Peeking Inside Yellen's Mindset

From Scotiabank’s Guy Haselmann

Yellen’s Mindset – Implementing Her Professor’s Theories

Bloomberg printed an article about Yellen’s educational background, noting that two of her professors were James Tobin and Arthur Okun.  The article is interesting because the Fed is currently trying to implement QE and “Twist” which are theories developed by these two Nobel Laureates.  Tobin attempted a form of “Twist” in the 1960’s.  He also championed Keynesian ideas and advocated government intervention to stabilize output and avoid recessions.  Okun developed an empirical “law” relating” changes in unemployment to GDP.

  • The FOMC is placing great faith in these theories; thus, policies are an experiment of colossal proportion but whose effectiveness has limited supporting evidence.  Fed models try to estimate benefits, but they assume that markets remain efficient over time.  Model errors are likely to occur when trying to asses market risks, particularly because markets are typically irrational and illiquid during crisis periods.
  • FOMC policy veered into unchartered waters as soon as it moved Fed Funds down to the zero lower bound.  When official interest rates were eliminated as a monetary tool, directly manipulating financial markets became the Fed’s only conduit to try to affect the broader economy.  Evidence of its effectiveness is open to debate.  Since asset price inflation has been a policy objection, knowing when to stop is critical to Fed’s credibility, especially with its history of fueling boom/bust cycles.

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And some additional thoughts from Guy on markets:

FOMC Statement – Smart Tweaks to Buy Time, and Manage Expectations 

The FOMC was probably uncomfortable that market expectations for tapering had moved to March or later. Yesterday’s FOMC statement was successful at opening the possibility of an earlier move without changing overall policy direction. The statement downplayed the effects of the government shutdown and left in place the word “moderate” to describe the state of the economy, rather than downgrading it to “modest”. More importantly, the statement removed the sentence about how financial conditions had tightened.

FOMC Discussion – Growing Risks for Every Decision

The discussion in the boardroom was likely more intense than reflected by the simple changes of the statement.  The risks to tapering at this meeting had grown due to the weak September employment report, and because the market was not expecting any changes to policy.  However, there are several FOMC members who believe the risks to not tapering grow higher every day in sync with the size of its balance sheet.  The stakes are rising not just because their exit strategy becomes more difficult as the balance sheet expands, but also because the Fed has lost any sense of the market reaction function once they actually announce a slower pace of purchases. 

Markets – Expensive, but Carry and QE Trying to Keep Them That Way 

The bottom line is that the current QE policy will continue for another 6 weeks (at a minimum). The Fed is trying to “buy time” in the hopes the economy can heal further. Therefore, the attractiveness of carry and roll-down trades in Treasuries will partially offset the lack of attractiveness Treasury yields (expect a slow leak next week on 10s down to 2.62%).

  • Buying equities because bonds look expensive is a bad rationale.  Equities are saturated with speculative excess based on Fed promises or the perception of promises.  This may work for a while longer, but speculators are likely playing a greater-fool-theory ‘game of chicken’.

    



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