QE2 and Rising Yields

More folks are now considering the possibility that the rise in long-term interest rates may be a sign of economic recovery.  For example, see Ryan Avent, Paul Krugman, Cardiff Garcia, and David Andolfotto.  This is a welcome reprieve from the those observers who point to the rising yields as a sign that QE2 is failing. 

Recall that the recovery view begins with notion that a successful QE2 will first raise inflation expectations.    The increase in  inflation expectations, however, also implies higher expected nominal spending (i.e. higher future nominal spending means higher future inflation).  Higher expected nominal spending in an economy with sticky prices and excess capacity should in turn lead to increases in expected real economic growth.  Finally, this higher expected real economic growth should increase current real long-term yields.  Given the fisher equation, this understanding implies that the rising long-term nominal yields are occurring because of both higher expected inflation and higher real yields.

Though it too soon to know for sure,  the data seem to support the recovery interpretation of the rising nominal yields.  Below is a figure showing the 10-year expected inflation rate and the 10-year real interest rate from the TIPs market.  This figure shows that inflation expectations pick up first and eventually the real interest rate does too: (Click on figure to enlarge.)

If this understanding  is correct, then QE2 seems to be doing some good.

Update:  Ryan Avent is now fully on board with the recovery view of rising yields:

BUTTONWOOD continues to be sceptical of the Fed's new security purchases. And, you won't be surprised to hear, I continue to think his fears are somewhat misplaced. He writes, for instance:

It is possible that the Fed's actions have actually been counter-productive, since 10-year bond yields are actually higher than they were when the second round of QE was announced. In part, this may be a case of "buy on the rumour, sell on the news". But the 30 basis point rise in bond yields over the last two days has revealed signs of investor cynicism.

Reduced bond yields are not the Fed's goal. The Fed's goal is to facilitate recovery, so as to move inflation and unemployment closer to the central bank's target levels. Beginning in late August, the Fed signalled its intent to do more to achieve its goal through additional purchases of Treasury securities. And indeed, the Fed's messaging was successful; Treasury yields were lower in early October than they were in late August. But lower yields were the means, not the end. The promise of more Fed action boosted markets and expectations, and before long actual economic data was following suit. But of course, we'd expect an improving outlook for the American economy to lift American government bond yields. Yields were low, aside from Fed activity, because investors were uninterested in putting their money in private projects. That's no longer the case; with rising growth expectations comes rising interest in private investment, which makes for falling bond prices and rising yields. Yields are rising because QE2 has been successful.

Bernanke Acknowledges Risings Yields a Sign of Success

For some time now, I have been making the case that a sign of QE2 success would be rising yields rather than falling yields.  Yes, interest rates may initially fall, but if QE2 is successful in raising expectations of real growth then interest rates should start to increase.  For example, back in December, 2010 I said the following:

If QE2 is successful, then we would expect treasury yields to rise!  A successful QE will first raise inflation expectations.  This alone will put upward pressure on nominal yields.  However, expectations of higher inflation are in effect expectations of higher nominal spending.  And higher expected nominal spending in an economy with sticky prices and excess capacity will lead to increases in expected real economic growth.  The expected real economic growth should in turn increase real yields.  It is that simple.

Here is an updated graph from a more recent post that indicates this is in fact happening:

Given this understanding, it has been frustrating to watch the Fed sell QE2 to the public as working through the lowering of interest rates.  This marketing of QE2 creates the false impression it will only work if yields remain low.  It gives critics of QE2 more ammunition and ultimately undermines the effectiveness of the program. Thus, I was please to see Bernanke say this today in his speech:

A wide range of market indicators supports the view that the Federal Reserve's securities purchases have been effective at easing financial conditions... Yields on 5- to 10-year Treasury securities initially declined markedly as markets priced in prospective Fed purchases; these yields subsequently rose, however, as investors became more optimistic about economic growth and as traders scaled back their expectations of future securities purchases. All of these developments are what one would expect to see when monetary policy becomes more accommodative.

It is about time.

QE2 and Rising Yields, Again

Late last year I was making arguments like this one about how QE2 would work:

[T]he recovery view begins with notion that a successful QE2 will first raise inflation expectations.    The increase in  inflation expectations, however, also implies higher expected nominal spending (i.e. higher future nominal spending means higher future inflation).  Higher expected nominal spending in an economy with sticky prices and excess capacity should in turn lead to increases in expected real economic growth.  Finally, this higher expected real economic growth should increase current real long-term yields.  Given the fisher equation, this understanding implies that the rising long-term nominal yields are occurring because of both higher expected inflation and higher real yields.

Thus, contrary to the sales pitch made by Fed officials that QE2 would lower yields, we should expect to see yields ultimately increase if QE2 is successful.  Below is an updated figure on the 10-year expected inflation and 10-real treasury yield. (Click on figure to enlarge.)

 

[Update: the labels on the graph were original reversed and now have been fixed]

To the extent the sustained rise in real yields is reflecting an improved economic outlook, can we not attribute some of that improvement to QE2?

Rising Yields Is A Good Sign

A key objective of QE2 is to raise nominal spending.  Given sticky prices and excess economic capacity, this increase in nominal spending would boost the real economy.  Now the way QE2 can raise nominal spending is by raising inflation expectations.  Higher inflation expectations creates the incentive for banks, firms, and households sitting on money to start spending it.  In fact, the key problem facing the U.S. economy right now is an excess money demand problem.  While it is true that rising inflation expectations may temporarily lower real interest rates too and thus stimulate interest sensitive spending, this effect is of second-order importance and is only temporary.  The real and lasting reason rising inflation expectations are important is that they address the excess money demand problem. 

Many observers miss this important point and its implications for interest rates. Imagine QE2 is successful in breaking the excess money demand problem and aggregate spending increases. The real economy starts recovering too.  These developments would imply the following: (1) expected inflation must have picked up at some point and (2) real interest rates would start rising in response to the recovery of the real economy.  In other words, one would expect to start seeing nominal interest rates--the sum of the real interest rate and expected inflation--to start  increasing if QE2 is successful.  QE2, then, would not only be a boon to the  real economy, but also to savers and folks living on fixed income given the rise in real interest rates. 

Now I think QE2 should have been implemented differently--the Fed should  have announced an explicit rules-based nominal target and forcefully commit to maintaining it--and I am concerned that political pressure may prevent it from being effective. Still, if it does work in its current form then rising yields would be one sign of success.  Though it is probably too soon judge its effectiveness based on this criteria, here is a look at the expected inflation and the real yield on 10-treasury securities.  The figure covers the last month and half, the time period when Fed officials first started talking up QE2 up through the present. (Click on figure to enlarge.)

Source: FRED Data

The blue line in the figure reveals that inflation expectations started increasing in October with the onset of the Fed's full court PR press on QE2.  Inflation expectations had been downward trending all year until this point.  QE2 reversed that trend. So on this point, QE2 appears to be working.  (Inflation expectations, however, have not continued climbing since QE2 was made official and that is a little troubling.) The red line indicates that the real interest rate has seen a sudden spike in the past week.  So on this point, QE2 appears to be working too.  Again, I reach these conclusions with some trepidation since it is so early into the QE2 program. 

I raise these points because some observers like the Wall Street Journal and Barrons are looking at the same data and making statements like the "Bond Market Defies the Fed" and "Bond Vigilantes Rise Again." They claim that the bond market is pushing back against the Fed and beating it.  I say not so fast guys,  the bond market may actually be following the QE2 according to plan. Let's wait and see how this plays out, but along the way don't forget that rising yields is actually a good sign.

Too Much Focus on Interest Rates

Though much needed, QE2 it is far from perfect.  One problem with QE2 is that it is being marketed as a monetary stimulus program that works by lowering long-term interest rates.  Dropping long-term rates, the story goes, will in turn spur interest-sensitive spending and jump-start the economy.  This marketing strategy seems wrongheaded to me because it (1) ignores other  important channels through which monetary policy can work and (2) creates the wrong expectation that QE2 will only be successful if it maintains long-term interest rates at a low level.

The emphasis on the so called "interest rate" channel through which monetary policy actions are transmitted to the economy is pervasive in QE2 discussions.  For example, here is Greg Ip explaining how QE2 works:

Under QE, the Fed shifts its focus to long-term rates from short-term rates, and buys as much debt as it needs to get long term rates down. If it ever gets long-term rates to where it wants, it will stop buying. If it thinks long-term rates have gone too low, it could sell...Monetary policy stimulates demand by lowering the real interest rate...

It is understandable that journalists would invoke this monetary transmission channel when explaining QE2 since Fed officials are doing the same.  Here is this channel being endorsed by Ben Bernanke:

[A] means of providing additional monetary stimulus, if warranted, would be to expand the Federal Reserve's holdings of longer-term securities. Empirical evidence suggests that our previous program of securities purchases was successful in bringing down longer-term interest rates and thereby supporting the economic recovery.

This view is further reinforced in the FOMC minutes for the October 15 meeting. These minutes show that the FOMC considered targeting an long-term interest rate: 

[P]articipants discussed the potential benefits and costs of setting a target for a term interest rate. Some noted that targeting the yield on a term security could be an effective way to reduce longer-term interest rates and thus provide additional stimulus to the economy.

This narrow emphasis on the interest rate channel ignores the fact that monetary policy can influence the economy through various transmission mechanisms.  This New York Fed article, for example, notes that the transmission channels include the bank lending channel, the balance sheet channel, the wealth channel, the interest rate channel, the exchange rate channel, and the monetarist portfolio adjustment channel.  I see the portfolio adjustment channel being much more important for QE2 than than interest rate channel for several reasons.   

First, the portfolio channel acknowledges the reality that Fed purchases of government securities will affect the prices and yields of  one's entire portfolio of assets, not just treasuries.  This includes real money balances and the demand for them as an asset.  Thus, it is through this channel that the real issue behind the weak U.S. economy  can be addressed: the excess money demand problem.  Ironically, Ben Bernanke acknowledged the importance of this channel at his Jackson Hole speech back in August, 2010.  Unfortunately, his other speeches and Fed statements more generally create the impression QE2 is all about the interest rate channel.  

Second, the interest rate channel works through a lowering of interest rates that stimulates interest-sensitive spending.  This cannot be an important channel, however, if QE2 actually works.    For if QE2 is successful in stimulating economy activity it must be the case that (1) expected inflation  picked up at some point and (2) real interest rates picked up at some point in response to the recovery of the real economy.  In other words, nominal interest rates--the sum of the real interest rate and expected inflation--will increase if QE2 is successful.  This channel, then, will at best be fleeting.   

That the interest rate channel will be fleeting if QE2 works is another reason why the narrow emphasis on this channel is wrongheaded: it creates the wrong expectation that QE2 will only work if long-term interest rates remain low.  Thus, QE2 is bound to be plagued by second guessing and criticism from observers who only see monetary policy through the prism of the interest rate channel.   For example, imagine there is a sustained rise in interest rates.  I would view this as a sign that QE2 is working. Many observers, however, would probably view such a development as failure of QE2.   I fear the  Fed is setting itself up for trouble by framing QE2 as working solely through the interest rate channel. 

Jeremy Siegel Gets It

Jeremy Siegel is making the case the case that rising yields indicate the Fed's policy is actually working:

The recent surge in long-term Treasury yields has led many to say that the Fed's second round of quantitative easing is a failure. The critics predict that QE2 may end up hurting rather than helping the economic recovery, as higher rates nip in the bud any rebound in the housing market and dampen capital spending. But the rise in long-term Treasury rates does not signal that the Fed's policy has backfired. It is a sign that the Fed's policy is succeeding.

Long-term Treasury rates are influenced positively by economic growth—which encourages consumers to borrow in anticipation of higher incomes and causes firms to seek funds to expand capacity—and by inflationary expectations. Long-term Treasury rates are affected negatively by risk aversion: Seeking a safe haven, investors pile into Treasury bonds, running up their prices and lowering their yields. 

The Fed's QE2 program has raised expectations of growth and inflation, sending long-term Treasury rates up. It has also lowered risk aversion, which implies rising long-term rates. The evidence for a decline in risk aversion among investors is the shrinkage in the spreads between Treasury and other fixed-income securities, the strong performance of the stock market, and the decline in VIX, the indicator of future stock-market volatility. This means that expectations of accelerating economic growth—and a reduction in the fear of a double-dip recession—are the driving forces behind the rise in rates. 

More and more observers are picking up on this notion that rising yields may be reflecting an improving economic outlook. As I have noted before, this is a welcome reprieve from the common but wrong view that QE2's success is dependent on the Fed maintaining low long-term interest rates.  The correct story goes something like this: higher expected inflation from QE2 should increase expected nominal spending and in turn raise expected real economic growth (given sticky prices and excess capacity).

Here is the latest figure on the 10-year expected inflation (red line) and the 10-year real yield (blue line) from the TIPs market. It continues to show an upward march for real yields. 

Update: Underscoring the view that rising yields indicate an improved economic outlook, Catherine Rampell notes three good economic reports came out today (retail sales, small business optimism index, and ppi) and that economic forecasts are being revised up.

Why The Continuing Bewilderment About QE2 and Interest Rates?

Why do we continue to get the following line of reasoning about QE2 and interest rates reported in the press?

The trouble [with QE2] is, though yields fell sharply between August and November as the markets anticipated the new program, they have risen since it was formally announced in November, leaving many in the markets puzzled about the value of the Fed’s bond-buying program. 

This particular quote comes from the New York Times, but it is ubiquitous in the press.  As I and others have said before, a truly successful QE2--one that helps revive the economy--should ultimately lead to higher bond interest rates.  Yes, yields may initially fall but an economic recovery should be accompanied by rise in interest rates as the demand for credit increases.  Amazingly, after spending several paragraphs raising doubts about whether QE2 is working because of rising yields, the NY Times article closes with this from Brian P. Sack, the head of the NY Fed trading desk:

“Rates have risen for the reasons we were hoping for: investors are more optimistic about the recovery,” said Mr. Sack. “It is a good sign.”

And they save that for the closer?  How much more insightful the article could have been had there been some discussion about this point up front.  QE2 is far from perfect, but it is probably in some way contributing to the change in economic expectations and thus the uptick in interest rates. It is that simple.

Hoity-Toity Fed People

It has been frustrating to watch Fed officials explain QE2.  The standard Fed story centers around the QE2 driving down long-term interest rates and stimulating more borrowing.  As I have repeatedly noted, this narrow focus on the interest rate channel leaves out many other channels through which monetary stimulus can work.  Moreover, it creates the wrong impression that QE2 will only be successful if long-term interest rates are held low.  Thus the rising long-term yields are seen by many observers as indicating QE2 is a failure when the opposite is probably true.  An anonymous commentator from my previous post eloquently summarizes this  confusion coming from the Fed's marketing of QE2:

I agree that rising yields actually indicate that QE2 is working.

But I also have sympathy for all the people who get "confused," because, of course, you have had hoity-toity Fed people themselves saying that one mechanism through which QE will stimulate things is by lowering long-term rates, supporting housing prices, and so on and so forth.

Bottomline, it would sure help if the Fed would clearly and succinctly communicate (a) the mechanisms by which its policies are supposed to work and (b) the sign-posts and markers (e.g., asset price movements) for people to look at to ascertain whether things are going as intended.

Right now we have the utter IRONY of QE2 working exactly as it was intended (thank the lord) and the "experts/pundits" getting downright angry because what they're seeing is not what they expected to see, and, of course, what they expected to see is simply no more and no less than what they were told to expect by the very people who are implementing QE2.

Well said.

A Failure to Act: Fed Policy and Interest Rates

Is the Fed responsible for the pernicious low-interest rate environment? Yes, but not for the reasons you think. I explain why in a new National Review article:

While this absolves the Fed of direct responsibility for the low-interest-rate environment, it does not absolve it for its indirect influence. Through its control of the monetary base, the Fed can shape expectations of the future path of current-dollar or nominal spending. Thus, for every spike in broad money demand, the Fed could have responded in a systematic manner to prevent the spike from depressing both spending and interest rates. In other words, the Fed could have adopted a monetary-policy rule that would have committed it to maintaining stable growth of total-dollar spending no matter what happened to money demand. A promise from the Fed to do “whatever it takes” to maintain stable nominal-spending growth would have done much by itself to prevent the money-demand spikes from emerging at all. Why hold a greater number of safe, liquid assets if you believe the Fed will keep the dollar value of the economy stable?

[...]

The Fed’s failure to adopt something like a nominal-GDP target in 2008 meant that the central bank would not be able to adequately respond to the subsequent money-demand shocks that arose over the next four years. That is, the Fed’s inaction allowed the pernicious low-interest-rate environment to develop. So while the Fed did not directly cause the low-interest-rate environment, our central bank allowed it and all of its associated problems to emerge. For that it should be blamed.

Readers of this blog will be familiar with this argument (e.g. see here, here, and here).  Here are some figures that corroborate the points made in my article. First,the figure below shows the Fed's share of treasuries over the past twelve years. It has been overall relatively stable around 15%. Observers who blame the Fed for pushing down treasury yields, though, often note the Fed's relatively large share of treasury purchases in 2011. What they ignore is the Fed also sold a similar proportion in 2007-2008. By their logic the Fed should have caused treasury yields to rise during this time. But this period is when the long decline in treasury yields actually begins.

When confronted this fact, some of these critics will then point  to long-term treasury yields and say the market is "front-running" the Fed stated plans to buy long-term treasuries. But if that is the explanation for the falling long-term yields then this next figure should not be possible. It shows the Fed's treasury holdings were relatively stable between the end of QE2 in mid-2011 and the beginning of QE3 in late 2012. It also shows that real interest rates on 10-year treasuries continued to fall. There was no front-running during this time since there were no QE programs. There were, however, ongoing global economic problems that can explain the decline.

Finally, it is worth pointing out that as the U.S. economic recovery has begun to appear more firm, long-term treasury rates have also started to gradually rise. The Fed has not changed its pace, but yields are now rising. The easiest explanation is that the long-term yields are directly reflecting the expected state of the economy. Indirectly, though, the rising yields can be traced in part to the Fed actions which under QE3 has become more closely to tied to the state of the economy. Too bad it took the Fed almost four years to get here.

Oh No, QE2 Might Actually Work!

Lawrence Lindsey is concerned that QE2 might work as intended.  He is afraid that if QE2 actually spurs an economic recovery there will be higher interest rates that, in turn, will create a fiscal crisis:

Now suppose quantitative easing is “successful” in the way the Fed intends, taking inflation close to the average 2.4 percent rate of the last two decades and government borrowing costs back to their two-decade average of 5.7 percent. To get an idea of what happens to the budget, assume this transition happens over three years, so that by 2013 interest rates are back to “normal.” This “return to normal” will mean the government’s interest costs will rise to $847 billion by 2015 and $1.15 trillion by 2019

[...]

Interest rates could also rise for a variety of other reasons. Much faster real economic growth could have the same effect. An additional point of real growth for five straight years would help by raising revenue by about $450 billion over five years, but a parallel increase in real rates would raise interest costs by $700 billion over the same period. The higher real rates and larger deficit would likely put a lid on the sustainability of any growth spurt

Lindsey is correct that an economic recovery will raise interest rates. In fact, rising yields will be a sure sign of economic recovery. His concerns, however, about a fiscal crisis seem rather misplaced on several fronts.  First, it would be easier to deal with fiscal problems in a growing economy created by QE2 than in a Japan-style economic slump created by an aborted QE2.  Second, keeping monetary policy tight by having no QE2 would create other problems that his analysis ignores, like further pressure for trade protectionism.  Third, tight monetary policy would increase the likelihood of more fiscal deficits and fiscal problems. Consequently, I will cast my lot with QE2 and pass on the Lindsey prescription of tighter monetary policy.

Asking the Wrong Question

Randall W. Forsyth dreams he is doing the 60 Minutes interview with Ben Bernanke and comes up with this exchange:

Bernanke: "What we're doing is lowering interest rates by buying Treasury securities. And by lowering interest rates, we hope to stimulate the economy to grow faster,"

Forsyth: "So, why are interest rates higher now after QE2? The key 10-year Treasury note yield is up to nearly 3% from 2.50% just after the Federal Open Market Committee announced the policy change in early November. Mortgage interest rates have climbed to three-month highs and applications fell the most this year in the latest week. So, what's the problem?

Part of the problem is Bernanke and the Fed itself. They should not be creating the perception that a successful QE2 is one that will keep long-term interest low for a sustained period.  As I have noted several times now, this is terribly wrong.  If QE2 is successful, then we would expect treasury yields to rise!  A successful QE will first raise inflation expectations.  This alone will put upward pressure on nominal yields.  However, expectations of higher inflation are in effect expectations of higher nominal spending.  And higher expected nominal spending in an economy with sticky prices and excess capacity will lead to increases in expected real economic growth.  The expected real economic growth should in turn increase the real yields.  It is that simple.  Randall W. Forsyth, therefore, is asking the wrong question. What he should be asking is why inflation expectations have not gone up anymore.  If anything, QE2 is much ado about nothing.  

Bernanke's Friday Night Special: Part I

Fed Chairman Ben Bernanke gave one of his better speeches last Friday night. In it, he explained why long-term interest rates have declined over the past four years and, in so doing, provided an important rebuttal to the popular view of the Fed as the great enabler of the large government deficits. The evidence Bernanke presented in his speech should give any honest proponent of the Fed as the great enabler (FGE) view pause. Unfortunately, this speech has not received the attention it deserves and many of the FGE proponents probably missed it.¹ Therefore, it is worth reviewing and elaborating on this important speech.  

Chairman Bernanke began by his speech by observing that both nominal and real long-term interest rates on safe sovereign debt have been declining across the world, not just in the United States. Here, for example, is his chart showing the global decline in real interest rates on government bonds:

 

What is striking about this figure is that there is both a sudden, downward shift in trend beginning in 2008 and a narrowing of spreads among these interest rates. This pattern is also evident in long-term nominal yields, as I noted last year. These figures alone undermine FGE claims since they indicate something global in nature is affecting all these yields in a similar manner. Blaming the Fed for the low, long-term interest rates ignores this global phenomenon.

Bernanke then turned to the movements in long-term U.S. yields. He did so by invoking the expectation hypothesis--the theory that long-term interest rates equal the average of expected short-term interest rates over the same period plus a term premium--to explain the decline in long-term treasury yields. He also decomposes the expected average short-term nominal interest rate into an expected real interest rate and expected inflation component. Here is how this break down comes out for for the 10-year treasury:

With this decomposition, Bernanke notes that most of the the 10-year treasury decline over the past four years comes from a decline in the expected average real interest rate and the term premium.

On the former, Bernanke correctly observes that though the Fed can directly influence the expected path of short-term real interest rate over the short-to-medium term, its influence beyond that is muted by real factors. In other words, the expected average real short-term yield over the next 10 years is shaped more by the economic outlook than by the Fed².

On the later, Bernanke attributes the term premium's decline to three things: increased interest rate certainty because of the zero lower bound (makes it easier to forecast), the safe asset shortage problem, and the Fed's large scale asset purchases (LSAPs). The first two of these developments are result of the crisis. Only the LSAPs are the Fed's doing. So most of the factors driving down the 10-year treasury yields have been developments outside the Fed. This is consistent with the pattern of safe asset yields falling across the world. It is hard to find support for the FGE view here.

There is more Bernanke could have said about the LSAPs. First, contrary to the claims of many FGE proponents, the LSAPs have not been terribly large in relative terms. The stock of marketable treasuries went from about $5.13 trillion at the end of 2007 to $11.27 trillion at the end of 2012.  Over this same time, the Fed’s holding started near $0.74 trillion and reached $1.65 trillion. The Fed’s net gains, then, are approximately $0.94 trillion over this time compared to $6.14 trillion change in marketable debt. (The Fed actually has purchased a little more, but it also sold some securities in 2007.) The figure below shows the Fed's holding of marketable securities at the end of 2012:

Relative, then, to the rise of total marketable debt the Fed’s holdings have not risen rapidly. In fact, the Fed now holds about 15% of marketable treasuries, roughly the same share it has held over the past few decades. Some FGE observers like to point out the Fed purchased 77% of marketable treasuries in 2011.³ What they ignore is that the Fed also sold off a sizable portion in 2007, leaving the Fed's overall share of treasuries about the same. Therefore, the large run up in in U.S. public debt has funded largely by individuals, their financial intermediaries, and foreigners. Blame them, not the Fed, for enabling the large budget deficits.

Second, the LSAP actually stopped with the end of QE2 in mid-2011 and did not resume until late 2012 with QE3. During that time, when the Fed's treasury holdings were relatively stable, real interest rates on 10-year treasuries continued to fall. How do FGE proponents explain this development? It is easy to explain if one looks to the other factors Bernanke listed as being important determinants of the long-term interest rates.

Third, even with the advent of QE3 and its $85 billion treasury purchases per month, it is unlikely the Fed will see its share of treasuries grow to the point where one can say the Fed is truly engaged in financial repression. Here is why. The Fed's QE3 purchases can be viewed as the Fed simply increasing the supply of the monetary base to match the demand for it. To the extent the Fed overshoots--and the FGE proponents are correct--then inflation will rise and force the Fed to reverse itself since QE3 is conditional on explicit inflation thresholds being hit. If the Fed does not hit these thresholds (and assuming no positive supply shocks that create downward pressure on inflation), then the Fed's treasury purchases will simply be accommodating growing monetary base demand. And if that is the case, the economy will still be weak leading to more budget deficits and a relatively stable share of treasury holdings for the Fed.

So far from being the great deficit enabler, the Fed's policies are actually playing catch up with soaring liquidity demand. And on that point the Fed can be held accountable for not doing enough, but that is subject of my next post.

 ¹Noteable exceptions include Joe Weisenthal, Jim Hamilton, and Ryan Avent.
²In other words, the natural real interest is low and the actual real interest rate is reflecting that. 
³According to this data, the number is actually 61%, not 77%.

Update:  Below is total marketable treasuries and the Fed's share in dollars.

QE Has Worked Before and It is Not Just About Lowering Interest Rates

Felix Salmon tries to defend his criticism of QE2:

I don’t think that we’re hysterically attacking QE2, so much as pointing out that it’s never been done before, that we don’t know whether it will work, and that, if it doesn’t work, we don’t know how it’s going to fail, either.

No, QE2 has been done before and it worked quite well.  As I showed in this post and as noted by Paul Kasriel, the original QE started in in late 1933 and was very effective at spurring a robust economic recovery.  And contrary to conventional wisdom, the key to making QE work then and now was not the lowering of long-term interest rates.  It was about addressing the excess money demand problem and thereby spurring a recovery in nominal spending.  Yes, interest rates may initially fall,  but if QE2 works according to plan there should ultimately be an increase in yields. In short, QE2's success is not contingent on a sustained lowering of interest rates.

A Surprising Look Back at the Fed's QE Programs

The Fed's QE3 program is scheduled to end later this year. This will bring to a close the Fed's five year experiment with QE programs. They have been incredibly controversial, especially among those who believe these programs enabled the federal government to run large budget deficits. Those holding this view typically make one of two claims. First, the large scale asset purchases (LSAPs) done under QE meant the federal government had a guaranteed purchaser of its securities. Second, the QE programs kept the federal government's financing charges inordinately low. So are these claims correct? Let's look back at the data to find out.

Consider first the Fed's share of marketable U.S. treasuries as seen in the figure below. The Fed's treasury holdings have gone from just under $0.8 trillion in late 2007 to about $2.39 trillion as of June, 2014. Over the same time, other holders of treasuries have gone from roughly $4.4 trillion to about $10.2 trillion.

The next figure shows these same two groups in terms of cumulative change in their holdings since the beginning of 2007. Note that the Fed actually sold off a sizable portion of its treasury holdings during 2008 just as the government deficits started growing.

In total, the Fed has acquired about $1.6 trillion of treasuries compared to $5.8 trillion acquired by the other holders. The largest run up in U.S. debt history, then, was mostly funded by foreigners, financial intermediaries, and individual investors. It was not the Fed.

Now it is true that under QE3 the Fed did start to buy up more long-term treasuries, so it could still be guilty of distorting long-term yields. The figure below shows the composition of its holdings relative to the total amount (not including TIPs) as of June, 2014:

So has the Fed been 'artificially' pushing long-term treasury yields? Even Fed officials claim that QE works by lowering long-term interest rates. Well that was the theory and these are the facts: long-term treasury yields tended to rise during periods of treasury purchases under QE. If anything, then, QE programs raised long-term financing costs for the government.

 

One way to explain this outcome is that the QE programs actually raised expected economic growth and that pushed up treasury yields. Okay, says the skeptic, maybe the Fed's QE programs raised the expected path of short-term interest rates by raising expected economic growth. But surely the Fed's large scale asset purchases (LSAPs) lowered the term premium portion of long-term yields. That was, after all, the deeper theory behind the claims that QE would make long-term interest rates fall.  Even if interest rates overall went up, the term premium must have fallen. Using the Adrian, Crump, Moench (2014) and Kim and Wright (2005) data, we see the opposite actually occurred. Term premiums tended to rise during QE programs.

It is particularly interesting to see the term premium fall so much between QE2 and QE3. It is as if the term premium needed QE to stay propped up. Here is one possible explanation. The QE programs increased the economic outlook and that, in turn, reduced the risk premium on other assets. Investors, therefore, were more willing to hold other higher-yielding assets and this meant they had to be compensated more to hold the low-yielding treasuries. Likewise, between QE programs, risk premiums on other assets rose and caused investors to flock back to treasuries. This migration caused the term premium to fall between QEs. In any event, this data indicates the Fed failed at lowering the term premium.

So claims of the Fed enabling the large budget deficit are not supported in the data. An alternative explanation that is that the overall increased appetite for safe assets over the past five years was the true enabler. And here is where I think the Fed is responsible. By failing to restore full employment to the economy, the Fed has allowed risk premiums to stay elevated and interest rates on safe assets to stay depressed.  In fact, the 10-year treasury real risk-free interest rate (the nominal treasury yield minus expected inflation minus the term premium) closely tracks the the CBO's output gap as seen below:

Now one could conclude from this that the QE programs did not make that much difference. I disagree. The evidence above suggest the Fed at least put a floor under long-term interest rates (and by implication a floor under the economy) with its QE programs. To know for sure how different the economy would have been in the absence of QE one needs to do a counterfactual. Here is my modest attempt at one and here is one by Barry Ritholtz. In both cases the economy would been a lot worse off without it.

So goodbye QE. It was good knowing you.

PS. Yes, the Fed's QE programs were flawed. They were very ad-hoc and designed in a way that would prevent them from restoring full employment. But again, the alternative may have been far worse.

Is the U.S. Treasury Department Undermining QE2?

According to Jim Hamilton, the answers is  yes.  He shows that the average maturity of publicly-held U.S. debt continues to grow despite the Fed's QE2 program.  This should not be the case.  Under QE2, the Fed is purposefully trying to lower the average maturity of Treasury securities for reasons that will be explained later.  The fact that the Fed is not shortening the average maturity means that the Treasury is issuing long-term debt faster than the Fed is buying it up.  Nonetheless, there is still evidence that that QE2 is having an effect on nominal and real expectations as seen here.  Thus, the U.S. Treasury Department has not completely thwarted the Fed's efforts, but it is surprising to see fiscal policy and monetary policy working against each other here.

So why does the average maturity of Treasury securities matter?  The standard answer is that if the Fed reduces the average maturity then there will be a drop in the net supply of long-term Treasuries.  This will cause their prices to go up and their yields to drop.  The drop in yields, in turn, would affect interest sensitive spending.  This interest rate effect, however, is only part of a bigger, richer story that gets overlooked.  This bigger story is how the shortening of the average maturity will lead to a rebalancing of assets in investors' portfolios and, in so doing, affect nominal spending.  This  rebalancing story is the portfolio balancing channel of monetary policy.  

  

The portfolio balancing story goes as follows.  Currently, short-term Treasury debt like T-bills are near-perfect substitutes for bank reserves because both earn close to zero percent and have similar liquidity.  In order for the Fed to get investors to spend some of their money holdings it must first cause a meaningful change in their portfolio of assets.  Swapping T-bills for bank reserves will not do it because they are practically the same now. In order to get traction, the Fed needs to swap assets that are not perfect substitutes.  In this case, the Fed has decided to buy less-liquid, higher-yielding, longer-term Treasury securities.  Doing so should lower the average maturity of publicly-held U.S. debt.  It should also overweight investor's portfolios with highly-liquid, lower-yielding assets and force investors to rebalance them.  In order to rebalance their portofolios, investors would start buying higher-yielding assets like stocks and capital.  This would ultimately drive up consumption spending--through the wealth effect--and investment spending.  The portfolio rebalancing, then, ultimately cause an increase in nominal spending.  Given the excess economic capacity, this rise in nominal spending should in turn raise real economic activity.

My description of the portfolio channel so far ignores the importance of expectations.  If the Fed could convince investors that it is committed to the objective of higher nominal spending and higher inflation (say through an  explicit  nominal GDP target) then much of the rebalancing could occur without the Fed actually buying the securities.  For if investors believe there will be a Fed-induced rise in nominal spending that will lead to higher real economic growth and thus higher real returns, they will on their own accord start  rebalancing their portfolios toward higher yielding assets. Likewise, if investors anticipate higher inflation, then the expected return to holding money assets declines and causes them to rebalance their portofolios toward higher yielding assets.  In other words, by properly shapping nominal expectations the Fed could get the market to do most of the heavy lifting itself. I believe this is why QE2 is still having some effect despite the Treasury working against it.

To put this portfolio rebalancing issue in perspective, it is useful to see how the combined portfolios of households and non-financial firms are weighted toward highly liquid assets.  Using the Flow of Fund data, the figure below shows for the combined balance sheets of households, non-profits, corporations, and non-corporate businesses the percent of total asset that are highly liquid ones (i.e. cash, checking accounts, saving and time deposits, and money market funds) as of 2010:Q3: (Click on figure to enlarge.)

Source

The figure shows that the spike in demand for liquid assets that began in the 2008 financial  crisis remains elevated through 2010:Q3.  This is why there is still an aggregate demand (AD) problem.  The nonfinancial private sector is still reluctant to spend its money holdings--there appears to still be an excess money demand problem.  The Fed' s job, then, is start a rebalancing of portfolios that is vigorous enough to bring the holdings of  money assets more into line with historical trends.  Once this happens the aggregate demand shortfall should disappear. 

P.S. It will be interesting to see what has happened to the above figure once 2010:Q4 data comes out.  Given the rise in inflation expectations and the improved economic outlook, we should see some meaningful adjustment to share of assets held as money.

About that Runaway Inflation The Fed is Creating

I am having a hard time finding it when I look to inflation expectations.  Here is the average annual expected inflation rate over the next five years implied the spread between nominal and real yields on treasury securities:

(Click on figure to enlarge.)

Note that most of the pick up in expected inflation occurs during October when Fed official were talking up QE2. Since then inflation expectations have not exploded but drifted around where they had been, around 1.6%.  It is also worth noting in this figure that inflation expectations were steadily heading down for most of the year.  QE2 has reversed that, but has yet to push inflation expectations up to the 2.0% value the Fed would like to see it. Contrary to the rhetoric, then, QE2 is not the great inflation creating machine some claim it is. And just to be clear, it is not inflation per se that the Fed or supporters of QE2 ultimately want.  What they really want is to increase aggregate spending.  Raising inflation expectations would do that as I explain here.  If only the Fed would adopt a nominal GDP level target many of these problems would dissappear. 

QE, Rising Yields, and the Right Way to Taper

Matthew O'Brien of The Atlantic gives us the 41 most important economic charts of 2013. The figures come from various contributors, including me. My figure is borrowed from chief economist Michael T. Darda of MKM Capital and shows that long-term treasury yields generally have risen under the QE programs. This pattern runs contrary to the stated objectives of the Fed and is also inconsistent with those who claim the Fed's large scale asset purchases (LSAPs) are draining the financial system of safe assets. Fortunately, there is a way to make sense of these developments.

The chart I borrowed from Darda came from a longer note that had other interesting charts and comments. I thought you might like seeing the rest of them, especially his thoughts on how to taper without tightening monetary policy. Here is Darda:

Most observers continue to (falsely) believe that QE works by lowering long rates and flattening the yield curve. However, a quick look at the data suggests this is not the case.

QE2 Will Not Usher in the Apocalypse

Though some folks would have you believe so.  It is far from perfect--it needs an explicit nominal target to make it truly effective--but it is a step in the right direction. Martin Wolf agrees:

The sky is falling, scream the hysterics: the Federal Reserve is pouring forth dollars in such quantities that they will soon be worthless. Nothing could be further from the truth. As in Japan, the policy known as “quantitative easing” is far more likely to prove ineffective than lethal. It is a leaky hose, not a monetary Noah’s Flood.

[...]

 The sky is not falling. But this does not mean the Fed’s policies are the best possible. It is probable that any impact on the yields on medium-term bonds will have a modest economic effect. It would be far better if the Fed could shift inflation expectations upwards, by issuing a commitment to offset a prolonged period of below-target inflation with one of above-target inflation.

In other words, Wolf believes QE2 may not pack a real economic punch in the absence of price level target.  Michael Woodford, William Dudley, Charles Evans, and  Paul Krugman agree with this assessment.  I too am a fan of level targeting (versus growth rate targeting), but would prefer to see it done by targeting some measure of aggregate spending such as final sales of domestic product or nominal GDP.  There are good reasons to favor an aggregate spending level target over a price level target, but either approach would bring the nominal economy closer to its trend and in turn spur real economic growth.  Unfortunately, though, the FOMC for some reason has chosen not to adopt a level target. This decision may amount to keeping the United Sates in economic purgatory.  So, rather than worrying about QE2 ushering in the apocalypse worry about it being much ado about nothing. 

The PIMCO Mystery

There is an interesting article on Bill Gross and PIMCO in The Atlantic.  It highlights PIMCO's decision to dump and then bet against U.S. treasury bonds.  According to Tyler Durden, the amounts involved are significant.  Bill Gross' explanation for these decisions is that the bond market is being artificially propped up by QE2 and once it ends so will bond prices. 

These decisions have me stumped.  First, Gross' view assumes that the flow of QE2 purchases is what matters to bond prices.  There are good reasons to think, however, that it is the stock of QE2 purchases that matter.  If so, there should be no bond market correction since the Fed is not planning to sell its newly-acquired assets anytime soon. Second, given the weak economic outlook the expected short-term interest rates going forward should remain low.  That in turn should translate into low long-term bond yields.  Finally, if PIMCO's view were correct would not the bond market be pricing it in already? The figure below gives no indication of the U.S. bond market bottoming out.  If anything, there is a downward trend in the long-term treasury yield since the start of the year.

Now Bill Gross and the folks at PIMCO are smart.  They saw the housing bust well in advance and have made lots of money over the past few decades. So when they place so big a bet against U.S. bonds it should give us pause.  Maybe they are bond vigilante harbingers. Or maybe they are wrong.  For now the bond market seems to be supporting the latter view. 

Musings on June's FOMC Meeting

The FOMC decided today to raise its target interest rate so that it now sits in the 1.00-1.25 percent range. This move was largely expected and the FOMC continues to signal via its economic projections that it wants one more interest rate hike this year. Nothing terribly new here, but there were several developments today that caught my attention and are worth considering.

First, the FOMC released a surprisingly detailed plan of how it will unwind its balance sheet later this year. Fed chair Janet Yellen also said during the press conference these plans could be "put in effect relatively soon" if the data come in as expected. The announcement today can be seen as part of the FOMC's ongoing efforts to get the markets ready for the shrinking of its balance sheet. 

To shed light on this development, recall that the main theory the Fed used to justify the the large scale asset purchases was the portfolio channel. It says the Fed's purchase of safe assets would force investors to rebalance their portfolios toward riskier assets. This rebalancing, in turn, would reduce risk premiums, lower long-term interest rates, and push up asset prices. In turn, these developments would support the recovery.

A key step in this story was the Fed reducing the relative supply of safe assets to the public. One way to see it is through the growth of the Fed's share of marketable treasury securities. This can be seen in the figure below. 

In addition to the QE programs, the figure reveals a rather striking development. Since about September 2014 the Fed's share of marketable treasury securities has been falling. This has been a passive development for the Fed--it has maintained a fixed level of treasury holdings while total government debt has grown--but it is effectively QE in reverse. Per the portfolio channel, this reverse QE should have caused long-term treasury yields to rise. Instead, they have more or less been falling over this period:

Put differently, the Fed has been effectively shrinking its balance sheet for several years now and it has been much ado about nothing. Whatever influence QE had, its seems to be dwarfed by other economic forces driving long-term treasury yields.

It should not be surprising, then, that the Fed's announcement today about how it plans to shrink its balance sheet and Janet Yellen's follow-up comments did not create another taper tantrum. Yes, the Fed has been conditioning the market for the eventual reduction for several months, but maybe the bigger story here is that QE really did not have that big of an effect on interest rates and the recovery in the first place. Jim Hamilton reaches a similar conclusion:

[T]oday’s evidence seems to reinforce the conclusion that many have drawn about the effects of the Fed’s large-scale asset purchases–whatever effects these may have had on long-term interest rates were likely less important than other fundamentals. That appeared to be the case on the way to building up the Fed’s balance sheet, and so far appears to be the case in the long process of bringing the balance sheet back down.

To be clear, QE1 probably had a meaningful effect since it was applied in the midst of the financial crisis. However, I am becoming less convinced that QE2 and QE3 mattered much except for signaling purposes. As I have written elsewhere, the fundamental flaw with these programs was that they were beholden to the Fed's desire for rigidly low inflation and therefore consigned to be temporary monetary injections. Which leads me to the other development that really caught my attention.

Second, during the FOMC press conference, Fed chair Janet Yellen once again attributed the unexpectedly low inflation in recent months to one-off events.  She specifically attributed the below-target inflation to lower prices for cell phones and pharmaceutical. Here was my real-time response on twitter:

Yep, either the Fed is the most unlucky institution in the world or the Fed has a problem. I think the latter. The Fed appears to have begun having a problem with 2 percent inflation around the time of the Great Recession. This can be seen in the FOMC's summary of economic projections (SEPs) figure below. It shows for each FOMC meeting where SEPs were provided to the public the central tendency forecast of the core PCE inflation rate over the next year. The horizon for these forecasts depend on the time of the year they were released and range from one year to almost two years out. The forecast horizons are long enough, in other words, for the FOMC to have meaningful influence on the inflation rate.

The figure shows that since 2008, the FOMC has consistently forecasted at most 2 percent inflation. Note that The FOMC’s description of the SEP states (emphasis added) “Each participant's projections are based on his or her assessment of appropriate monetary policy. Longer-run projections represent each participant's assessment of the rate to which each variable would be expected to converge under appropriate monetary policy…” As former FOMC member Naranaya Kocherlakota notes, this means the projections reflect what members think inflation should be if they had complete control over monetary policy over the forecast horizon. It reveals their preferences for the future path of monetary policy. Consequently, the central tendency of FOMC members since 2008 indicates that they see the optimal inflation rate not at 2 percent, but at a range between 1 and 2  percent. 

The actual performance of the Fed's preferred inflation measure, the PCE deflator, has been consistent with this view. It has averaged about 1.5 percent since the recovery started in mid-2009. That is a revealed preference, not a series of accidents caused by bad  luck.

To be clear,  the Fed has only been explicitly targeting inflation at 2 percent since 2012, but many studies have shown it to be implicitly doing so since the 1990s. So this truly has been an eight-year plus problem for the Fed and one that makes Janet Yellen's remarks all the more disappointing to hear. One would think after almost a decade of undershooting 2 percent inflation there might be an acknowledgement from the FOMC like the one that came from Minneapolis Fed President Neel Kashkari (my bold):

[O]ver the past five years, 100 percent of the medium-term inflation forecasts (midpoints) in the FOMC’s Summary of Economic Projections have been too high: We keep predicting that inflation is around the corner. How can one explain the FOMC repeatedly making these one-sided errors? One-sided errors are indeed rational if the consequences are asymmetric. For example, if you are driving down the highway alongside a cliff, you will err by steering away from the cliff, because even one error in the other direction will cause you to fly over the cliff. In a monetary policy context, I believe the FOMC is doing the same thing: Based on our actions rather than our words, we are treating 2 percent as a ceiling rather than a target. I am not necessarily opposed to having an inflation ceiling...  I am opposed to stating we have a target but then behaving as though it were a ceiling.

It is time for the FOMC to come clean on what it really wants to do with inflation. Until it does so continue to expect confusion and  repeated questions to Fed officials over the Fed's inflation target.