We’ve suggested that the Fed has drunken a bit too much of its own confidence Kool-Aid to be talking about tapering QE. The problem now, as we’ve stressed, is that the effect of QE may prove to be asymmetrical, that the flattening the yield curve exercise when short rates were already in ZIRP land haven’t done much to stimulate the real economy (where was the Fed in calling for more fiscal stimulus, or in arguing against deficit scare-mongering?). But perversely, taking it away could be more of an economic downer than the central bank anticipates. Mere talk of ending QE is tantamount to urging on a rate hike for the longer end of the yield curve. And higher rates there will not only prove to be a damper, but with economic growth slowing all over the world, has the potential to have knock-on effects.
Three front page stories at the Wall Street Journal tonight all highlight reasons why the Fed might dial down taper expectations.
The first is that mortgage refinancings have fallen, which we predicted would happen. Even though there is some whistling-in-the-dark talk about how some consumers might refinance with rates going in the wrong direction, the most you are likely to see is people who’ve been distracted and haven’t gotten around to doing the paperwork. Anyone who is remotely attentive to rates has likely refied multiple times already. Refis are a weak but real source of stimulus, since lower mortgage payments means more money in consumers’ pockets to spend on other stuff. So a big drop in rates takes that source of incremental spending away.
The second is on how the Fed-induced interest rate increases have led to worrisome interest rate increases in Eurozone periphery countries. Suddenly the belief that the Eurozone crisis was over is coming into question> From the Journal:
Government bonds have recently taken a hit around the world, now that investors are preparing for the possible end of central banks’ boundless economic stimulus. And those bonds of the weakest euro-zone countries have shown some of the biggest drops…
Yields on the 10-year Greek bond, which had strengthened remarkably since last summer, ended Thursday at 10.03%. That is two percentage points higher than where they stood on May 22, when the U.S. Federal Reserve signaled its giant bond-buying program might slow this year. At 6.47%, the Portuguese 10-year is more than one percentage point above its May low. Bond yields rise when their prices fall.
The 10-year Spanish bond, which was near 4% in early May, closed Thursday at 4.61%, flat on the day. The Italian 10-year, a hair stronger Thursday at 4.35%, also is off over the month. The spread—or the amount of additional yield investors demand, above that paid by benchmark Germany—also has risen for both countries over the period.
And the piece points out how putting these countries on the austerity rack is not going to improve their ability to make good on their obligations:
But a larger problem may be looming: In order to restore their economic viability, weaker countries must improve their industries’ competitiveness by pushing down wages and other costs, relative to Germany and other northern countries. But the German economy appears to have settled into a pattern of low growth and low inflation.
That means Italy, Spain and the others need more of this so-called internal devaluation. And devaluation makes it harder to pay down debt.
Some economist have question whether wages are even the source of the periphery countries’ woes. One line of thought is the simple, “you can’t starve labor and expect to have anyone to buy.” A second is that the periphery countries have the wrong industrial mix, and cutting wages won’t make enough of a dent in their competitiveness. They need to be in more value-added products (which is basically the approach taken by Mondragon, and the Basque region has much lower unemployment than the rest of Spain as a result).
The third article in the Journal addresses another topic near and dear to our heart, that inflation rates and inflation expectation are falling. The Fed has been taking the view that this is an aberration but if current patterns hold or intensify, it will have to rethink its assumptions. From the article:
The Fed has a 2% inflation goal and doesn’t want consumer prices to veer too much above or too much below that number over time. Some recent inflation measures have dropped below that level this year, but Fed officials haven’t been too worried because expectations of future inflation were stable….
“It is no longer clear that inflation expectations are so stable,” Jan Hatzius, chief economist at Goldman Sachs Group Inc., said in an interview. Market-based measures of inflation expectations are now on “the low side of comfortable.” In a note to clients June 10, he predicted that expectations of lower inflation are likely to make Fed officials less willing to pull back on the bond-buying programs out of fear it could destabilize those expectations about future inflation….
In that context, the Fed launched its bond-buying program to bolster economic growth by pushing down long-term interest rates and pushing up asset prices, hoping that would spur spending, hiring and investment. If officials believe the economy is on track to gain strength in coming months, they might start to reduce the size of the bond purchases. But if they thought low inflation and falling expectations signaled new weakness in the economy, they might want to continue the program at its current level for longer.
The Fed’s next pronouncement is late next week. It’s too bad no one is capable of Greenspanian obfuscation. I’m not much good as a Fedwatcher since I’m not good at identifying with their point of view. Logically, given the above, you’d expect the Fed to walk back the taper talk a bit. But they may believe more “we’re staying with the program” messaging is better for the confidence fairy.
This piece is cross-posted from Naked Capitalism with permission.