Amer­ica’s risky re­cov­ery

Financial Mirror (Cyprus) - - FRONT PAGE -

The United States’ econ­omy is ap­proach­ing full em­ploy­ment and may al­ready be there. But Amer­ica’s favourable em­ploy­ment trend is ac­com­pa­nied by a sub­stan­tial in­crease in fi­nan­cial-sec­tor risks, ow­ing to the ex­ces­sively easy mon­e­tary pol­icy that was used to achieve the cur­rent eco­nomic re­cov­ery.

The over­all un­em­ploy­ment rate is down to just 5.5%, and the un­em­ploy­ment rate among col­lege grad­u­ates is just 2.5%. The in­crease in in­fla­tion that usu­ally oc­curs when the econ­omy reaches such em­ploy­ment lev­els has been tem­po­rar­ily post­poned by the decline in the price of oil and by the 20% rise in the value of the dollar. The stronger dollar not only low­ers the cost of im­ports, but also puts down­ward pres­sure on the prices of do­mes­tic prod­ucts that com­pete with im­ports. In­fla­tion is likely to begin ris­ing in the year ahead.

The re­turn to full em­ploy­ment re­flects the Fed­eral Re­serve’s strat­egy of “un­con­ven­tional mon­e­tary pol­icy” – the com­bi­na­tion of mas­sive pur­chases of long-term as­sets known as quan­ti­ta­tive eas­ing and its prom­ise to keep short­term in­ter­est rates close to zero. The low level of all in­ter­est rates that re­sulted from this pol­icy drove in­vestors to buy eq­ui­ties and to in­crease the prices of owner-oc­cu­pied homes. As a re­sult, the net worth of Amer­i­can house­holds rose by $10 trln in 2013, lead­ing to in­creases in con­sumer spend­ing and busi­ness in­vest­ment.

Af­ter a very slow ini­tial re­cov­ery, real GDP be­gan grow­ing at an­nual rates of more than 4% in the sec­ond half of 2013. Con­sumer spend­ing and busi­ness in­vest­ment con­tin­ued at that rate in 2014 (ex­cept for the first quar­ter, ow­ing to the weather-re­lated ef­fects of an ex­cep­tion­ally harsh win­ter). That strong growth raised em­ploy­ment and brought the econ­omy to full em­ploy­ment.

But the Fed’s un­con­ven­tional mon­e­tary poli­cies have also cre­ated danger­ous risks to the fi­nan­cial sec­tor and the econ­omy as a whole. The very low in­ter­est rates that now pre­vail have driven in­vestors to take ex­ces­sive risks in or­der to achieve a higher cur­rent yield on their port­fo­lios, of­ten to meet re­turn obligations set by pen­sion and in­sur­ance con­tracts.

This reach­ing for yield has driven up the prices of all longterm bonds to un­sus­tain­able lev­els, nar­rowed credit spreads on cor­po­rate bonds and emerg­ing-mar­ket debt, raised the rel­a­tive prices of com­mer­cial real es­tate, and pushed up the stock mar­ket’s price-earn­ings ra­tio to more than 25% higher than its his­toric av­er­age.

The low-in­ter­est-rate en­vi­ron­ment has also caused lenders to take ex­tra risks in or­der to sus­tain prof­its. Banks and other lenders are ex­tend­ing credit to lower-qual­ity bor­row­ers, to bor­row­ers with large quan­ti­ties of ex­ist­ing debt, and as loans with fewer con­di­tions on bor­row­ers (so-called “covenant-lite loans”).

More­over, low in­ter­est rates have cre­ated a new prob­lem: liq­uid­ity mis­match. Fa­vor­able bor­row­ing costs have fu­eled an enor­mous in­crease in the is­suance of cor­po­rate bonds, many of which are held in bond mu­tual funds or ex­change-traded funds (ETFs). Th­ese funds’ in­vestors be­lieve – cor­rectly – that they have com­plete liq­uid­ity. They can de­mand cash on a day’s no­tice. But, in that case, the mu­tual funds and ETFs have to sell those cor­po­rate bonds. It is not clear who the buy­ers will be, es­pe­cially since the 2010 Dodd-Frank fi­nan­cial-re­form leg­is­la­tion re­stricted what banks can do and in­creased their cap­i­tal re­quire­ments, which has raised the cost of hold­ing bonds.

So that is the sit­u­a­tion that the Fed now faces as it con­sid­ers “nor­mal­is­ing” mon­e­tary pol­icy. Some mem­bers of the Fed­eral Open Mar­ket Com­mit­tee (FOMC, the Fed’s pol­i­cy­mak­ing body) there­fore fear that rais­ing the short-term fed­eral funds rate will trig­ger a sub­stan­tial rise in longer-term rates, cre­at­ing losses for in­vestors and lenders, with ad­verse ef­fects on the econ­omy. Oth­ers fear that, even with­out such fi­nan­cial shocks, the econ­omy’s cur­rent strong per­for­mance will not con­tinue when in­ter­est rates are raised. And still other FOMC mem­bers want to hold down in­ter­est rates in or­der to drive the un­em­ploy­ment rate even lower, de­spite the prospects of ac­cel­er­at­ing in­fla­tion and fur­ther fi­nan­cial­sec­tor risks.

But, in the end, the FOMC mem­bers must rec­og­nize that they can­not post­pone the in­crease in in­ter­est rates in­def­i­nitely, and that once they begin to raise the rates, they must get the real (in­fla­tion-ad­justed) fed­eral funds rate to 2% rel­a­tively quickly. My own best guess is that they will start to raise rates in Septem­ber, and that the fed­eral funds rate will reach 3% by some point in 2017.

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