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The Fed's Bond Market Partner
The Federal Reserve, that enigmatic nemesis of borrowers, is not as powerful as it was a dozen years ago. Today, the Fed shares its power with investors all over the world, and in particular with investors in bonds.
A consequence of this new partnership is better control of inflation at the cost of slower economic growth.
Until the late 1980's, the Fed's job had been four-fold, and in the following order of priorities: maintain stable markets, be a lender of last resort, fine tune the economy, and fight inflation. The new arrangement has changed these priorities, moving inflation from last to first.
The Fed's tools remain the same. The Fed really has only one socket wrench that matters: the absolute ability to set short term interest rates. If the Fed wishes the overnight interbank interest rate ("Fed Funds") to be 3.00% instead of 3.25%, 3.00% it will be.
In the old days, the whole interest rate structure would follow any Fed change in short term rates. If the Fed tightened (raising the Fed Funds rate), everything from 90-day T-Bills to 30-year bonds would have a bad day. If the Fed eased, all rates would come down: mortgages, bond yields, the works.
Not any more.
The Fed's new investor-partner was not invited to attend the party. The Fed is a dignified, private, and thoughtful institution: the same cannot be said for bond investors.
The individuals, governments, and institutions which invest in bonds are unruly, emotional, and live in paranoid dread of inflation. They don't worry about anything else. Buy an 8.00% bond and watch inflation go to ten, and you will be directed to pursue a new career.
Inflation anxiety is nothing new to bond investors. However, since 1980, there are lots more bond investors.
In the slowpoke, pre-computer, pre-Michael Milken world, there weren't many bonds to buy. Mortgages disappeared in to S&Ls. Governments issued some five-year plus debt, but budgets were mostly in balance. Few corporations had long term creditworthiness.
In a short dozen years, United States Treasury tradable debt alone is about six times what it was. Mortgages are a trillion dollar sub-set of the bond market. You aren't anybody in corporate America if you can't bring some bonds to market. And there is a rumor that state and local governments are borrowing a bit more than in the past.
Somebody has to buy all this debt paper, and then take the risks of ownership. Not everybody can be a broker.
At any given moment, these investors may or may not be happy with the Fed. They are delighted with a Scrooge Fed. However, let the Fed appear to be more interested in engineering an economic recovery than stopping inflation, and bond investors will sell. Mass dumping of bonds raises long term interest rates, and tends to abort economic activity.
Tinkering with economic growth rates used to be a major pastime at the Fed. It also used to be an unspoken part of the Fed's job to accommodate Congressional interest in unbalanced checking, or Presidential intent to grease underemployed palms.
Every time the Fed looks as though it will ease, or ease too fast, the rowdies sell their bonds. Repeatedly in the last five years, a Fed easing has been greeted with higher long term rates. Fed efforts to end the 1990-91 recession were often sidetracked by this very mechanism.
This new era is upsetting to the Fed. Here you are, having a nice holiday party, tentatively passing the easy money hat to help Tiny Tim out of his depression, and here comes an angry crowd to shut you down. And take the hat.
The Fed can't get a good economic recovery going without getting long term interest rates down. By any historical measure, five to thirty year rates are at least a point too high versus inflation. So here we are, slow growth, low (and falling) inflation, and an agonizing ratcheting down of long term rates -- much slower than the Fed wishes.
This phenomenon is hardly unique to America. Inflation is falling all over the world at the cost of much more economic pain than governments ordinarily would tolerate. New forecasts for growth in industrialized economies in 1993 have been cut from 3% to a negligible 1%.
Except for Germany and Russia, every government on earth would be opting for easier money. (Germany doesn't because its Bundesbank already thinks like a bond investor, and Russia is already neck-deep in wallpaper.)
In the new era, no government can get away with easy money. At the slightest sign of funny money, your bondholders will sell until rates go so high that they wreck your economy. In the end, wrecked economies with millions of people out of work generate notoriously low inflation. Thus are great bond victories won.
Mr. Clinton was elected above all else to rescue the economy. He is not even in office, and has had to abandon his modest plans for more deficit spending. Given the mean bent of the Fed's investor-partners, we will have to get by with the courage to rearrange.
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