04 Jun 2011

The End of QE2 and Interest Rates

Economics, Federal Reserve, Krugman 20 Comments

Hmm another Krugman Kontradiction? Possibly, though if so, not as bad as some of the others I’ve documented. When (understandably) running a victory lap recently about his predictions on US interest rates compared to the deficit hawks, Krugman said that they came up with a bunch of ad hoc explanations after the fact, for why their predictions of crowding out etc. were so wrong:

The apologists offer a series of special explanations; it was the Greek debt crisis driving investors into the dollar safe haven; it’s the Fed’s purchases; whatever. We’ll [see] what happens when the latter end at the end of this month, by the way.

Now just read that a couple of times. It seems to me that Krugman is arguing, “At the end of this month, QE2 will end, and I bet you interest rates don’t zoom up. So that will be one less excuse that the deficit hawks can use to wipe the egg off their faces.”

And yet, even if you thought Fed purchases of bonds drove down interest rates, you wouldn’t necessarily think that the end of QE2 would make them zoom back up. Apparently, there is a whole school of respectable economic thought that says the stock of Fed purchases matters, not the flow. You know who explained this the best to me? Paul Krugman, back in April:

I’ve been getting questions about what happens when the Fed wraps up QE2 — related especially to Bill Gross’s public view that interest rates will shoot up. This is related to the question of the extent to which QE2 has kept interest rates low. So a quick exposition of my theoretical position, which also happens to be more or less standard economics.

So: I basically think of asset prices in a Tobin-type stock equilibrium framework (pdf). People make portfolio choices, allocating their wealth among bonds, stocks, etc.. Asset prices – including the famous “q” – rise and fall to match these portfolio choices to the actual asset supplies.

On this view asset purchases matter because over time they change the stocks of assets available : by buying long term federal debt, the Fed takes some of that debt off the market, and hence drives up the price of what’s left, reducing interest rates. The flow – the rate of purchases – matters only to the extent that it affects expected returns.

On this view, the fact that the Fed is currently buying some large fraction of debt issuance is irrelevant; interest rates are determined by the willingness at the margin of private investors to hold the existing stock of debt, regardless.

I’d also add that if flows matter a lot — if it’s hard to persuade investors to buy a suddenly increased quantity of newly issued Treasuries per month, as opposed to being willing to hold the total amount of Treasuries outstanding — the big shift into budget deficits and the corresponding increase in Treasury issuance should have led to sharply rising interest rates. And as you may recall, some people did predict just that — and ended up not just with egg on their faces, but losing a lot of money for their investors.

So I don’t buy the notion that rates are low only because the Fed is doing QE2; if there were really a problem with the marketability of US debt, rates would be high regardless. And so I don’t expect rates to spike when QE2 ends unless there’s good economic news that gives us a reason to believe that the zero-rate policy on short-term rates will end sooner than expected.

I’ve included the full discussion to be fair to Krugman; his underlying position here has been consistent: He doesn’t think QE2 is a big reason for low interest rates. However, I’m pretty sure there are economists out there who think QE2 (and QE1) did push down interest rates–after all, that was one of the original justifications I heard for QE1. To wit: “We can’t push down short-term rates any more, because we’ve hit the zero lower bound. So the Fed should buy longer-term Treasuries to push down yields further out on the curve.”

(Note that this gets really nuanced really quickly. There are a lot of people–especially the quasi-monetarists–who have argued that a successful QE program would raise interest rates, as people start expecting stronger economic growth.)

So my point here is this: Somebody who believed in the original, standard justification for QE1 and QE2, could think that Treasury yields would be significantly higher if the Fed dumped its holdings next week. At the same time, such a person could think that yields wouldn’t zoom upward, just because the Fed stops adding to its stockpile at the end of June. And the reason for this view is the whole stock/flow analysis Krugman described above.

Last point: Am I missing something? I don’t see that there is a huge distinction between the stock/flow approach. Suppose Batman and Robin are tied up by the Joker’s goons, and are standing in a pool that’s being filled with water. Robin says, “Holy suffocation, Batman, that flow is pretty fast. We’re goners if you can’t reach your acid pack!” But Batman says, “Easy there, chum. Our impending death is no reason for imprecision. The flow of the water is irrelevant. It’s when the depth of the water equals our noses, that we need to panic.”

20 Responses to “The End of QE2 and Interest Rates”

  1. Scott says:

    This stuff is getting all so weird.

    Suppose the FED really did dump its holdings next week. Might not interest rates fall due to recession and deflation? Makes sense to me.

    Doesn’t seem to matter what the FED does. So long as it does anything, it lowers rates.

  2. John Becker says:

    The treasury market makes no sense to me at all. The US passes the debt ceiling and can’t agree to cut spending or raise the ceiling and interest rates….plummet? I smell a rat. I’d be really curious to hear what Bob thinks is driving this. Is it the Fed and China, or are a lot of people anticipating deflation? It doesn’t make sense for a country with this much debt and no way to pay it off to be able to borrow at 2.95%.

    • MamMoTh says:

      It makes no sense to keep thinking that a country that can pay for whatever it wants needs to borrow its own money, and that the market should determine the price at which it borrows.

      • John says:

        What I was saying was that it doesn’t make sense for the market to price the bonds so high/put interest rates so low. Interest rates should have some connection to the ability to pay the loan back and get a return above the level of inflation, as well as time preference of course. None of those three factors appear to adequately explain the current rates.

        • Blackadder says:

          John,

          Perhaps the reluctance to raise the debt ceiling indicates larger spending cuts down the line than what you would expect if congress had raised the ceiling without a fuss.

          • John says:

            Interesting point, but if you were a gambling man, what would you say are the odds of the government cutting a significant amount say greater than $250 billion per year for the next year, or running a surplus in the next 15 years? I think it would be great if they did but I don’t think anyone sees serious spending reductions in the near future without a default.

  3. Tel says:

    If QE1 and QE2 had no effect on interest rates, what was the point? Is Krugman still clinging to the idea that QE is somehow different to money printing?

    On this view, the fact that the Fed is currently buying some large fraction of debt issuance is irrelevant; interest rates are determined by the willingness at the margin of private investors to hold the existing stock of debt, regardless.

    Well duh! The margin moves.

    Suppose it was houses, and not treasuries. So some guy is out there (for God knows what reason) building houses like a man posessed, and sells new houses to the highest bidder. There’s an existing stock of houses, and an existing stock of people wanting houses. As new houses come on the market, some are bought by renters who figure they would be happier owning a home, some are bought by speculators hoping to rent them out or on-sell them.

    As the stock of houses gets significantly bigger than the stock of buyers, the margin shifts to different potential buyers — all the people who previously wanted to buy a house, now have bought one thank you very much. This new round of buyers is less interested so they won’t be tempted until the price falls (which it must).

    Some massive institutional investor starts slurping up every vacant house around, just to keep them vacant… yeah that’s going to drive the price back up.

    Back in the real world, Greece is looking like a mess. The Euro and the USD are in a race to the bottom. I can see some grains of wisdom in Bernanke devaluing the USD at a controlled rate to spread the pain, while I kind of suspect that the rigid structure of the Euro is going to result in a step-function default situation where it just snaps rather than bending.

    Easy there, chum. Our impending death is no reason for imprecision. The flow of the water is irrelevant. It’s when the depth of the water equals our noses, that we need to panic.

    It’s impossible to read that without putting on the Adam West and Burt Ward voices.

    What would happen is that the flow of water would slow down at the last moment and then stop completely… with the level staying just half an inch above their noses. They call him Joker for a reason you know.

    This reminds me of the old joke about how to fall off a tall building and live… You do nothing at all almost all the way down. When you get to within a few feet off the ground you can safely jump down from there.

  4. AP Lerner says:

    About the only positive aspect of the policy known as QE is it has exposed how little academic economists ( especially Austrian economists) understand about basic banking and monetary operations.

    Basic rule of thumb: if an economist labels QE simply as money printing and believes the goal of QE was to lower interest rates, they do not understand monetary operations.

    If the point of QE was to lower long term rates, then why doesn’t the Fed just guarantee a certain rate along the curve, just like they do w/ the overnight rate? Even Beranke, if you actually pay attention to what he is saying, explains the point of QE is to create a wealth effect by artificially keeping asset prices to stimulate credit growth. It’s a horrible policy, but for none of the reasons stated on this blog.

    So when the Fed stops buying, assuming the economy remains weak and inflation expectations low, rates will remain low. The level of rates has nothing to do with china, the Fed, or QE. Risk assets will fall (already are) since the portfolio rebalancing trade will unwind. Rates will remain well bid, and are in high Demand

    • John Becker says:

      Fair enough but how do you explain the solid performance of commodities if the economy is weak and inflation expectations are low? It sounds like your using standard Phillip’s curve reasoning when if you look at statistics of worldwide economies, there’s no significant relationship between inflation and unemployment.

    • Bob Roddis says:

      If the purpose of QE is to keep asset prices high, isn’t that a form of inflation at least in this sector? Isn’t it just another form of masking the equilibrium price that would obtain absent funny money dilution and government debt/spending?

      We’re trying hard to understand what you are saying. You should work as hard trying to understand what we’re saying.

    • bobmurphy says:

      AP, I am genuinely open to your views on banking. I’ve told you before that even some Austrian insiders (with experience in banking) have told me that the textbook economist story isn’t right (about how excess reserves lead to more loans etc.). But when you say stuff like the above, it really takes my enthusiasm away.

      Look: What you said is entirely consistent with my post. I said that a lot of economists said the original justification for QE was to lower long-term interest rates. Then, to “blow me up,” you complain that a lot of economists think the purpose of QE was to lower long-term rates.

      You mention that an alternate explanation involves other mechanisms, having nothing to do with interest rate reductions. You’ll get no argument from me, since I said the exact same thing in the post above.

      • Major_Freedom says:

        AP Lerner is being contrary for the sake of being contrary. You’re an Austrian, ergo you’re wrong, even when you’re right.

      • Gene Callahan says:

        Bob, he was responding to Tel, it seems to me.

    • Major_Freedom says:

      >>Basic rule of thumb: if an economist labels QE simply as money printing and believes the goal of QE was to lower interest rates, they do not understand monetary operations.

      The reason the Fed bought long term bonds as opposed to short term bonds was because short term rates were already at near zero. They bought long term bonds to hold long term rates down.

      If they did not want to lower long term rates, then they would have just kept buying short term bonds.

      >>If the point of QE was to lower long term rates, then why doesn’t the Fed just guarantee a certain rate along the curve, just like they do w/ the overnight rate?

      You are arguing from your own ignorance. You obviously don’t understand the reason for why the Fed would buy long term bonds, so you take your ignorance on the matter and use it as a premise to try and refute those who do hold that it was to lower long term rates. You did not give an actual positive reason.

      >>Even Beranke, if you actually pay attention to what he is saying, explains the point of QE is to create a wealth effect by artificially keeping asset prices to stimulate credit growth.

      Artificially keeping asset prices…..what exactly?

      >>The level of rates has nothing to do with china, the Fed, or QE.

      Hahahaha, yeah, because the Fed doesn’t target interest rates.

      >>Risk assets will fall (already are) since the portfolio rebalancing trade will unwind. Rates will remain well bid, and are in high Demand.

      They are in higher demand because the bond market knows it can flip the bonds they buy right back to the Fed.

      • MamMoTh says:

        Maybe the Fed intended to, but if they wanted to lower long term rates they should have targeted price and not quantity.

      • Gene Callahan says:

        “Artificially keeping asset prices…..what exactly?”

        It’s pretty obvious he just forgot to type “high.”

  5. Bob Roddis says:

    Slightly off topic. Over at Bill Anderson’s blog, someone named Django found a Krugman quote from a few days after the Obama election:

    All indications are that the new administration will offer a major stimulus package. My own back-of-the-envelope calculations say that the package should be huge, on the order of $600 billion.

    So the question becomes, will the Obama people dare to propose something on that scale?

    Let’s hope that the answer to that question is yes, that the new administration will indeed be that daring. For we’re now in a situation where it would be very dangerous to give in to conventional notions of prudence.

    http://krugman-in-wonderland.blogspot.com/2011/06/who-is-to-blame-for-coming-downturn.html

    I just love that phrase “conventional notions of prudence“, if only to differentiate it from Keynesian “unconventional, irrational, irresponsible and preposterous notions of waste, theft and indulgence”.

  6. Aristos says:

    Your last paragraph is genius.

  7. flow5 says:

    The effect of taking Treasury’s off the market (600b out of the 2011’s estimated 1.48t deficit – 41%) is understated. This is especially true since QE2 created new IBDDs remunerated past the 1 year yield curve mark. I.e., IOeRs induced dis-intermediation among the non-banks (e.g., MMMFs), decreasing the available supply of loan-funds.

    Deficits obviously generate a net increase in the demand for loan-funds; the larger the deficit, the greater the demand. That doesn’t necessarily mean interest rates will be higher. But if they are not higher, the only other conclusion is that QE2 keep interest rates lower than they would be in the absence of these purchases.

    • Yancey Ward says:

      IOeRs is interest on reserves?

      It took me a while to find it again, but does this paper below, recently put out by the New York Fed, basically reflect your view? I thought about putting your first paragraph into Google Translate, but figured it would be better to just ask.

      http://www.newyorkfed.org/research/staff_reports/sr497.pdf