I have decided to create a mailing list for sending future articles that I
write in the Wall Street Journal, Financial Times, and elsewhere. Probably
about two or three things a month. Let me know if you would prefer not to
be on this list
My latest WSJ piece follows:
Originally published in The Wall Street Journal July 2, 2013
The Fed Should Start to 'Taper' Now
By MARTIN FELDSTEIN
The Federal Reserve should begin now to end its program of long-term asset
purchases. It should not wait for the improved labor market that it
predicts will come later this year, an improvement that is unlikely to
occur. Instead, the Fed should emphasize that the pace of quantitative
easing must adjust to the likely effectiveness of the program itself, and
to the costs and risks of continuing to buy large quantities of bonds.
Although the economy is weak, experience shows that further bond-buying
will have little effect on economic growth and employment. Meanwhile, low
interest rates are generating excessive risk-taking by banks and other
financial investors. These risks could have serious adverse effects on bank
capital and the value of pension funds. In Fed Chairman Ben Bernanke's
terms, the efficacy of quantitative easing is low and the costs and risks
are substantial.
At his June 19 press conference, Mr. Bernanke described the Fed's plan to
start reducing the pace of bond-buying later this year and to end purchases
by the middle of 2014. He stressed that those actions are conditional on a
substantial improvement in the labor market, leading to an unemployment
rate of about 7% by mid-2014 with solid economic growth supporting further
job gains. He emphasized that the "substantial improvement" would be judged
by more than the unemployment rate.
Over the past year, unemployment has declined to 7.6% from 8.2%. However,
there has been no increase in the ratio of employment to population, no
decline in the teenage unemployment rate, and virtually no increase in the
real average weekly earnings of those who are employed. The decline in the
number of people in the labor force in the past 12 months actually exceeded
the decline in the number of unemployed.
These poor labor-market conditions are unlikely to improve in the coming
months. The Fed's forecast of substantial employment gains rests on the
assumption that real GDP will grow by about 2.5% during the four quarters
of 2013 and by more than 3% in 2014. That would represent a substantial
rise from the growth rates of less than 2% in 2012, 1.8% in the first
quarter of 2013, and a likely 1.7% in the second quarter. Reaching the
Fed's GDP forecast for this year requires the growth rate to jump to more
than 3% in the third and fourth quarters.
It is difficult to see how this can happen. U.S. exports are declining in
response to weaker growth in other countries and a stronger dollar. The
sequester and the higher tax rates that took effect on Jan. 1 will continue
to reduce aggregate demand. These forces will more than offset the
favorable but small effect on GDP from increased residential investment.
Corporate profits and nonfarm inventory investment declined in the first
quarter, and nonresidential fixed investment was essentially unchanged.
Spending by state, local and federal governments fell. Personal income
declined and after-tax personal income declined even faster. The growth of
GDP was sustained primarily by a faster pace of consumer spending that will
be hard to maintain with stagnant earnings and a household saving rate that
has dropped to only 3.2%.
The higher interest rates that followed the Fed's announced plans for
tapering its bond-buying will further weaken GDP and employment. This will
make it even more difficult for the Fed to achieve the robust labor market
it says is necessary to scale back the bond purchases.
The Fed is also understating the impact of its tapering plan on interest
rates. Mr. Bernanke has made it clear that he believes the level of
long-term interest rates depends on the total stock of bonds held by the
Federal Reserve, and not on the monthly rate of purchases.
But the planned shift from the current monthly bond purchases of $85
billion to zero over the next 12 months clearly had a large impact on
long-term rates, pushing them to levels not seen since July 2011. This
impact is hard to explain by any effect the tapering might have on the
ultimate size of the Fed's bond portfolio. Mr. Bernanke admitted in his
June 19 press conference that the very large jump in rates that has
occurred was therefore a "puzzle."
The sudden jump in rates suggests that the Fed's statements acted as a
"trigger" indicating that the low- rate equilibrium was coming to an end.
Market participants have recognized that the interest rate on long-term
Treasury bonds is unsustainably low. The real level of 10-year rates was
negative until a few months ago and is now only slightly positive.
That real rate would normally be at least 2%. Given the size of the fiscal
deficit, the relative size of the national debt, and the low rate of
household saving, the real rate should now be significantly higher.
Investors nevertheless continued to hold long-term bonds to gain a bit more
yield, hoping they would be able to exit quickly before higher interest
rates caused asset prices to fall.
Mr. Bernanke's congressional testimony at the end of May and again in June
may have been the trigger that caused portfolio investors to start selling
bonds, just as the observed problems with subprime mortgage securities
triggered a much wider selloff in 2007. If so, long-term interest rates are
likely to go higher.
Although interest rates have increased, they are still abnormally low.
Investors and financial institutions are still accepting significant risks
in order to enhance the yield on their portfolios by buying low-quality
corporate bonds, holding longer-term bonds, making covenant-light loans
that increase the risk to lenders by imposing fewer restrictions on
borrowers. They are also bidding up prices of agricultural land and other
assets.
The danger of mispricing risk is that there is no way out without investors
taking losses. And the longer the process continues, the bigger those
losses could be. That's why the Fed should start tapering this summer
before financial market distortions become even more damaging.
Mr. Feldstein, chairman of the Council of Economic Advisers under President
Reagan, is a professor at Harvard and a member of The Wall Street Journal's
board of contributors.
7/2/2013
Received on Mon Jul 08 2013 - 15:11:17 EDT
