The Most Logical Path for Central Banks

 | Nov 21, 2012 | 4:35 PM EST
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Over the past few years, I've written several columns on the subject of flattening sovereign yield curves and the emergence of competitive depreciation in the world's primary currencies -- the U.S. dollar, euro and Japanese yen. I think that, for all three of these regions, both of these phenomena are on the verge of becoming the focus of central-bank monetary policy.

Domestic economies are growing below potential in the U.S. and Japan, and Europe is in the nascent phases of contraction. At the same time, all three regions are also suffering from a lack of consensus and cohesion on the application of fiscal policy in response to their collective economic malaise. As a result, these three are also finding that monetary policy is their primary public-policy financial tool. But their monetary systems are also supposed to be independent of their respective governments.

None of the monetary leaders in these countries are pleased with the current state of private-sector economic activity in their respective countries or regions, and they are unhappy with the government leaders' fiscal policies. The most stunning evidence of this has been last week's comments from Dallas Federal Reserve Bank President Richard Fisher:

"Our Congress -- past and present -- has behaved disgracefully in discharging its fiscal duty. Its members have not shown themselves to be true born leaders. We all know it is far past due for our federal politicians -- Democrats who may "enjoy it more" and Republicans who are distinguished only by that single difference -- to begin acting like the responsible fiduciaries of the nation's fiscal accounts they are supposed to be, rather than as the parasitic wastrels they have unwittingly let themselves become."

But, regardless of whether they like it, all three central banks are now in a position to be the only immediately viable tool for effecting change in the consumption, production and investment attitudes and actions of their respective private sectors. As a result, I expect that all are on the verge of implementing monetary policy with the explicit goal of flattening their respective sovereign yield curves and attempting to force their private sectors into risk-taking.

Since Lehman Brothers' failure in 2008, the sovereign yield curves of all three have been in the process of flattening and converging toward parity. This has been driven both by monetary policy and by a flight from risk by private capital.

The Bank of Japan has been implementing quantitative easing for years with little success in stimulating domestic investment. The U.S. Federal Reserve has been doing the same since 2008, and additionally targeted the long end of the yield curve directly with "Operation Twist." Now the Fed is targeting mortgage rates with the September announcement and implementation a third round of quantitative easing. So far, even though long-term interest rates are now at 50-year lows, the U.S. economy has not responded with the intended growth. The European Central Bank has gone through two rounds of long-term refinance operations (LTRO), also intended to stimulate economic activity. It, too, has failed.

For this trio of central banks, the most logical course of action at this juncture is to concentrate monetary policy and action on flattening their respective yield curves. For the U.S. and Europe (Germany), this requires targeting the shoulder to long end of their respective yield curves and driving the five-to-30-year maturities to match those of Japan now.

If they do this, it will drive 10-year yields under 1% and 30-year yields below 2%, perhaps as soon as the end of the first quarter of 2013. In the U.S., this policy -- coupled with the targeting of mortgages announced last September -- implies a 30-year fixed-rate mortgage in the 2.5% range at par by next spring.

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