Jeremy Siegel on 2010: Good for Stocks, Bad for Bonds -- and Why Interest Rates Will Go Up - Knowledge@Wharton

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Understanding the rules for 2010. Interview by Knowledge@Wharton of Wharton Professor Jeremy Siegel.

Jeremy Siegel on 2010: Good for Stocks, Bad for Bonds -- and Why Interest Rates Will Go Up - Knowledge@Wharton


Knowledge@Wharton: What is inflation going to do?

Siegel: Inflation is going to be under control this year and probably into 2011. However, we will have an upward tilt to inflation, which means the longer-run trends point to a 2%-to-4% range of inflation rather than zero to two, which unofficially is what most central banks and the Fed have targeted.

The scaremongers, who worry that the ton of money the Fed created to fight off the crisis is going to fuel the next [period of] inflation, are wrong.

Knowledge@Wharton: But the 2%-to-4% range is standard over the long run, right?

Siegel: It's not. I remember when I was studying economics, we talked about what a victory it would be if we could get down to between 2% and 4%. We've been spoiled with very low rates. Most central banks use zero to two. They come closer to two.

We'll move closer to between 2% and 4%, particularly in the United States, given the large deficits that we have and the liquidity that was created. But just as Bernanke acted very responsibly in providing the liquidity necessary to prevent [a repeat of] the Great Depression, he is also an excellent enough economist to know that money is what fuels inflation. The Fed is really solely responsible for inflation. He will not let it go above five, and probably not even four. He will raise interest rates to whatever level is necessary if inflation starts running into the mid-single digits or higher.

Knowledge@Wharton: When we talk about inflation, we also often talk about commodities. There has been a pretty good run in some commodities, especially gold. What do you see happening there?

Siegel: The commodities cycle has followed the world economy. It had hit its low very close to the same time the stock market did. Now that the world markets have recovered, we see oil has recovered. I would love to see it in the 70-to-80 range.

Commodities are fully priced. Gold ... is priced for an inflationary scenario that is much worse than will be realized. Gold is a risky investment now.... That is not going to be a good investment throughout 2010 and the longer term.

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Fed Warns of Global Deflation

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“The Fed statement yesterday said its prediction of a “gradual recovery” in the U.S. economy later this year has “significant” risks of failing to materialize. At their meeting, central bank officials gave updated forecasts for gross domestic product, inflation and unemployment that will be released with meeting minutes on Feb. 18.

It sounds like the worry is not so much recession as it is depression,” said Chris Rupkey, chief financial economist at Bank of Tokyo-Mitsubishi UFJ Ltd. in New York. “We can only hope that the famous long and variable lags of monetary policy will eventually kick in.”

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Key report on financial reform

Image via WikipediaImage via WikipediaImage via WikipediaFrom The Economist - An important new report on regulating the financial industry released Thursday (Jan 15) should play a crucial role in shaping the financial reform agenda.


The Group of Thirty’s “Financial Reform: A Framework for Financial Stability” is important both because of the concreteness of its 18 recommendations and because of who was involved. The authors were led by Paul Volcker, Tim Geithner, Larry Summers, and Jean-Claude Trichet, (president of the European Central Bank).

Banks:

• banks deemed systemically important would face restrictions—in the form of “strict” capital requirements—on high-risk proprietary activities, that is bets made using their own money
• strongly encourage investment banking arms of banks to focus on client businesses, such as merger advice, rather than trading
• separating these needed because they seem “unmanageable in financial conglomerates"
• also require raising the level at which banks are well-capitalised
  

Non-bank financial institutions:

• pools of private capital that live on borrowed money should have to register with a regulator and produce regular reports, disclosing things such as leverage and performance.
  
• biggest of them would even be subject to capital and liquidity standards.
  
• bank-like regulation for money-market funds
  
• legislation in America to set up a mechanism for dealing with non-bank failures

Other key issues:

• Central banks should be more involved in supervising banks—but to safeguard integrity the role of chief firefighter should be played by others once trouble ignites. Central bankers “need to be more concerned about financial stability, but less involved in crises,”
• formal system of regulation for over-the-counter derivatives, such as the type of credit swaps that sank American International Group
• urges regulators to force banks to hold on to a significant portion of credit risk when they package loans into securities and sell them on, in order to curb reckless underwriting of mortgages and other debt.
  
• calls for a rethink of certain accounting principles that may exacerbate downturns through pro-cyclicality, including the practice of marking assets to the current market value;
  

The other important message is that a global crisis requires a global fix. Mr Volcker was typically modest, insisting it was more an agenda for discussion than a hard-and-fast blueprint. But, given his closeness to Mr Obama, it is hardly far-fetched to imagine much of it becoming official policy. All that talk of the biggest overhaul of financial regulation since the 1930s just took a step towards reality.
"

Fed-style QE is Printing Money

Image via WikipediaBarclays Capital lays out a primer for what the Fed is really doing for monetary policy. The Fed can't drop interest rates below 0%, but there are other weapons in the Fed arsenal. Barclays Capital in their most recent Weekly Market Monitor talks in depth about the current Fed policy called Quantitative Easing. (See Help! What is Quantitative Easing?)

"Without making a formal announcement, the Fed has already moved to a policy that is effectively QE. While its policy objective is still the fed funds rate, the Fed's balance sheet has more than doubled over the past three months to over $2 Trillion as it has expanded its emergency lending programs, foreign currency swap lines, and open market purchases. When the Fed began creating new lending facilities last year, it financed them by selling Treasuries, thereby keeping its balance sheet from expanding.

A few months ago, the Fed ran low on Treasuries it could sell and began to expand its
balance sheet; however, it sought to soak up or sterilize this expansion through the use of a special Treasury bill program. The Treasury sold bills and deposited the proceeds in its account with the Fed, and the Fed used the proceeds to extend loans to banks based on illiquid collateral. While the Fed's balance sheet was being grossed up, the Treasury was soaking up cash through bill issuance and systemwide liquidity was unchanged.

The Treasury program is being wound down and the expansion of Fed programs is being
financed through increases in excess bank reserves. In this case, the Fed is extending the same collateralized loans, generating excess reserves, and grossing up its balance sheet without sterilizing the transaction through the Treasury facility. Thus, the Fed is currently "printing money" and the over-provision of reserves to the banking system is far beyond what would be required to meet the FOMC's target funds rate."

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Help! What is Quantitative Easing?

Image via WikipediaA great Weekly Economic Monitor from Barclays Capital this week. (If you don't get it, start building a relathipship with the Barclays team. Their research is the best.)

Quantitative easing (QE) is the name given to a three-part monetary policy program implemented by the Bank of Japan (BOJ) from March 2001 to March 2006. At the outset of the program, the BOJ believed that economic conditions warranted monetary easing as drastic as is unlikely to be taken under ordinary circumstances, and therefore made the following changes to its policy strategy:

1. A switch in the operational objective of monetary policy the policy instrument from an overnight interest rate to current account balances(bank reserves plus deposits of non-bank financial intermediaries at the central bank).

2. A reduction in the overnight interest rate to zero.

3. A commitment to maintain the new procedures until y/y CPI inflation registers stably at zero percent or higher.

Virtually all developed-world central banks conduct monetary policy in the same way: by adjusting the supply of bank reserves balances in accounts commercial banks maintain at the central bank in order to target a specific short-term interest rate. The amount of reserves supplied is a passive variable in this process. Banks demand a certain quantity of reserves to meet reserve requirements plus an additional, much smaller, amount of precautionary reserves. The central bank simply meets the amount of reserves demanded at the targeted interest rate. As a result, the total amount of reserves in the banking system is, in a normal environment, very close to the level of required reserves (i.e there are very little excess reserves).

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Bloomberg.com: Economy

Bloomberg.com: Economy: "Oct. 15 (Bloomberg) -- The Bank of Japan said it will offer lenders as many dollars as they want, joining European counterparts in attempting to lower borrowing costs in money markets and freeing up credit worldwide.

The central bank will provide dollars at fixed interest rates for an ``unlimited amount against pooled collateral,'' it said in a statement late yesterday. It also announced measures to improve companies' access to cash, expanded the range of Japanese government bonds it accepts from lenders, and suspended a program of selling shares it bought from banks between 2002 and 2004.

The Bank of Japan's supply of dollars comes from a swap agreement with the U.S. Federal Reserve. Last month the two central banks agreed to swap as much as $120 billion for yen. The increase to unlimited dollar supply came a day after the Fed removed caps on swap lines with the European Central Bank, Bank of England and Swiss National Bank."

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