumer debt, and other associated problems. Still the FED in all their hubris likely feels they saved the day. The housing bubble and the consumer debt bubble will be dealt with like every other bubble: when they pop. The housing bubble is popping now.
6) What direction is the FED looking?
This is sort of a trick question. Judging from all the recent “FedSpeak” the FED sees a robust expansion, increasing jobs, wage expansion, no housing bubble, etc, etc etc, but the bottom line is that after 14 consecutive rate hikes the FED is finally worried about inflation. Simply put, this just does not add up. On the surface it seems the FED is looking North (up). Please review question # 1 at this time. If the FED is really looking North then I simply must change my answer to question #1. It is possible the FED is talking North when they are really looking South.
7) If FED is looking North what direction is the economy headed?
Given the answers to #6 and #1 it just might be hard to say what direction the FED is looking. However, it should be perfectly clear that the FED is talking North. Just as when Greenspan advised people to climb aboard adjustable rate mortgages at THE absolute bottom in interest rates, if the FED appears to be looking North, the prudent investor should be looking South.
8) What are the implications?
This is another tough one. Does the FED have any real clues or not? Notice how I am still questioning my original answer to question #1. What we do know however, is what the FED is actually doing. That is far more important than what the FED is saying. What the FED is doing is hiking into a housing bubble that has clearly popped. I maintain that the FED has long overshot neutral. The collapse of the housing bubble to me is proof. The lagging affect of hikes (and I think at least 3 hikes have not yet been felt), should be enough to give someone pause for concern. But No! Just as the FED way overdid things by slashing rates to 1%, it is all too likely they have way overdone things by hiking. But do they have a choice? The FED must at any costs (consumers be damned) preserve corporate balance sheets to weather the upcoming recession. Notice how I am conveniently once again giving the FED the benefit of the doubt. But wait. I think it is too late. The forces of the FED hiking too far into the face of unprecedented consumer debt and a world wide housing bubble far bigger than the stock market bubble of 1929 will prove too much for this FED. That is the bottom line implication of this mess and going back to question #1 for one last time: No the FED does not see the deflationary credit bust that is coming. The FED in all their hubris will be powerless to stop it.
Mike Shedlock / Mish/