Steven Roach thinks the Fed is losing control

And with the economy teetering on the brink of deflation, this could be very bad indeed.

I posted this on Atrios's comments this morning:
I think this will contribute to deflation. The Federal Reserve needs to be unambiguous in its deflation-fighting and start using some of its nontraditional methods such as buying longer-term bonds to inject cash into the economy and drive long-term rates down. It doesn't matter if they only do a little of it, as long as the Fed shows it can and will, it will reassure the animal spirits of the traders.

Global: Losing Control
Stephen Roach (New York)

What happened? No one wants to accept blame for bad things -- least of all the Federal Reserve. But America’s central bank is hardly an innocent bystander in the extraordinary volatility that has afflicted the bond market. A deflation-fighting Fed initially encouraged the markets to accept two key premises -- the first being it that it would not repeat the mistakes of the Bank of Japan and take its policy rate to “zero.” Second, the Fed went out of its way to assure market participants that it had an ample arsenal of “non-traditional” policy tools available to fight deflation should it run out of conventional ammunition. At the top of the laundry list insofar as non-traditional remedies were concerned was the distinct possibility that the Fed would make direct purchases of long-dated Treasuries. As its deflationary concerns intensified in early May, the US central bank did little to dissuade market participants that such actions might have been the offing. Largely on the basis of those expectations, there was a stunning rally at the long end of the US Treasury market that took yields to record lows in early June. The market remained a believer right up to the eve of the Fed’s late June policy meeting. On June 24 -- the day before its policy pronouncement -- yields on 10-year Treasuries stood at 3.25%.

And then the world tilted. Actually, it all really started with a late-June article in the Wall Street Journal (“Next Fed Rate Cut May Be Smaller Than Expected” by Greg Ip on June 20, 2003), which suggested that the Fed’s research staff was having second thoughts about the non-traditional tactics involving direct purchases at the long end of the Treasury yield curve. The Fed went on to ease by only 25 bp on June 25 -- an action that not only fell a bit short of a more aggressive move that had been priced into fixed income markets but one that failed to pay any lip service to the issue of non-traditional easing. Then Chairman Alan Greenspan made matters far worse in his semi-annual policy statement to the Congress in early July. By stating that that the Fed still had plenty of leeway for a substantial easing of its traditional policy instrument, he changed dramatically the operative assumption on the lower boundary of the federal funds rate. Previously, we had been led to believe that the Fed would be reluctant to go through the 50-75 bp threshold on the funds rate. Now it seems as if the Fed would be willing to entertain the possibility of a BOJ-like “zero” federal funds rate target, should circumstances so dictate. With markets now convinced that traditional policy options were likely to be on the table for much longer that previously expected, it seemed reasonable to conclude that the non-traditional option of buying the 10-year deserved a lower probability. And then the rout was on -- a massive unwinding of the “deflation trade.” From the eve of the Fed’s policy announcement on June 24 through the July 21 close, yields on the 10-year have surged some 94 bp.

(snip)

This is hardly an outcome that the Fed, or any of us, would deem desirable in the current climate. It runs the very real risk of spilling over into other asset markets -- especially given the mounting potential for an a further sell-off in the US dollar as part and parcel of America’s long overdue current-account adjustment. Moreover, a sharp additional back-up in long rates poses a serious threat to a nascent recovery in the US economy -- not only crimping the credit-sensitive sectors of homebuilding, capital spending, and consumer durables but also aborting the home mortgage refinancing cycle that has been so supportive of consumer demand. We tend to forget that the US economy is still closer to the brink of deflation than inflation. Wouldn’t it be ironic -- and tragic -- if the perils of deflation were compounded by a rout in the bond market?

In my view, all this is indicative of what happens when deflationary risks of post-bubble economies take monetary policy into uncharted waters. As short-term nominal interest rates approach zero, central banks start to lose control of financial markets and the real economy. That’s precisely what has happened in Japan under the BOJ’s zero-interest-rate regime. And the rout in America’s bond market may well be a warning sign of a similar fate for the Fed.