FM: One thing PIMCO noted after its 2009 forum and reiterated in its 2010 forum is that the United States will de-lever. How much of this has occurred and how much is yet to come?
ME: The best way to think about this is in terms of both stocks and flows. Certain sectors, such as large companies, have completed the de-leveraging and are building robust balance sheets as they are also cash flow positive. Others, including consumers, are cash flow positive but still need to de-lever. And then you have the government, which is cash flow negative and adding to a debt stock that has already risen significantly due to the 2008-09 global financial crisis.
FM: So in a sense, businesses and individuals are de-leveraging and government is taking on more leverage. How sustainable is this?
ME: Governments had no choice in 2008 and 2009 but to step in with their balance sheets to compensate for what was a disorderly private sector unwind. The alternative would have been a global depression. It is critical that this exceptional use of the sovereign balance sheet, including that of the central bank, be a bridge to the resumption of high sustained growth led by the private sector. Otherwise, what was a private sector balance sheet problem will become a sovereign balance sheet problem.
FM: You have said QE2 is likely to backfire. Why?
ME: There are both domestic and global dimensions. By buying securities, QE2 seeks to push investors and consumers out the risk curve. History suggests that when people are being pushed to do something they would not do on their own, they either resist or end up making unsustainable decisions.
Globally, QE2 is flooding emerging economies with liquidity at a time when many of these economies are already very close to overheating. And then there are the unintended consequences. The involvement of the Fed as a non-commercial player in markets that are functioning normally can cause distortions.
FM: The Fed has become significantly involved in markets since the end of 2007, from creating special auction facilities and opening up the discount window to non-commercial banks and brokerages to QE 1 and 2. At some point do they need to be less involved?
ME: Yes, definitely. Like fiscal stimulus, this aggressive use of the Fed’s balance sheet is a bridge and not a destination. And the longer the Fed stays in this unusual mode of unconventional policy activism and experimentation, the greater the risks to its institutional integrity, to the proper functioning of markets and to efficient price signaling that is so key for proper resource allocation.
FM: Most critics of QE2 feared a larger devaluation of the U.S. dollar. The dollar is much higher since the November QE2 announcement. While initially this could be attributed to “buy the rumor, sell the fact” activity, it has gone beyond that. What is going on? What is your outlook for the dollar?
ME: A couple of things. First, starting with Chairman Bernanke's Jackson Hole speech at the end of August, the markets positioned for QE2 over many weeks and ended up overdoing it. Second, we should never forget that the dollar's exchange rate is a relative price. As such, it is impacted by the crisis in Europe's periphery which has weakened the euro.
FM: Has the nearly 20-year bull market in U.S. Treasuries ended? What is your outlook for Treasuries?ME: Given how far yields have come down during the last 20 years, there is no longer the same room for U.S. Treasuries to rally. Where we go from here is mainly an economic call. On the one hand, a rebound in growth would translate into a backup in yields. On the other hand, a weak growth outlook would see yields go lower.
FM: What is your outlook for the yield curve for 2011 and beyond?
ME: Range bound, with a tendency to flatten. The front end will be anchored by the Fed pinning policy rates essentially at zero. The long end will be a tug of war between the impact of sluggish growth and concerns about medium-term inflation and the erosion of the global standing of the United States.