Business Insider

Peter Crabb: Changing government policy creates financial-market risks

The Fed has started pushing on the string again. On Wednesday the Federal Open Market Committee voted unanimously to keep its target fed funds rate near zero.

The low interest rates of these past three months have so far failed to spur greater investment or consumption. Interest rates on U.S. Treasury bills continue to trade near zero, so there is little effect on bankers when the fed funds rate changes.

If we were living in normal times, these lower rates would reduce the cost of borrowing for households and businesses, creating the incentive for more borrowing and purchasing — that is, more economic activity.

Obviously, these are not normal times, and economic policy is not what it used to be. The Fed has therefore sought out a new string – a new way to influence bank lending.

The Federal Reserve said Wednesday that it will buy up to $300 billion in longer-term Treasury notes, with maturities of 2 to 10 years. It will also increase the size of current government-backed programs aimed at reducing mortgage rates.

The decision to buy longer-dated Treasury securities and additional mortgage-related debt could mean lower rates for both business and consumer loans.

According to the Fed’s statement, “the economy continues to contract. Job losses, declining equity and housing wealth, and tight credit conditions have weighed on consumer sentiment and spending. Weaker sales prospects and difficulties in obtaining credit have led businesses to cut back on inventories and fixed investment to help improve conditions in private credit markets, The Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months.”

The immediate effect of this announcement was a strong rally (over 4 percent) in the price of 10-year Treasury notes and a flattening of the yield curve. The yield curve is a graphical representation of the relationship between interest rates on a particular debt security with different terms to maturity.

Here the interest rates refer to the total return to investors received when a bond is held to maturity, or yield-to-maturity (YTM). This is not the bond’s current yield. The YTM includes both the interest earnings and the return of principal.

One factor that can explain an upward slope to the yield curve is that investors perceive the risks of holding securities for longer periods of time to be greater than those of shorter periods. This preference for shorter-term securities is called the liquidity premium and raises the yield on long-term securities.

The liquidity premium is due to the fact that the longer the time until the principal is due to be returned, the higher the probability that the principal will not be returned. When investors get more risk averse, they sell current long-term securities and buy short-term securities, respectively raising and lowering the yields on each.

In today’s market the liquidity premium is now much lower. With these actions of the Fed, Treasury bond investors are lowering projections for higher future interest rates.

If the liquidity premium theory is to hold here, the market is saying the Fed must know we are in for a very long recession and interest rates will remain low for nearly a decade. The stock market of rally of the past week contradicts this outcome.

If the rally in stock prices holds, it must be that economic conditions are improving. The Fed would then reverse its new policy just as quickly. Interest rates on long-term debt will rise just as rapidly as they fell this week.

The continuing announcement of varying government policy appears to simply create more financial-market risks for stock and bond investors.

Since 2000, Peter R. Crabb has been a professor of finance and economics at Northwest Nazarene University in Nampa. He earned his doctorate in international and financial economics from the University of Oregon.