Morning Must-Read: Jon Hilsenrath: Could Lower 10-Year Yields Spark A More Aggressive Fed?
At least one thing here from William Dudley seems to me to be completely wrong: The US economy did not need higher interest rates in 2004-2007–there were no signs of accelerating wage or core price inflation that would indicate that the Federal Reserve was behind the curve as far as aggregate demand management was concerned. There were macroprudential failures–a failure to ensure that mortgage borrowers understood and could manage the risks they were running, that MBS purchasers understood and could manage the risks they were running, and that key too-big-to-fail-institutions were not creating systemic risk via regulatory arbitrage by which they held as reserves things they claimed were reserves but were not in fact safe enough assets to be reserves. These were major policies surveillance failures. But they have little to do with raising interest rates to hit the economy on the head with a brick and raise unemployment.
More thoughts about the rest later…
Could Lower 10-Year Yields Spark A More Aggressive Fed?:
“Falling long-term interest rates pose a quandary for Federal Reserve officials….
…If falling yields are a reflection of diminishing inflation prospects… it ought to prompt the Fed to hold off on raising short-term interest rates…. If… lower long-term rates are a reflection of investors pouring money into U.S. dollar assets, flows that could spark a U.S. asset price boom, it might prompt the Fed to push rates higher sooner…. The latter interpretation is less conventional, but it is one that New York Fed President William Dudley made….
During the 2004-07 period, the (Fed) tightened monetary policy nearly continuously, raising the federal funds rate from 1 percent to 5.25 percent in 17 steps. However, during this period, 10-year Treasury note yields did not rise much… the availability of mortgage credit eased…. With the benefit of hindsight, it seems that either monetary policy should have been tightened more aggressively or macroprudential measures should have been implemented in order to tighten credit conditions in the overheated housing sector.
Mr. Dudley’s conclusion was that the pace of the Fed’s short-term interest rate moves this time around ought to be dictated in part by whether the rest of the financial system is moving with or against the Fed’s intentions when it decides it ought to start restraining credit creation:
When lift-off occurs, the pace of monetary policy normalization will depend, in part, on how financial market conditions react to the initial and subsequent tightening moves.’…
The challenge for the Fed is that one can make any number of arguments about the cause of falling long-term rates today…. The Fed’s next policy meeting is three weeks away. It is clear officials will spend a considerable time debating the correct response to a perplexing lurch down in long-term rates.