The Caution of the Fed Comes With a Risk: Ben Bernanke believes that he and his Federal Reserve colleagues have the ability to lift economic growth.... Mr. Bernanke also believes that the economy is growing “not fast enough”... that unemployment will remain high for years and that “a lot of people are going to be under financial stress.” Yet he has been unwilling to use his power to lift growth and reduce joblessness.... How can this be? How can Mr. Bernanke simultaneously think that growth is too slow and that it shouldn’t be sped up? There is an answer — whether or not you find it persuasive.
Above all, top Fed officials are worried that financial markets are fragile. They are not so much worried about inflation, the traditional source of Fed angst, as they are about upsetting the markets’ confidence in Washington. Yes, investors remain happy to lend the United States money at rock-bottom interest rates, despite our budget deficit and all of the emergency Fed programs that will eventually need to be unwound. But no one knows how long that confidence will last. In effect, Mr. Bernanke and his colleagues have decided to accept an all-but-certain downside — high unemployment, for years to come — rather than risk an even worse situation — a market panic, a spike in long-term interest rates and yet higher unemployment. As the last few years have shown, market sentiment can change unexpectedly and sharply.
Still, you have to wonder if the Fed is paying enough attention to the risks of its own approach. They do exist. The recent data on jobless claims, consumer spending and home sales have been weak. On Tuesday, Britain announced a budget-cutting plan that will depress short-term growth there and spill over somewhat into the global economy. The necessary budget cuts in Greece and other parts of Europe won’t help global growth, either...
But nobody out there in the private markets is betting on such a scenario. The Treasury real yield curve is at 1.2% for ten years. The Treasury nominal yield curve is at 3.2% for ten years. If anybody out there in the private market thought that such a panic was possible, or even likely, its possibility would be priced into the Treasury yield curve right now.
At the start of December 2008 credit default swaps on Greece were at 250 basis points, on Ireland 220, on Portugal 170, on Spain 130, on Italy 100--the marginal investor in the market was betting that there was one chance in 100 that Italy would experience a credit default event, and 2.5 chances in 100 that Greece would experience such an event. The market in December 2008 did not expect that a Greek crisis was more likely than not. But it thought that there was some noticeable, non-zero possibility. Panic did not spring full-grown from nowhere: panic came out of market belief that fundamentals were weak, the willingness of some investors to place big bets that that weakness was worth betting on, and the unwillingness of other investors to place big bets that everything would be fine:
Now the United States is at 40: way down from the 100 it was at at the start of March 2009:
And the U.S., unlike Portugal or Greece or Spain or Ireland or Italy, prints up the paper that it has to pay its bonds off in.
I agree that Greece has no business engaging in fiscal stimulus right now. But the U.S.? For a market panic to take place investors have to panic. And for them to panic, they must first think that there is a chance that there might be a panic. When CDS prices in the U.S. rise to indicate that there are some investors in the U.S. who think it is worthy buying insurance by betting that there might be a panic, then I can undersand Bernanke's caution.
But that's not where we are, is it?