20 Mar 2009

Fed’s Long-Term Bond Purchases: I Learn From Krugman

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This is one of the few times on this blog where I’m not being sarcastic. Krugman actually makes some really good points in this blog post (HT2 Brad DeLong).

Anyway, Krugman’s post is worth reading if for nothing else than this: “I think quantitative easing (it’s really qualitative easing, but I give up on trying to fix the terminology) is the right way to go.” Thank you Dr. Krugman! I have been wondering what in the heck quantitative easing could even mean. (It’s not like the Fed used to cut interest rates from funny to amusing, but now they are cutting them from 2% to 1%.)

But Krugman also makes the important observation that the Fed will lose money if there is indeed a Treasury bubble. And that means that even if he wanted to, Bernanke couldn’t merely “unwind” his terrifying pumping up of the Fed’s balance sheet in order to withdraw all of the new reserves from the system. As Krugman says:

But here’s the rub: if and when the economy recovers, it’s likely that long-term interest rates will rise, especially if the Fed’s current policy is successful in bringing them down. Suppose that the Fed has bought a bunch of 10-year bonds at 2.5% interest, and that by the time the Fed wants to shrink the money supply again the interest rate has risen to 5 or 6 percent, where it was before the crisis. Then the price of those bonds will have dropped significantly.

And this also means that selling the bonds at market prices won’t be enough to withdraw all the money now being created. So the Fed will have to sell additional assets; if the rise in interest rates is at all significant, it will have to get those assets from the Treasury. So the Fed is, implicitly, engaged in a deficit spending policy right now.

My back of the envelope calculation looks like this: if the Fed buys $1 trillion of 10-year bonds at 2.5%, and has to sell those bonds in an environment where the market demands a yield to maturity of more than 5%, it will take around a $200 billion loss.

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