I didn’t watch Fed Chief Ben Bernanke’s appearance before the Senate Budget Committee yesterday, but there was an interesting exchange with Sen. Pat Toomey (R-PA) recounted in this Wall Street Journal story($) on the subject of the central bank creating market distortions that they may not be able to counter if and when sentiment changes.
At issue is the Fed’s continuing policy of bond-buying. While the central bank has stopped expanding its balance sheet with new asset purchases, it is engaged in a plan to sell short-dated Treasury bonds and replace them with a like amount of long-dated government debt. The result? Ten-year Treasury borrowing rates are around historic lows, and with them, mortgage rates.
For Bernanke, this is by design, not accident. He told Toomey a significant aim of the Fed is to gobble up enough risk-free Treasury debt so that investors are forced into riskier investments that will in principle generate better levels of growth.
“We don’t want to go too far,” Bernanke told the committee. He said the Fed was “very attentive” to signs that its stimulus was in the process of generating imbalances, and added the central bank had “greatly expanded” its surveillance of financial markets, in a bid not too be caught off guard.
“The effects of Fed policy, independent of all the other factors, on Treasury rates [are] modest,” Bernanke said. The bigger problem is investor confidence in future government borrowing. “Rates will rise eventually, and if investors were to lose confidence in U.S. federal fiscal policy, there is nothing the Fed can do to stop those rates from rising”.
If memory serves, it was Ken Rogoff (of This Time is Different fame) who observed that, throughout history, there is virtually no warning for when the bond market turns on a nation’s sovereign debt (so much for the Fed’s “attentiveness”) and, when combined with Bernanke’s warning above that there’s little they’ll be able to do under those circumstances, this sets the stage for one monster U.S. sovereign credit crisis somewhere down the road.