In this interview with St. Louis Fed President James Bullard, Wharton finance professor Jeremy Siegel covers a range of topics including interest rates, the outlook for the economy, the recent tumult in the repurchase agreement (repo) markets and the inverted yield curve. The discussion also touched on the economic challenges posed by the trade war with China, which Bullard sees as one downside risk in an otherwise robust economy.
Bullard favors an additional 25-basis-point cut in the Fed Funds Rate that could help the U.S. economy “power through” recent signs of economic weakness and extend the longest economic expansion since World War II. Joining the discussion, which occurred on Wharton Business Radio’s Behind the Markets show on SirusXM, was moderator Jeremy Schwartz from WisdomTree ETF Investments. Below are edited excerpts from the interview. (Listen to the full podcast at the top of this page.)
An edited transcript of the conversation follows.
Interest Rate Levels
Bullard discussed his dissent on the decision by the Federal Open Market Committee (FOMC), in a 7-3 vote, to lower short-term interest rates by a quarter point on Sept. 18. He favored a half-point cut.
Jeremy Schwartz: Jim, maybe you could start with your overall look of the world and why you felt [the FOMC] should cut 50 basis points.
James Bullard: I dissented at the meeting. I … basically cited the idea that inflation and inflation expectations are quite low in the current environment, so that probably gives us room to maneuver. Manufacturing and industrial types of companies aren’t doing very well in the current environment. It looks like they’re in contraction mode. So I cited that.
Global growth is low. The trade war is having a large impact outside the country and some impact inside the country on sectors like agriculture. And then you’ve got the inverted yield curve. I don’t think we have a good reason to have the policy rate in the U.S. be higher than almost all sovereign yields out to 10 years across the G7 (Group of Seven countries).
Schwartz: Do you worry about lowering interest rates more, sooner — that it may take away ammo you might need later? What are the tools you guys would consider after that?
Bullard: Yes, if there were a really big shock, then we would have to lower rates down to zero, and we’d have to consider unconventional monetary policy again. But I don’t think that’s the situation we’re in right now. What we have now is just a pretty good overall performance of the U.S. economy, certainly great labor markets, good consumption growth. We’ve got some sectors in industrial and agriculture that maybe aren’t doing very well, partly because of the trade war. We’ve got slowing global growth. So we’ve got some downside risk in what is otherwise a high-performing economy. The idea here is to take insurance out against the idea that this downside risk manifests itself in much slower growth in 2020.
“[If] there were a really big shock, then we would have to lower rates down to zero, and we’d have to consider unconventional monetary policy again.” –James Bullard
If all goes well, this insurance will pay off, and we’ll be able to power through the downside risk. Those risks will subside, and we won’t have any recession. Then we can raise the policy rate back up, and then we’d have plenty of ammunition for those who are concerned about that in the future. This is a good way of thinking about how to manage the risks for the U.S. economy. We do have occasions in the 1990s where this worked very effectively, and I think we should play this expansion the same way we played that one, and hopefully we’ll get an even longer expansion than we otherwise would.
What I like to do is get the policy right to the point that we think rates are where they should be, and then react to data going forward from there. We haven’t quite been as nimble as we could have been over the last couple of months, but we’re still moving in the right direction, and I penciled in one more cut for the rest of the year — although I’d reserve judgment [based on] the data coming in between now and the meeting. I also think that these are insurance cuts, so it’s very possible that we’ve done enough — or will have done enough by the end of the year.
The U.S. Economy
Jeremy Siegel: Things did look, a week and a half ago, pretty scary when the ISM (manufacturing index) number came out under 50 for the first time in three years, and the components were really weak. Then, in the last 10 to 12 days, there have been surprisingly very good economic data. Both Bloomberg and Citi’s economic surprise indicators show the U.S. actually hitting a 12-month high. Have you been surprised by some of the strength that we’ve been seeing, and some of the recent data we’ve been getting?
Bullard: Well, not really because I think we have a very strong labor market which is underpinning good consumption growth in the U.S. and a household sector that, generally speaking, is doing well. But around that, we have the trade war going on. We have businesses that are partly dependent on income from overseas. The overseas growth rate is slowing, possibly precipitously — Europe in particular looks like it might be teetering on recession.
Also [China’s economic growth is] much slower than would have been otherwise predicted. So it’s not surprising that you would get good numbers that are related to domestic factors that aren’t too far from household spending here in the U.S. But nevertheless, you would see other companies that are global operators doing poorly, and sectors that are directly affected by the trade war — like agriculture — doing poorly. And so you’ve got disruption going on in some parts of the economy, but good times in other parts of the economy. You’re going to see a mixed message from the data, I think.
“I don’t think we have a good reason to have the policy rate in the U.S. be higher than almost all sovereign yields out to 10 years across the G7.”— James Bullard
Siegel: One of the very few differences of the [latest FOMC] statement compared to the previous one was you added exports to business spending as one of the weak points in the economy. So your point, I think, is certainly well taken on those exports.
Unusual Stress in the Repo Market
Bullard discussed the recent sharp, but short-lived, signs of stress in the repurchasing or repo market. (A repo agreement is a short-term borrowing transaction, often just overnight, used typically by dealers in government securities. Often a dealer will sell government securities overnight to raise money to fund other purchases of securities, and settle the accounts the following day if they are not rolled over.)
Overnight borrowing costs shot up — from 2.2% on Sept. 16 to 6% the following day. Such a large spike had not been seen since just before the financial crisis. Normally the market has more than enough money to remain very liquid. But this time, according to press reports, it appeared that a tax payment deadline for big companies, a holiday in Japan, and a recent auction of government bonds that sucked up funds led to the brief squeeze — and created a kind of perfect-storm credit squeeze that officials claim did not go out of control.
Siegel: The disturbances that we saw in the repo market really took everyone, maybe even the Fed, by surprise…. [Fed Chair] Jay Powell implied that they didn’t expect it. We know the banks have what’s called an “ample reserve” system — excess reserves, hundreds of billions of dollars, if not trillions. They were getting 2.15%, 2.10% on that.
Why didn’t the banks step in and lend it to the dealers and say, “Hey, listen, I can lend you the cash that you need to do that settlement.” Were they just not set up to lend in the repo market, or was it because it just came on so suddenly? Shouldn’t that have happened under an excess reserve system? Could you give us your take on that?
Bullard: This issue is about volatility in short-term funding markets. There was a time years ago … when these markets would have been that volatile every day. … They’ve been so tame in recent years that this turned out to be a headline event. Yes, we do have ample reserves. It sounds to me like there were special factors in the market. We’re trying to learn more about that as time goes on. There are some tax payments going on, and for one reason or another, the match-up between borrowers and lenders wasn’t as smooth as it would have been on other days.
I’ve suggested in the past that we should look at a repo facility to complement our reverse repo facility. In my view, that would bring us closer to an international standard on how this is done by other central banks. We’ve actually blogged about this — some of our economists here — and listeners can look that up if they want. But I think that’s something that maybe should be considered and then we wouldn’t have to worry about this.
“We’ve got some downside risk in what is otherwise a high-performing economy.” –James Bullard
Siegel: I’m trying to understand the reasons why it isn’t as tight as it seemed to be in those earlier years.
Bullard: I guess what markets are saying is, “Well, there are less reserves than there were.” So that’s a fact. Our reserves are down a good 40%, 50% from off their peak, but it’s still an ample reserves regime. I think there are special factors. The market is quirkier than it once was because rates are so low and lots of institutions aren’t trading there the way they would have in the pre-crisis era, so it’s not quite as thick of a market as you would otherwise think. So I think we’ll keep an eye on this, and I think we have plenty of ways we could address this situation.
Trade War and Financial Risk
Schwartz: In your dissent and wanting a larger rate cut — an insurance policy — you said there’s one risk to the upside for the economy. What would make the economy do better than you were expecting?
Bullard: We could be just overestimating the impact of the trade war, and it won’t be nearly as large. And in that case, we might want to take some of these insurance cuts back. Right now that’s not what I’m thinking, but it’s possible that we could go in that direction.
Negative Interest Rates
Siegel: If you look at Europe, it’s growing slower. Its GDP is about 1% less (than U.S. GDP), but its short-term real interest rates are minus 1-1/2 to minus 2 at present. Even if you compensate for the difference of GDP growth in the United States and Europe, you still don’t get as high a difference in rates as it seems the Fed thinks there should be. As an FOMC member, that’s another way to think about the fact that the real short-term Fed funds rate could really have dropped below zero.
Bullard: A lot of people have been pointing out that there are more than $15 trillion in sovereign yields that are negative nominal today, and that seems to be growing. I think we have to just face up to the idea that it’s an extremely low-interest rate environment globally, and U.S. yields can’t get too far out of line from those global yields, even though our economy is somewhat better than some other places in the world. That’s not enough to allow the hundreds of basis points differential between the U.S. and other countries.
“There are more than $15 trillion in sovereign yields that are negative nominal today, and that seems to be growing.” –James Bullard
An Inverted Yield Curve
Siegel: We may be seeing a flatter yield curve as a normal state of affairs. It seems like long Treasuries have become a very favorite hedge asset of many holders. They move in the opposite direction of the stock market and risk assets, and as a result, there’s a tremendous demand for them. And that would tend to bend down the curve. We might be seeing much flatter curves going forward than what we’ve certainly experienced in the past. Have you given any thought to that issue?
Bullard: Well, it’s certainly possible that trading patterns are changing, and the status of the U.S. 10-year is different than it was…. But you’re right, the (recession-prediction reliability of the inverted yield curve) — the track record — has been so good over the post-War era that I’m just reluctant to try to test some theory about why you think yield curve inversion is all right this time. And we don’t really have to. Inflation is below target, and inflation expectations are below where we’d like them to be. So we have some room to maneuver on this.
When you get into yield curve stories, there are always different points on the yield curve that you can compare. And the 10-year/2-year is one of the most common. That one hasn’t quite inverted on a sustained basis during this 90-day period here, and I take a little bit of heart there, because the 2-year part of that spread is anticipating that the Fed will lower rates somewhat, and it may be just enough to keep the inversion from occurring, and maybe just enough to keep us out of the recession prediction that you would otherwise get from that.
So whether the committee does that in a couple of different steps or does something more aggressive, like I was recommending at this last meeting, the market takes all that into account in the 2-year part of the 10-year/2-year spread.