BondSquawk

by Rom Badilla, CFA – Bondsquawk.com

June 24, 2010

Federal Reserve Bank of Kansas City President, Thomas Hoenig is batting 1.000 in terms of dissents in the last four meetings as mentioned in a Wall Street Journal article. With today’s announcement and the rest of the committee expressing more caution about the sustainability of the U.S. economy, Hoenig was the lone opposing vote to keep rates near zero along with the “extended period” language. The Jayhawk Fed President, unfazed by the European debt crisis, was outnumbered 9-1.

The FOMC’s post-meeting statement repeated Mr. Hoenig’s rationale offered in the April statement: “continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted because it could lead to a build-up of future imbalances and increase risks to longer-run macroeconomic and financial stability, while limiting the Committee’s flexibility to begin raising rates modestly.”

For months, Mr. Hoenig has warned about the potential for near-zero interest rates to create imbalances — that is, bubbles — and spur inflation in the longer run. In a June 3 speech, he again called monetary policy “a blunt instrument that has a wide set of intended but also unintended consequences that can and have worsened economic outcomes including misallocation of precious resources, inflation and long-term unemployment.” He added, “That is why we want to return to a sustainable long-term equilibrium policy rate, starting soon.”

While I do not agree Hoenig’s recent position, I do agree with his belief that near-zero interest rates create imbalances as monetary policy is indeed a “blunt instrument”.

The problem is that this characterization applies to Greenspan’s monetary policy after the recession of 2001-2002 that eventually led to the housing bubble and not of today’s. It was the low rate environment where mortgage rates dipped to a then-low of 5.5 percent in 2003, coupled with Greenspan encouragement and the Fed’s blind eye that allowed everyone, from borrowers to lenders, to take on excessive risk in real estate. Back then debt accumulation could be justified in the minds of consumers, by stable income and job prospects as well as the perception that housing “always appreciates”. In essence, the expected “return” of an asset exceeded the cost of capital on debt. Speculation driven by both the greed for more and the fear of being left behind, led to massive increases in asset prices.

Today and after the greatest crash in economic history, monetary policy isn’t just “blunt”. Actually, monetary policy no longer has its edge as this low interest rate environment doesn’t have any teeth since it is having a muted affect on credit creation. The Fed’s plan of the past two years to re-inflate asset prices has been a major disappointment. Home sales have plummeted and further price pressures are on its way in both commercial and residential real estate.

The economy has been bitten by the debt bug and is now thrice shy. Mortgage applications continue to decline despite low interest rates. Purchases in housing are down due to high unemployment while refinancings are low because nearly 1 in 4 homeowners with mortgages owe more than the current value of their homes. In addition, lenders are reluctant to open the flood gates in fear of adding too much risk to their balance sheets.

Indeed, monetary conditions can be seen as accommodative as evident by low rates. However, people are reluctant to add more debt to existing debt. Why take out debt on an asset that could decline in an environment where many workers are sitting idle? There is a lack of confidence in the stability of the current economy. The “gotta have it now” mentality has been replaced by the “age of austerity”. Unless there is some mechanism to make it all disappear, then monetary policy will be relatively ineffective for quite some time. Because of this, its hard to see any unintended consequences like inflation that is a result of low interest rates.