By late in the second decade of the twenty-first century, we could say that the long-term US interest rate market had been dysfunctional for a long time. We could identify the starting point as being the immediate aftermath of the Nasdaq bust and recession of 2000/01. In signalling that the rise in the Fed funds rate would be slow and gradual over a prolonged period (described by central bank watchers as a pre-commitment to a given rate path), the Greenspan Fed put an unusual dampener on long-term interest rates at the time—in hindsight the start of manipulation under the 2% inflation standard and a powerful impetus to the asset price inflation which started to form during that period. Many contemporary market critics, including senior monetary officials, attributed the “artificially low” long-term rates not to their own manipulations in the short-term rate markets but to such factors as the “Asian savings surplus”. Indeed, Federal Reserve speakers stimulated that particular speculative narrative followed widely by carry traders (including prominently the “Asian savings surplus”!) in search of term risk premium to bolster the meagre returns available in the money markets. (It is also possible that the only contained rise of long-term rates at this time reflected widespread concern that present asset inflation would end with a bust and that indeed the long series of Fed rate rises could end in speculative over-kill).
Even so the corruption of signalling in the long-maturity interest rate markets in the early 2000s paled in comparison to what was to occur under the use of the non-conventional tool box in the second decade. And the central bankers added to the corruption by citing the low long-maturity interest rates as evidence that the so-called neutral level of interest rates had indeed fallen. Yes it was a puzzle why ostensibly low long-term rates were not sparking strong growth of capital spending. Central bankers, however, were not ready to embrace the obvious explanation that their monetary manipulations had created such huge uncertainty which discouraged long-run investment spending. In particular, if almost everyone and their dog realized that a wide range of asset prices—including, crucially, equities—had become hot due to the monetary manipulations and that they were likely to crash within a few years, this would surely restrain capital spending especially for long-gestation projects to well below levels which would pertain if the hot prices were for real.
And so the prevailing central bank doctrine became long-term rates were not very different if at all from neutral. Yes, it made sense for central banks to gradually shed their huge portfolios of long-maturity debt built up during the active years of [quantitative easing] QE, but they should be ultra-cautious not to set off a snowball process of rising long-term rates and falling asset prices. Gradual should be the order of the day—or, better yet, glacial. And to match, the rise in short-term rates strictly under the control of the authorities should proceed very cautiously.
There was an alternative to the phoney normalization programme, which in any case could readily implode along the way. This would have been to turn the clock back on interest payments on reserves (permanently zero again as before 2008) accompanied by immediate action to restore the monetary base to a normal proportion of the broader money supply. Yes, long-term rates could well jump under this programme, and there could be some decline in asset prices (from the sugar highs of peak asset price inflation). But the return of reliable signalling could also have gone along with a new robustness in spending, especially capital spending, given no longer the malaise of “artificial” capital prices which could break at any point.
Policy normalization—defined as closing down the non-conventional tool box and restoring a well-functioning price signalling mechanism to the bond market—is in fact multi-dimensional. At the most fundamental level, it requires abandoning the 2% inflation standard—in particular its ignoring of the natural rhythm of prices over time. The second dimension is to get the monetary base back to the pivot of the monetary system. This means no payment of interest on reserves and the supply of monetary base in line with demand as consistent with a non-inflationary path forward. The third dimension is getting the share of long-maturity government debt in the total liabilities of the government sector (including the central bank) back to normal proportion. That can be accomplished over a period of many years.
Action in the second dimension can take place very quickly. The central bankers take their portfolio of long-maturity bonds to the Treasury and exchange them for short-maturity Treasury bills (T-bills). The central bank conducts open market operations in Treasury bills (short maturity) to shrink the monetary base to “normal”. Of course there is much ambiguity about where is normal, and so the process of normalization on this dimension could go along with some considerable monetary turbulence for some time. That is an inevitable consequence of the huge experiment.
The normalization in the third dimension starts from the situation where the Treasury department, looking at the consolidated balance sheet of the Treasury and central bank, admits that years of QE mean in effect that an abnormally large share of government bonds outstanding are in the form of floating rate short maturities. Traditionally such a high proportion of floating rate is seen as exposing the central bank to large political pressure not to raise the short-term rates under their control (because of direct funding cost implications in terms of budget deficit)—even when it suspects that monetary inflation has got under way. If the central bank buckles under such pressure, then it becomes indeed an important source of tax collections for the government—in the form of inflation tax. One form is the suppression of interest rate income (to below what would be the case under sound money) on Treasury paper—the other is the capital tax (in real terms) on government bonds and monetary base enacted by inflation erosion.
This article is a selection from The Case Against 2 Per Cent Inflation: The Negative Rates to a 21st Century Gold Standard (Palgrave Macmillan, 2018).
