Bubble, Bubble, Toil, And Monetary Policy Trouble

Via Scotiabank's Guy Haselmann,

In my note from Tuesday entitled “Treacherous Market Conditions,” I attempted to outline the precarious position the FOMC has put itself in.  I mentioned that the Fed’s depleted ammunition applies greater pressure on its attempts to ensure a strong recovery.   Yet, I hinted that the Fed is in a race against time, because risks to financial stability aggregate with each passing day, while economic benefits approach zero.   Despite differences as to the extent and degree of financial risks, FOMC members have (finally) become aware that they have arisen.

As such, the FOMC, despite their desperation to err on the side of over-accommodation to ensure success, their concerns about financial stability prevailed and were a key reason why the Fed began exiting from QE in January.   Supporting this belief is the lunch conversation during Bernanke’s recent visit with key people of a high profile firm.   In the summary notes sent to clients, the firm reported that Bernanke complimented Stein’s work (on the risks to financial stability), and admitted that “the Fed’s decision to start to taper had a significant financial stability component to it”.

The FOMC has repeatedly admitted that their tools available to fix economic ailments are limited and that these tools can only target those ailments indirectly.  This is why it has always been a leap of faith to believe that increasing the wealth effect (via boosting asset prices) would improve consumption enough to afford the Fed progress on its dual mandates without causing adverse financial market conditions.   Common sense tells me that using such massive indirect experimental tools was destined to cause bubble conditions and many unintended consequences.

Draghi seems to share concerns about bubble conditions.  In referring to what makes the ECB’s new TLTRO plan different, Draghi uttered today,”...the determination that this money not be spent for sovereigns on sovereigns and on sectors that are already experiencing or have just come out of a kind of bubblish situation”

On the website of the Bank for International Settlements it states that, “The mission of the Bank for International Settlements (BIS) is to serve central banks in their pursuit of monetary and financial stability, to foster international cooperation in those areas, and to act as a bank for central banks.”  The BIS might have concerns that it is failing to perform its mission.

Here are a few excerpts from some of its publications:

“A persistently aggressive monetary policy risks exacerbating collateral damage, both domestically and internationally, as unwelcome spillovers foster the build-up of disruptive financial imbalances in other countries whenever financial cycles are out of sync. And as results disappoint, such a policy can ultimately sap the central banks’ credibility, effectiveness and public support. More generally, there is a serious risk of exhausting the policy room for maneuver over time. As policymakers respond asymmetrically over successive business and financial cycles, hardly tightening or even easing during booms and easing aggressively and persistently during busts, they run out of ammunition and entrench instability.”


The major asymmetry in the global monetary and financial system that worsens the picture is that easy monetary conditions in major economies spread to the rest of the world. As a result, the system has produced inappropriately low interest rates for the world as a whole. Non-crisis-hit countries find it hard to operate with interest rates that are significantly higher than those in the large crisis-hit jurisdictions because of the fear of exchange rate overshooting, even when the economy has been growing strongly. In several cases, this has been fuelling unsustainable financial booms (“financial imbalances”). The result is expansionary in the short run but contractionary over the longer term.”


In economies still recovering from balance sheet recessions, reacting ever more aggressively with monetary and fiscal policy will not resolve the problem. After a certain point, it may even be counterproductive (e.g., depletion of policy ammunition, development of new imbalances).


Negative real interest rates, especially when associated with zero policy rates, are not equilibrium phenomena. As a result, they risk causing collateral damage, not only in the crisis-hit countries themselves, where they may further delay balance sheet adjustment or encourage unhealthy forms of risk-taking, but also, and more visibly, elsewhere in the world, by causing a build-up of financial imbalances. This, in turn, could end up validating those low interest rates, as the unwinding of the imbalances could make normalisation extraordinarily difficult globally.”

I maintain my bullish bond view.  Buy long-dated Treasuries. I predict the year’s low in 10’s and 30’s of 2.44% and 3.29% will be surpassed within the next 2 months.
“In the complete separation of government from the bank and credit system consists the chief hope of renovating our prosperity, and restoring to the people those equal rights, which have so long been exposed to the grossest violations. Leave credit to its own laws.” – William Leggett (1837)