Thomas Hoenig, Top Fed Official, Warns Fed Risks Repeating Past Mistakes
Nine of the 10 policy makers in the Federal Reserve voted to send a message Tuesday that the economic recovery is weakening and needs further stimulus to ensure that the nation recovers from the worst economic downturn since the Great Depression.
The Fed will continue to keep the main interest rate near zero; it will reinvest the proceeds from maturing mortgage-backed securities and Fannie Mae and Freddie Mac debt into Treasuries; and will "continue to monitor" the recovery to ensure it doesn't slow down further.
But one official disagreed. The economy doesn't need further stimulus, Federal Reserve Bank of Kansas City President Thomas M. Hoenig said. Rather than worry about juicing an economy mired in slow recovery, we should take note that the economy is recovering and instead be wary of repeating the mistakes of the past.
It's like 2003 all over again, according to Hoenig.
Seven years ago, the specter of a downward spiral in wages and prices dominated Fed meetings. Policy makers grappled with how to respond to a muted recovery -- slow job creation, too-low inflation, sluggish growth -- following the bursting of the stock market bubble.
Deflation was openly discussed and worried about. In May 2003, the Fed body that dictates interest rates, the Federal Open Market Committee, cautioned there was a chance the economy would experience plummeting prices. During the committee's meeting the next month, the word "deflation" was mentioned nearly 100 times, according to a transcript.
Today, the Fed confronts a similar problem. Following the worst economic downturn since the Great Depression, policy makers are dispirited by slowing growth; the public is clamoring for nonexistent jobs as the unemployment rate hovers near 10 percent; and prices continue to grow at a pace well below the Fed's unofficial target rate.
Worse, the Fed is under increased pressure to act from Congress and the Obama administration as legislators balk at another round of fiscal stimulus to boost demand after having passed an $800 billion plan last year.
And it's an election year.
So liberal-leaning economists and commentators have turned their attention to the Fed. The central bank is charged with pursuing policies that maintain stable prices and maximize employment. The Fed's preferred inflation gauge -- an index tracking consumer prices excluding food and energy items -- registered a 0.2 percent monthly increase in June after rising just 0.1 percent in May, Labor Department figures show. For the year ending in June, it rose a modest 0.9 percent. The Fed's unofficial target is about 2 percent.
In the wake of the financial meltdown in September 2008, the Fed lowered the main interest rate -- the rate banks pay each other for overnight funds -- that December to a range of 0-0.25 percent. The emergency measure, which resulted in lower interest rates for everyone, was meant to spur investors and borrowers who may have considered retrenching after the financial system nearly collapsed.
But 20 months after the Fed lowered rates to record lows, they haven't changed. The effective rate in July was 0.18 percent, Fed data show. By comparison, it was 2 percent in August 2008 and 5 percent in August 2007.
The Fed also engaged in another form of stimulus by buying federal government debt and mortgage-backed securities. Its balance sheet ballooned from nearly $900 billion at the start of 2008 to more than $2.3 trillion as of last week.
Meanwhile, the national unemployment rate hasn't dipped below the current 9.5 percent rate since July 2009. It was 7.7 percent when President Barack Obama took office.
And the economy, after growing at a 5 percent clip in the fourth quarter of 2009 and 3.7 percent through the first three months of this year, slowed to a more modest 2.4 percent growth rate in the second quarter, Commerce Department figures show.
Getting The Message
All of these factors have ratcheted up the pressure on the Fed. On Tuesday, it told the market that it got the message.
But companies are hiring. The economy is still growing. Corporate profits are up 34 percent compared to last year and set to exceed the boom highs of 2006-07, according to the Commerce Department. Personal income is up nearly 2 percent since December, government data show.
And Hoenig, the central bank's longest-serving policy maker, thinks we should remember that.
Hoenig has been at the Fed since 1973, assuming the top job at the Kansas City Fed in 1991. He's seen the 1980s land-and-agriculture boom that eventually wrecked the Midwest; the savings and loan crisis; the spectacular crash and resulting Fed-organized bailout of hedge fund Long-Term Capital Management; the bursting of a few stock market bubbles; and now the housing meltdown and subsequent financial crisis.
Hoenig, like former Treasury secretaries Paul O'Neill and Robert Rubin, believes that while the economy will exhibit "slow and bumpy growth," as Rubin put it during a Sunday interview on CNN, it nevertheless is growing.
"The economy is modestly improving," Hoenig said in a July 29 interview. While he said that unemployment is too high "for anyone to be comfortable with," the recovery will continue to generate new jobs.
Fed Chairman Ben Bernanke said Aug. 2 that "rising demand from households and businesses should help sustain growth."
"There's nothing that says to me this is not going to be self-sustainable," Hoenig said.
But the data is choppy.
After starting the year with four straight months of increasing private-sector job growth, topping out at 241,000 new non-government jobs in April, job creation has sputtered the last three months: 51,000 new jobs in May, 31,000 in June and 71,000 new private-sector jobs in July, according to Labor Department data.
Private employers have created 630,000 jobs in 2010, but 8.4 million were lost in 2008-09.
Optimism and confidence indices measuring the sentiment of consumers, investors, chief executives and small business owners have fluctuated over the past few months. There is growing pessimism that the sputtering recovery will give way to negative growth.
That Deja-Vu Feeling All Over Again
"Each data release is causing people to make long-run conclusions about the economy," Hoenig said. "We need to be patient."
The Kansas City Fed chief sees parallels to 2003.
"It was a summer not unlike our current summer where we saw data coming in mixed, and people were talking about an economic collapse and we weren't going to see the recovery, he said."
Back then, "we also had a jobless recovery," Hoenig said. In the five months from May to August 2003, the private sector created just 14,000 jobs.
"And so we in fact did ease in that period. The following quarter we had almost 7 percent growth, and a little more than a year later our inflation was more than double what it was," Hoenig said.
Within four years, the economy was on the ropes. Critics of the Fed's failure to rein in the growing housing bubble point in part to the Fed's low interest rate policy at the time. The main interest rate was below 2 percent for three years beginning in December 2001. And though the Fed began raising rates between 2005 to the summer of 2007, eventually reaching nearly 5.3 percent, it wasn't enough, critics argue. The bubble didn't deflate; it burst when it was too late.
"The lesson to be drawn from 2003 is we were in a modest recovery. We began crying wolf. We got a bad employment number, or we got a bad industrial production number, and we would overreact to that -- instead of looking at the array of data, the positive and the negative, and the longer trend lines, then making judgments and having patience," Hoenig said.
"Recoveries have mixed data and that's what we're seeing today," he continued. "We tend to focus on the negative, but if you look at the trend [the economy] is growing. That's what we have to keep in mind."
Because the economy is growing, he said, now is the time to communicate to the markets that interest rates will soon rise.
"It's not my view -- in any sense --- that I want high interest rates," Hoenig cautions. "But I do think we need to change the language... and also get off of zero in a way that outlines it for the public so they know what we're going to be doing and therefore can be confident in that, rather than unsure about what the Fed will do next."
The heads of the regional Fed banks in Dallas, Atlanta, Richmond, Philadelphia, and St. Louis have said or indicated they want to see interest rates gradually increased.
Zero And Counting
"Zero is an emergency rate -- it is not a rate that will sustain long-term growth," Hoenig said. "It will create imbalances, and imbalances are what caused this last crisis, and that's what we want to avoid. Everyone knows zero is unsustainable."
Instead, because the economy is improving Hoenig wants to see the benchmark interest rate raised to 1 percent, and kept there to gauge how the economy responds. If all goes well, the rates can begin their upward climb to a more normal rate.
Leaving it at zero, he argues, creates too much uncertainty because it's an emergency rate. We're no longer in an emergency.
"To try to artificially hold rates down... risks repeating some of the mistakes of the past," Hoenig said.
But a particularly pernicious effect of a zero interest rate policy is what it causes investors and savers to do, he warns. Because the Fed rate affects all other interest rates, it forces rates on savings accounts to drop. And because it makes it cheaper to borrow, rates on debt securities like company bonds are forced downward.
The weighted average interest rate on bank deposits and other liquid assets primarily held by households stood at a paltry 0.29 percent through June, according to data maintained by the St. Louis Fed. It was five times that just two years ago. It's the lowest rate the Fed has recorded since it began collecting the data in 1959.
The average yield on corporate bonds rated Aaa by Moody's Investors Service has dropped to 4.72 percent, according to Federal Reserve data through July. The rate hasn't been that low since 1966.
Yields on 2-year Treasury notes dipped to 0.4977 percent last week, the first time they had ever broken the 0.5 percent barrier.
Last week, IBM sold $1.5 billion in three-year notes to investors, offering 1 percent interest to investors who willingly gobbled them up. In other words, IBM is borrowing $1.5 billion and paying the minuscule rate of 1 percent a year.
The incredibly low yields cause investors and savers to search for higher rates, otherwise known as yield. Hoenig said that leads to imbalances which manifest in unwanted and unforeseen ways. For example, rather than investing in safe corporate securities that allow firms to expand and grow, fueling the recovery, investors may instead invest in securities that exist purely for speculative purposes.
Christopher Whalen, a noted bank analyst at Institutional Risk Analytics, notes in his latest note that big banks "are busily creating the next investment bubble on Wall Street -- this time focused on structured assets based upon corporate debt, Treasury bonds or nothing at all -- that is, pure derivatives.
"Like the subprime deals where residential mortgages provided the basis, these transactions are being sold to all manner of investors, both institutional and retail," Whalen wrote.
"One risk manager close to the action describes how the securities affiliates of some of the most prominent and well-respected U.S. [bank holding companies] are selling 5-year structured transactions to retail investors," Whalen noted. "These deals promise enhanced yields that go well into double digits, but like the subprime debt and auction rate securities which have already caused hundreds of billions of dollars in losses to bank shareholders, the FDIC and the U.S. taxpayer, these securities are completely illiquid and often come with only minimal disclosure.
"Of course retail investors love the higher yields on complex structured assets. Who can blame them for trying to get a higher yield than available on Treasuries, while the Fed keeps rates at historic lows to, among other things, re-capitalize the zombie banks," he said.
Whalen wrote that "one thing that you can be sure of is that nobody at the Fed or the other bank regulatory agencies knows anything about this new bubble."
Hoenig, though, said he's seeing the emergence of a bubble in his district.
"I do know the conditions that support the emergence of bubbles, and frankly...I am seeing land auctions go up ever higher," Hoenig said. He added that investors and business owners, worried about the future direction of Fed policy, are investing in hard assets like land rather than in new machinery or building up their businesses.
"I do know, based on experience, based on prior experiences not unlike this, that you also run risks, long-term risks, when you leave rates at zero or very near zero for extended periods of time. That encourages a speculative mode, that encourages consumption over savings.
"You need to turn that policy slowly so that the economy can readjust. Monetary policy is a blunt instrument -- it cannot solve all problems. It cannot solve fiscal issues that we have to confront and deal with.
"If you don't do that, what you do is you impede [the recovery]. For example, if you have banks and you say banks aren't lending and there is an issue with demand for loans. But think of it on the supply side.
"If I can go into the market and borrow funds at the Fed Funds rate of almost zero, and then re-lend that to the federal government in 10-year securities for 3 percent, and am also told that that margin will be secure, what will I do with my money? I'm going to get a guaranteed return.
"You encourage that, rather than say, 'Alright, what kinds of loans can we make, how do we do it, and let's look more broadly.' So those are the subtle issues that we need to work our way through."
By guaranteeing "exceptionally low levels of the federal funds rate for an extended period," Hoenig argues that the Fed is essentially guaranteeing Wall Street's profits -- a charge he leveled in a March interview with HuffPost.
"If you know that... you can borrow at zero and lend back to the government at 3 [percent], you are going to do that, and you're going to feel comfortable and confident in doing that," Hoenig said.
The Fed needs to be "mindful of the unintended consequences of doing that for long periods of time."
"It encourages speculative activity [and] it does adjust and affect the risk premiums that are so important for market signals," the policy maker said. "And those are the things that are in front of us all to deal with."
Hoenig points to the 1970s and this decade, two decades in which there were extended periods of negative real interest rates. Defined as the federal funds rate minus the previous year's inflation figure, a negative rate means that a borrower is getting paid to borrow, rather than paying to borrow.
The consequences were disastrous, Hoenig said.
"From the 70s to 80s we had inflation. We had an ag-land bubble, we had an energy bubble, [and] we had a commercial real estate bubble," he said. In this decade, negative rates led to bubbles in subprime mortgages, residential real estate and then commercial real estate.
"Those are consequences that, in the short-run, you don't think about because what you want to do is get unemployment down, and you want to get it down as quickly as possible," Hoenig said. "So you leave [rates] really low."
In the early part of the decade, the unemployment rate jumped from 3.9 percent to 6.3 percent. The main interest rate dropped to 1 percent.
"The consequences longer term are you create new imbalances that then have to be corrected [which could have a] devastating impact on the economy," Hoenig said.
While Hoenig agreed with the Fed's move to initially lower rates to near-zero, he thinks it's past time to raise them -- or at least communicate to the market that the Fed will soon raise them.
"I understand the need, and was part of the need, to bring interest rates down during the crisis, and that was an important step," he said. "At the beginning of this year I dissented, and I dissented because I felt that we should not allow the language to assure Wall Street -- the financial markets -- of a guaranteed return, that they needed to begin to think about risk and the risk return that is part of an economic system that works effectively."
A rise in rates would help level the playing field between savers and borrowers, and it would "give them the sense that the economy was in the process of healing."
But Hoenig, along with some of his colleagues, will have to wait. The Fed said Tuesday that the "pace of recovery in output and employment has slowed in recent months"; household spending "remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit"; "housing starts remain at a depressed level"; and "bank lending has continued to contract."
The recovery "is likely to be more modest in the near term than had been anticipated." And the Fed will "continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to promote economic recovery and price stability."
Hoenig was the lone dissenter among the 10 policy makers, according to the committee's statement.
Hoenig "judges that the economy is recovering modestly, as projected. Accordingly, he believed that continuing to express the expectation of exceptionally low levels of the federal funds rate for an extended period was no longer warranted and limits the committee's ability to adjust policy when needed. In addition, given economic and financial conditions, Mr. Hoenig did not believe that keeping constant the size of the Federal Reserve's holdings of longer-term securities at their current level was required to support a return to the committee's policy objectives."
Speaking to HuffPost, Hoenig acknowledged the pressure the Fed faces in trying to keep prices stable while also pursuing policies that power the recovery.
"The markets always want more stimulus, always want more ease, always want low interest rates," he said. "We all have the view that lower interest rates mean things will get better, and you have that pressure across the economy."
He said the "hard part" of sticking to his forecast of a broad-based recovery is "having the patience to let us grow out of it."
"Are the data today generally in a positive trend? Yes. Are we having some data coming in weaker than we expected or wanted? Yes. Does that mean we ought to become more accommodative or not think about the long-term as the economy builds? No.
"We should learn from the experiences around the bubbles we've seen -- the financial bubbles that have been repetitive throughout the 90s, through the 80s, and into this decade as well.
"I don't want to see unemployment this high," Hoenig said. "But I also don't want to see it this high three or four years from now following another crisis because we were so impatient. That's a very hard trade-off and it's very difficult to explain, but it's what we need to do."
Shahien Nasiripour is the business reporter for the Huffington Post. You can send him an e-mail; bookmark his page; subscribe to his RSS feed; follow him on Twitter; friend him on Facebook; become a fan; and/or get e-mail alerts when he reports the latest news. He can be reached at 646-274-2455.
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