The Macroeconomic Outlook and Liability Management Strategies

Abstract

The current macroeconomic outlook presents a duality: On the one hand, Federal Reserve forecasters believe that short-term rates will remain excessively low (0-25 basis points) for a prolonged time period, possibly extending into 2015. On the other hand, the balance sheet of the Federal Reserve has nearly tripled ($850 billion versus approximately $3 trillion) since the onset of the great contraction of 2008-2009, suggesting skyrocketing future inflation accompanied by skyrocketing interest rates. The main reasons behind this very low interest rate environment are twofold: first, the unemployment rate is significantly higher than its steady state level (approximately 8% versus 5%), and second inflation is not significantly higher than its policy level of about 2%-2.5% p.a. The Federal Reserve follows some version of the frequently-cited Taylor rule, or framework, which suggests that the Fed Funds rate equals the long-run real rate (about 2%) plus the steady-state inflation rate (approximately 2% to 2.5%) and a weighted average of the GDP gap and the inflation gap. Though there are many interpretations of the Taylor rule, most economists would agree that the current environment implies a very low or even a negative Fed Funds rate that will remain as such until the unemployment rate reaches its full-employment level. Under normal circumstances such an increase in base (or high-powered) money would have resulted in significant levels of inflation. Currently, however, because the money multiplier has declined significantly due to the contraction, M1 and M2 have not grown as fast as high-powered money. And, heretofore inflation has not materialized. Nonetheless, global economic history suggests that inflation may hit suddenly and violently. And, this is the current macroeconomic duality: very low interest rates projecting into the distant future offset by high-levels of inflation risk. This duality intuitively suggests that an optimal funding strategy should consist of short term borrowings (to exploit the low short-term rates) coupled with long-term borrowings (to hedge against rising inflation and interest rates). In this paper, I empirically demonstrate that a barbell funding strategy is indeed on the efficient frontier, and most efficient frontier strategies consist of the barbell with episodic inclusions of the 5-Year, particularly under increased liquidity or funding risk eventualities. Once we delineate the efficient frontier, the CFO can choose the optimal fixed versus floating mix based on his pain tolerance for declines in Earnings per Share (EPS) given likely moves in short term rates.