Thursday, July 22, 2004

Monetary Policy: Up to our necks in debt,

Earlier today, the oldman posted a brief summary and "translation" of Greenspan's testimony, as well as a rebuttal of his assertion that the pain from interest rate rises would not be extensive. The story is essentially that the ratio of financial obligations for households has risen from about 25% to 31% in the past decade, even though debt service has only risen slightly. Meanwhile the financial obligations ratio to personal disposible income has remained more or less the same for renters.

Adding his two cents, is Ian from BOP-news. Ian has some truly interesting graphs that one has to see personally, and he summarizes them with:

Now, go back and take a look at that chart again. Look at what happened to the consumer debt ratios in the early eighties and early nineties recessions. Now take a look what happened from 2001 to the present. In both prior recession the ratio dipped for the duration of the recession as people paid down loans and refused to take on new debt during hard times. This time around consumer debt kept rising, then has stayed approximately even (if you use NBER's recession it rose throughout, if you assume the recession continued to late 2003 then it rose and then stayed even.)

This is further rebuttal that Americans have used the period of low interest rates to repair their personal balance sheets. They have instead opted apparently to maintain the same or slightly higher levels of debt service, and added to their financial obligations. They have pulled back a little from the peak, but not by much. So the data shows that consumers have acted on the whole in a way not consistent with Greenspan's description of how the general economy has been affected by his policies.

Furthermore, a poster named dd to Ian's post links to Roach's commentary on the effects this monetary policy has had on the financial markets:
To date, of course, the Fed has taken but one small step in returning its policy rate toward a more neutral setting. This has done next to nothing to discourage the vast array of carry trades that are still on the books in financial markets. Amy Falls, our global fixed income strategist, argues that most of these levered bets are now almost back to positions prevailing before the Fed's late June move. That's especially the case, in the view of our fixed income team, insofar as most spread products are concerned -- namely mortgage-backed securities, high-yield bonds, emerging market debt, and even investment grade paper. Our European equity strategists, Teun Draaisma and Ben Funnell, make a similar point -- that with sharply negative real short-term interest rates, it takes a lot more than 25 bp of monetary tightening to unwind the carry trade (see their July 13 essay, "The Crowded Carry"). They underscore the weakest link in this daisy chain -- that the risks to the levered community are likely to fall most acutely on banks and consumers, where the need for carry-trade-induced income generation is most acute. That pretty much fits with my own concerns, especially with respect to the over-extended American consumer.

What worries me the most in all this are the mounting systemic risks toward carry trades and the asset bubbles they spawn. To the extent that such trading strategies create artificial demand for assets, a seemingly unending string of bubbles is a distinct possibility. That's precisely what's occurred in recent years -- from equities in the late 1990s, to sovereign bonds, a host of spread products, and now possibly to a global housing bubble (see my 15 July dispatch, "Global Property Bubble?" and the accompanying round-up of worldwide housing market conditions conducted by our global economics team). This profusion of carry trades would not have occurred were it not for the Fed's extraordinary degree of monetary accommodation and the steep yield curve it fostered.

This is the signal that the oldman saw in the mortgage rates dropping. Now apparently they're dropping even more.
NEW YORK, July 22 /PRNewswire-FirstCall/ -- Fixed mortgage rates inched
lower as evidence of an economic soft-patch mounts. The average 30-year fixed
rate mortgage fell to a three-month low of 6.06 percent from 6.11 percent last
week, according to's weekly national survey of large lenders. The
last time 30-year fixed mortgage rates were this low was the week of April 21.
The 30-year fixed rate mortgages in this week's survey had an average of 0.32
discount and origination points.

The 15-year fixed rate mortgage popular for refinancing dipped from 5.5
percent to 5.47 percent. The average rate for the jumbo 30-year fixed rate
mortgage declined by a similar amount, dropping from 6.3 percent to 6.26
percent. The average one-year adjustable rate mortgage increased four basis
points to 4.39 percent. A basis point is one one-hundredth of one percentage

Mortgage rates have decreased consistently in recent weeks in response to
tepid economic growth.

If mortgage rates are dropping, it means that the market has discounted Greenspan's testimony. Despite his claims that he might raise interest rates stiffly, as indeed he might, the market believes he won't. The market is calling Greenspan's bluff, or perhaps rather it's more accurate to say that he's overly conditioned them to believe that he will err on the side of GDP growth over inflation. If this is a misunderstanding and the markets believe Greenspan will do one thing while he is about to do another then that may be a cause for concern. More likely Greenspan will err on the side of not popping the asset inflation bubble, just as he backed off from his statement of irrational exuberance and lowered interest rates after raising them once the markets got wobbly in the 90's. Having been burned by that experience, since then he has erred on the side of GDP growth even at the cost of overinflating asset prices.

Clearly the markets don't believe Greenspan when he says that he is going to raise interest rates significantly.


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