The Bernanke Blunder
Fed Interest Rates or Treasury Yields?
What really controls U.S. interest rates?
He will be making his regular semi-annual reports to Congress on Fed monetary policy.
This time around will be interesting for two reasons:
- Bernanke’s announcement last month of an end to $85B/month in Fed bond purchases
- Bernanke may not be around to make it happen and see its impact
Bernanke is now pushing the idea that it is enough to hold down Fed interest rates at the minimum until unemployment drops to 6.5%. The economy, after all, is improving.
The ‘Bernanke Blunder’ is that he believes that holding federal interest rates at the “zero lower boundary” will keep overall interest rates low. It won’t.
The Lead-up into This Week’s Testimony
In came out in the minutes of the last FOMC meeting six days ago that sentiments to end accommodating monetary policy (giving away free money) was not as strong as originally believed.
Wall Street loved it. They adore free money. The equity markets hit all-time highs.
Bernanke further tried to ease Wall Street concerns about monetary policy by assuring it that the Federal Funds Rate (0.25%) and the Federal Discount Rate (0.75%) will remain at rock bottom until the employment picture improves.
The Federal Funds Rate is the interest rate charged member depository banks of the Federal Reserve for overnight loans to another depository bank. The Federal Discount Rate is the interest charged to depository member banks of the Federal Reserve for regular liquidity loans.
Both affect the cost of banking throughout the United States. Both influence interest rates paid by the rest of us. They go up and we pay more. Bernanke says they will not be going up any time soon.
That would be that, if only Fed rates were the soul determining factor of interest rates. They aren’t. That is what Bernanke is forgetting or ignoring.
The Topsy-Turvy World of Treasury Bond Yields
What Bernanke minimizes is the effect of U.S. Treasury bond yields. That is the interest the government pays to finance its debt and the debt for a lot of other folks.
That rate is determined by open market conditions.
It has a greater impact on interest rates for the rest of us than anything else. Treasury bonds fund all kinds things, like home mortgages. Treasury yields rise; interest rates rise. It is as simple as that.
The U.S. Treasury bond universe is totally upside down. Here is the situation:
- The U.S. economy is weak
- The federal government has issued nearly $7 trillion in Treasury bonds to pay it’s debts since 2008
- The Fed creates $40B/month in new QE money with MBS asset purchases using Treasury bonds
- The Fed creates another $45B/month by just buying Treasury bonds
- The Federal Reserve has debt of $3.8 trillion on its balance sheet
By any sensible economic measure, Treasury yields should be high. They aren’t. Exactly the opposite is true. They are at near record lows.
Why? The “Safe Haven” Effect! A ‘safe haven’ is “An investment that is expected to retain its value or even increase its value in times of market turbulence.”
The entire world is in “market turbulence”. Foreign governments and large banks and mega-investors have flocked to U.S. Treasury bonds as a safe haven investment. That has driven yields down when pure economic logic dictates that T-bonds should be avoided or sold, thus making yields rise.
When Fed Chair Bernanke announced an end to bond purchases – something that in normal times would have made yields go down – Treasury 10-year bond yields counter-intuitively leaped higher… by about 0.5%!
The impact on home mortgages was immediate. 30-year mortgages have risen from 3.4% just a couple months ago, to between 4.50% and 4.75% today. That increases a monthly payment by about $75 to $90 a month on a $200,000 home.
U.S. Treasury yields drive real interest rates more so than Fed interest rates do.
Fed Chairman Ben Bernanke is sure to be grilled on Capitol Hill this week.
Wellll… he’ll be grilled on the parts that partisan politicians understand; which, admittedly, is not much.
It is doubtful Bernanke will be questioned about the ‘Bernanke Blunder’, overlooking the effect of rising Treasury bonds yields over the next several years as the economy improves and investors start dropping U.S. Treasury bonds like hot potatoes, making interest rates soar.
Congressmen won’t ask, but should. The economic fate of nation depends on it.