Fed paper suggests investors get used to low rates

Bond investors reading the tea leaves on where interest rates are headed can look to a paper wrote by a pair of Federal Reserve Board staff economists, which argues that official rates and Treasury yields are likely to remain historically subdued, helping to keep corporate bonds—and equities—attractive. The paper suggests that quantitative easing will remain an important monetary policy tool in the U.S. central bank’s arsenal, according to Torsten Slok, chief international economist at Deutsche Bank. It argues that interest rates may remain substantially below the averages of the last half-century because of middling growth brought on by an aging population and low productivity. One solution, then, to lift off from the zero bound—when interest rates are close to zero—is to raise the inflation target from 2% to 3% or 4%. But such a proposal was unviable in Slok’s eyes. ”In the real world,” inflation targeting could spark a sudden recession by leading to a premature increase in interest rates, bringing up borrowing costs and crimping profits. In comparison, quantitative easing and balance sheet expansion appear to be the best of bad options, he wrote. “That is why shrinking the Fed balance sheet is currently such a high priority for the [Federal Open Market Committee]; because the Fed wants to make sure they have ammunition for the next slowdown,” Slok wrote. “In the meantime, the entire yield curve will be at lower levels than it has been historically, and that means more demand for higher-yielding assets, i.e. spread products such as [investment-grade] and [high-yield] credit and also equities,” Slok wrote.