Tags: Pimco | Gross | Fed | Growth

Pimco’s Bill Gross: Fed’s Rate Strategy Stalling Economic Growth

Tuesday, 07 February 2012 09:12 AM

Bill Gross, founder and co-chief investment officer of Pimco, says the Federal Reserve’s strategy of zero interest rates is halting economic recovery and could be steering the United States into a Japanese-style “lost decade.”

"Who could have conceived 30 or 40 years ago that interest rates could ever approach zero for an extended period of time?" Gross writes in the Financial Times. "Probably no one."

His argument appears to focus on Operation Twist, a Fed program meant to push down yields on long-term government securities through sales of short-term securities, Business Insider reports.

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The Fed's logic is that the low cost of long-term borrowing will catalyze growth in the housing sector in particular, driving construction and economic recovery.

As the interpretation of Gross’s editorial published by the Business Insider noted, lenders require and are incentivized by a yield premium for longer term loans, historically expressed as a positively sloping yield curve.

A flat yield curve, by contrast, is a disincentive for lenders to extend intermediate or long-term credit unless there is sufficient downside room for yields to fall and bond prices to rise, resulting in capital gain opportunities.

Nor do Pimco or banks have incentive to buy five-year Treasurys at 75 basis points when the potential risks far outweigh potential benefits.

Banks want to lend when there is room for yields to fall further. However, as Gross points out, interest rates are already close to zero — indeed they have never been lower — banks are less likely to lend because the only way yields can turn is up.

Plus which, the indefinite extension of low rates could push the U.S. into a Japanese-style lost decade.

“Historically, because nominal and real yields have been high and substantially positive, even in flat curves credit markets have continued to function, helping spur economic and asset price expansion,” Gross explains.

“A liquidity trap caused by ‘zero-bound yields’ has always been averted because, in the past, yields have had further to fall, meaning investors were comforted by the prospects of capital gains.”

According to Reuters, St. Louis Federal Reserve President James Bullard said he disagreed with the Fed's decision last month to keep interest rates exceptionally low through late 2014 to bolster a recovery that was moving too slowly.

Bullard also said that the central bank should start raising interest rates next year because many years of near-zero rates will do little to return economic output to pre-recession levels and risks causing "disaster."

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