PIMCO Chairman Bill Gross took to the pages of the Financial Times on Wednesday to warn that the Federal Reserve’s attempts to combat deflation may end up harming long-term lending.
Referring to economist Milton Friedman’s term for action taken by central banks in times of financial stress, Gross writes, “The concept of showering money over national economies to combat deflation has been an accepted principle of monetarism for decades. A helicopter, however, is not your average [airplane], and the usual laws of aerodynamics do not necessarily apply in all cases. Similarly, monetary policy at the zero interest rates introduces a new dynamic that may conflict or even reverse standard logic that lower interest rates across the sovereign yield curve are everywhere and always stimulative to economic growth.”
Gross notes lessons learned from observing Japan over the last two decades, as well as “from an analysis of our modern-day financial system and its potential inadequacies.”
“Borrowing short-term at a near risk-free rate and lending at a longer and riskier yield has been the basis of modern-day finance,” he writes. “Renowned economist Hyman Minsky explained that this was one of the inherent flaws of the Keynesian neo-classical synthesis.”
Gross explains that borrowers wanted lengthy loans to match the practical lives of their plant and equipment, but lenders were disposed toward shorter maturities because of the resultant financial volatility.
“However,” he writes, “in recent weeks … the rules have changed. Pilot [Fed Chairman Ben] Bernanke has changed planes from a fixed wing to a rotor-based helicopter by “conditionally” freezing policy rates for at least the next two years … by flooring maturities out to two years then, and perhaps longer as a result of maturity extension policies envisioned in a forthcoming operation twist later this month, the Fed may in effect lower the cost of capital, but destroy leverage and credit creation in the process.”
In that interview, Gross said he favored longer-maturity debt, and saw the Federal Reserve pushing policies that were likely to narrow the difference between short- and long-term borrowing rates as employment growth stagnated.
“We’ve advocated hard duration; that basically means something beyond five years,” Gross said. “The front end of the curve, in the U.S. at least, is inert. You have to move out into longer duration, harder duration.”