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Weekly Economic Commentary


The first steps towards fiscal congress have been taken, but the finish line is far off

October 11, 2013

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  • The first steps towards fiscal congress have been taken, but the finish line is far off
  • How long can U.S. borrowing costs remain low?
  • Janet Yellen is a pragmatist, not a dove

In past debates over raising the U.S. debt ceiling, our two political parties have been sharp with one another in front of the cameras for a time, but eventually settled into private conversation. It appears that transition took place on Thursday, with high-level discussions among the principals at the White House leading to follow-on negotiations among their staffs. So we close the week on an encouraging note, but there is some difficult terrain left to traverse.

The proffer of a four to six week extension in the debt ceiling is helpful, but may be seen by some as insufficient. The initial proposal did not include a re-opening of the government, and it creates the possibility of a second nervous period around Thanksgiving when the temporary increase in the borrowing limit ends.

One challenge to the process has been the mismatch between the voting cycle and the fiscal cycle. Representatives face primary elections in about six months; any overt sign of conciliation risks the entry of a more doctrinaire competitor to those contests. Does an incumbent risk a seat in Congress next spring by engaging on entitlement reform, the benefits of which accrue many years into the future? This calculus is not conducive to progress.

A client made a poignant point this week. A successful negotiation, he observed, is one in which both sides can declare some level of victory. Until yesterday, it appeared that neither side would be happy with anything short of total conquest. Let’s hope that the improved tone eventually leads to consensus.

The financial markets have really done a nice job of taking all of this in stride. While trading has seemed a bit nervous to this observer, asset prices have held up very nicely. Market volatility rose just a bit in the middle of the week, but the experience was nothing like the debacle of the summer of 2011 (when the VIX measure of market volatility rose to 48).

The exception to market calm was trading in one-month Treasury bills, whose yields rose sharply amid reports that fund managers were avoiding securities that might be most at risk for interest deferral. For a time, borrowing rates for the U.S. government exceeded the LIBOR rate, a very rare juxtaposition.

Next week will be crucial. Projections from the U.S. Treasury indicate that it will reach the debt ceiling on or about October 17. Many of us have been digging into the details of government cash flows to see how spending might be affected from there; any “prioritization” of outlays (paying some and deferring others) would be gradual at first, but full consequences will likely set in by November 1, when Social Security and Medicare disbursals are scheduled to go out.

Prioritizing interest payments to avoid default is likely, but the resulting reductions in other programs could have an important impact on economic activity. Extreme projections put our economy back into recession if we fail to increase the debt ceiling within the next month or so.

Our most-likely case remains an accord at the 11th hour, which will include an extension of the debt ceiling in an amount that will not be sufficient to cover the entire fiscal year. This design would keep up a certain level of dialog around entitlement spending. As we argued last week, we should not defer these discussions any longer.

One reason for urgency is that the cost of carrying our nation’s debt cannot stay low indefinitely. The United States has been the beneficiary of good fortune on this front; annual debt service has moderated, even as the level of debt has been increasing.

The decline in interest rates has several root causes. The Federal Reserve’s zero interest rate policy has held down carrying costs for shorter-term issues, and quantitative ease has held down longer-term yields. Treasury securities have served as a risk-free part of global portfolios, one that has gained in popularity amid faltering foreign markets and the lingering risk aversion that was kindled during the financial crisis.

Each of these favorable trends is at significant risk of reversal in the years ahead. The Federal Reserve will, one day, see fit to bring its benchmark rates back to more normal levels. The consensus among private economists and the Fed’s own forecasts sets the long-run level at around 4%.

In the longer tenors, investors may gradually steer their allocations from bonds to stocks to seek better risk-adjusted returns. An increase in the risk premium created by a loss of confidence in our fiscal process (which could be accelerated by a ratings downgrade if we fail to increase the debt ceiling) would also add to the cost of carry.

It is important to note that since many other bonds are priced relative to Treasury securities, increases in the risk premium would increase borrowing rates for homeowners and businesses, further dampening economic performance.

Each 1% increase in borrowing rates adds $160 billion, or a little over 1% of gross domestic product (GDP), to the government’s annual interest payments. The Treasury has been trying to limit its exposure to rising bond yields by increasing the maturity of its outstanding securities, which presently stands at its longest level in 11 years.

The goal is to ensure that national debt remains “sustainable,” meaning that the interest cost of carrying it does not accumulate so quickly that debt becomes impossible to reduce. If we fail in this endeavor, then we might encounter great difficulty attracting investors to purchase our obligations at reasonable prices.

It would certainly have been better had we made progress on long-term spending reform when times were better and coffers were flush. But those flush times enabled the deferral that makes things much more challenging to deal with. It will take vision and some courage to reach resolution; I hope those qualities become more evident among policy makers in the days ahead.

Janet Yellen – A Dove or a Pragmatist?

Market participants perceive Janet Yellen, the Chairman-designate of the Fed, as a dedicated “dove” with a larger tolerance of inflation as compared with the more serious “hawks.” We feel this view is somewhat misinformed.

Her track record as a member of the Federal Open Market Committee (FOMC) consists of two stints: the first between August 1994 and February 1997, when economic conditions were rosy, and her recent tenure as Vice Chair of the Fed, when it has been steering the economy under severe duress. Therefore, her views about inflation are best assessed from remarks made during more prosperous times when inflation was a greater threat than economic weakness.


The Fed raised the federal funds rate aggressively during 1995, taking it to 6% from 3%. During this period, Yellen’s voting record does not include dissents, and transcripts of FOMC meetings during 1996 reveal that Yellen is a pragmatist rather than a dove. Here are her views about inflation from transcripts of FOMC meetings in 1996:

May 1996: “Clearly, we have an economy operating at a level where we need to be nervous about rising inflation … this is a major risk.”

July 1996: “We may be living on borrowed time, and there may end up being a price to pay for having allowed the economy, to use Governor Lindsey's phrase, ‘to push the envelope’.”

December 1996: “To my mind, labor markets are undeniably tight … so, I still feel that we need to avoid complacency about potential for inflationary pressures to emerge from the labor down the road.”

During her current stint at the Fed, her comments on conditions are perhaps more balanced than some think:

April 11, 2011 (speech): “The FOMC is determined to ensure that we never again repeat the experience of the late 1960s and 1970s, when the Federal Reserve did not respond forcefully enough to rising inflation and allowed longer-term inflation expectations to drift upward.”

Yellen also brings to the table credentials as the head of an internal communications subcommittee in 2010. The committee’s goal to increase transparency and accountability led to enshrining officially the Fed’s inflation target of 2%, publication of the Fed’s longer-run objectives and strategy, and the introduction of forward guidance with thresholds for inflation and unemployment.

Speaking of communications of Fed policy, the minutes of the just released September 17-18 FOMC meeting indicate that members spent a great deal of time deliberating the effectiveness of the Fed’s recent communications. Some were concerned that the Fed’s decision to postpone a reduction of asset purchases would affect the FOMC’s credibility, diminishing the predictability of monetary policy and creating uncertainty about the Fed’s reaction function. Reframing messaging to markets will require attention in the early months of Yellen’s tenure.

The fiscal impasse in Washington, mentioned as a risk by the FOMC in September, has come to pass. This creates a host of complications for Fed policy: delayed, incomplete and imperfect data flows, and uncertain effects on the economy are just two of these. The Fed also may be called on to bolster liquidity in the financial system if any Treasury securities enter technical default.

It has been our view that asset purchases would be reduced at the December FOMC meeting, starting the process before the leadership transition and offering the opportunity at a press conference to explain next steps. That timing is now somewhat up in the air.

Whatever the challenges, though, markets should come to have full confidence in Janet Yellen’s ability to handle them. Her intellect is unquestioned, and her orientation is much more balanced than some might think. The process of selecting her was not the most orderly, but it ended in the right place.

The opinions expressed herein are those of the author and do not necessarily represent the views of The Northern Trust Company. The Northern Trust Company does not warrant the accuracy or completeness of information contained herein, such information is subject to change and is not intended to influence your investment decisions.