Standard Financial Models Wouldn’t Predict That Yields Would Spike After End of QE3
When it helped his cause, Krugman understood the stock/flow distinction and why you wouldn’t think the well-anticipated end of asset purchases would cause a sudden change in market price. Yet that didn’t stop Krugman from arguing recently that Treasury yields since the end of QE3 must mean Fed hasn’t been holding down yields.
I walk through the evidence and logic in my latest Mises CA. Then I end with this analogy that I hope will make it perfectly obvious:
Suppose the central banks around the world announced, “We have been reading a lot of Mises lately and so during the course of 2015, we are going to smoothly replace all of our bond holdings with gold, while maintaining the total market value of our balance sheets. Then we will stop our net purchases of gold in December 2015, and maintain our balance sheet’s market value from that point forward, adjusting our holdings of gold accordingly.”
Would it be reasonable to assume that these actions by the central banks would push up the world price of gold, higher than it otherwise would have been? I hope we can agree that would be a reasonable view.
Now the trickier questions: Would the world price of gold respond immediately to the news, or would it spike only when the central banks actually started buying gold on January 2?
Finally, would the world price of gold suddenly crash in December 2015 when the net purchases stopped, and go back to whatever it would have been in the absence of the purchases? Or might it permanently prop up the world price of gold (relative to the counterfactual) if central banks held several trillions of dollars worth of more gold?
I think Krugman gets off on a technicality. He says:
“For years those of us pointing to low interest rates as evidence that fiscal scolds were all wrong met, over and over again, one stock answer: those low rates were meaningless, because the Fed was buying up government bonds and keeping rates artificially low.”.
So in this quote he is only pointing out that those who think the buying was causing low rates were proven wrong , as rates stayed low even when when the buying stopped. He says nothing about stocks here and the fact that he thinks that the existence of a large stock of bonds on the CBs books would keep their price up irrespective of the slow in the flow of purchases is therefore irrelevant here.
Transformer, if you’re right, that means Krugman could actually believe that the QE programs made Treasury yields 2% rather than 4%, and (if your defense goes through) he still could have written those same sentences. Do you really want to go to the barricades on that?
I.e. you’re drawing a big distinction between these two possible statements by the fiscal scolds:
(1) “those low rates were meaningless, because the Fed was buying up government bonds and keeping rates artificially low”
(2) “those low rates were meaningless, because the Fed was buying up government bonds according to the schedule it had announced and wasn’t giving any hints that it would dump the bonds when the program ended, hence keeping rates artificially low”
I was just looking at the literal meaning of the words written. They are definitely consistent with (1) – which only relates to flows and does not mention stocks.
It is possible that Krugman implicitly meant to attribute (2) to the scolds , but he doesn’t actually say that – which is why I said he gets off on a technicality.
Also, Krugman goes on to say after the the bit you quote as (1) – “There was a big logical problem with that story: How can the Fed do that without causing inflation? “. The “story” is clearly the fed buying program (the flow) not the large number of bonds on the Feds balance sheet (the stock). His comments do seem to be about flow not stock.
I do agree though that if Krugman thinks it is stocks not flow are are relevant to interest rates then its a bit disingenuous to then say : “Maybe rates weren’t artificially low, after all?”, after a discussion that seems to ignore stocks. He really should have said “We can’t tell if rates were artificially low, after all, just by looking at flows”.
“Transformer, if you’re right, that means Krugman could actually believe that the QE programs made Treasury yields 2% rather than 4%, and (if your defense goes through) he still could have written those same sentences. Do you really want to go to the barricades on that?”
I wouldn’t go to the barricades on it, but as Krugman says “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.” .it does seem consistent that he would be criticizing only (1) and not (2).
Where’s monopoly theory when you need it?
I have three observations on this issue:
1) QE3 ended in terms of creating new money to buy bonds, but the bond interest earned will be reinvested by purchasing bonds. This guarantees a continued flow of money, albeit at a slower rate.
2) The target rate didn’t change. The FOMC announcement stated that the Fed might maintain that low rate for the next 1-2 years. A bond investor might reasonably think that, if rates started to increase, the Fed might take action to keep the rates where they are. That’s standard open market operations, whether or not it’s labelled QE.
3) In finance, we have found that pretty much all the price action occurs around announcement dates, not when the activity actually takes place. The only disruption to this pattern is if something unexpected occurs – a surprise. Financial markets don’t like surprises.
Imagine all records of past prices disappeared from existence, and imagine every last human being on Earth suddenly forgetting what past prices have been.
Now imagine people want to buy and sell. Before buying and selling though, imagine that everyone had a Matdix-like neural-direct learning program on what prices are, and why they have money. Imagine all required learning of the price system and takes place so that the only thing people have to do so go out and set bid and ask prices.
The weak form of the EMH states that future prices cannot be predicted based on past prices. In other words, knowledge of past prices should have no effect on future prices. This of course implies that a lack of knowledge of past prices should also not have any effect on future prices.
The weak form of EMH therefore predicts that today’s prices should be unaffected by yesterday’s mass amnesia event (assuming for simplicity no quicker than daily adjusting prices).
Now I don’t know about you, but I think it is reasonable to assume that the probability of today’s prices being unaffected by yesterday’s mass amnesia event is practically nil. Why? Because how would I even begin to form a first estimate of a fair price for anything? I have no memory of even my own labor rate. My employer has no memory either. Nobody has any knowledge of what prices used to be the day before. Should I sell a loaf of bread for $100? Or maybe $5.00? $3.45? $1.00? I could try to set a price that I think makes sense to me, but what are the chances I would set the same price I set the day before I forgot? The probability for just me is low enough, practically zero chance. Now imagine 7 billion people. The probability that the sum total of all prices goes unaffected would be so low it makes no reasonable sense to even assume it is possible in a billion lifetimes of the universe.
Not even the weak form of EMH is reasonable. Past prices are indeed a positive, significant factor of today’s prices. Going to Murphy’s post, I think Mises’ lesson about prices existing today because of a valuation and hence knowledge and hence a causal effect in today’s prices, is the correct theory. So if the Fed bought ANYTHING, it will have had a positive influence in all future prices! Price formation is in fact a path dependent process.
Just ask what price of money you would set next year if the government told you, and it was credible, and true, that it will get out of money altogether next year. Are we supposed to believe that we will set the same prices compared to if the history of the world was free market in money? Not a chance!
The above analysis reveals an even more troubling aspect of government intervention into prices. Even if it got out of a market, say treasuries, or stocks, after having interfered for so long, it will have already partially destroyed our ability to set “efficient” prices once they get out. And the longer it is interfering, the longer people will have to go without all the fruitful history of past market prices to serve as a guidepost!
The government literally destroys knowledge that ONLY a market makes possible.
So to take a stab at your question Murphy, I think even if the Fed got into the gold market, as it has, then there can be no question of the Fed not affecting future prices…even if it eventually got out of the gold market.
Let us expand the point. In what markets have governments been interfering the most, and for the longest? Security and protection of course! Without any knowledge of past market prices of security and protection, we are literally incapable of setting “efficient” prices for protection tomorrow if suddenly the world’s governments collapsed. But only a free market in protection can give us that first set of security and protection prices out of which our knowledge of past prices progresses, and thus provides a guidepost for future prices also conditioned by expectations. We literally cannot know what prices should be for security and protection unless we first legalize, I.e. first abolish governments. Private property is more fundamental than knowledge of prices. Mises over Hayek on that one.
“Now I don’t know about you, but I think it is reasonable to assume that the probability of today’s prices being unaffected by yesterday’s mass amnesia event is practically nil. Why? Because how would I even begin to form a first estimate of a fair price for anything?”
Remember that there’s no such thing as a fair price. All you’re doing when you trade is observing what other people do for themselves and then, if you’re an individual who can supply the means for which they’re looking, and at an opportunity cost that you rank lower than your highest ranked preference, then you can make a profit by trading.
And since there’s no value in trading away something for less than what others are willing to offer, you should be trying to get as much as you can out of every trade.
Economic calculation would still be entirely possible without past prices. As long as no one interfered with voluntary trade, a lengthening of the capital structure, and the emergence of money from barter would take place in relatively short order (knowledge of existing technology still exists in your scenario).
Agreed.
You are talking about the difference between equilibrium and kinetics I think (from a chemists perspective). I think you mean that the prices would not instantaneously adjust. It would take in practice more than a day to reach equilibrium. But I would also think that you would believe there was an equilibrium position. That is, there is some value of prices where everybody gets optimum value.
To this extent, weak EMH just says that the amnesia should have no effect on what I am calling the equilibrium price. The prices would be affected, but that is a kinetic effect – it takes longer to find out what things are worth than the 1 day price change frequency.
In contrast, what would happen if everyone forgot the price of just one thing. You say bread in your example. If everyone forgot how much bread cost, would the new price very quickly re-establish at the old level? I think it probably would.
Pretty sure EMH pertains to actual prices, not “fair/equilibrium” prices, which requires choosing a pricing model and rejecting all others.
I agree though with your point about amnesia over a single good, like bread. It would be an instance of effectively solving for one unknown given a bazillion knowns, such as constraints to endowments. I mean that rhetorically, not literally.
QE not only lowers interest rates, but also raises interest rates by increasing economic stimulus. That is why QE is a terrific tool. The real question is, will just Fed go to QE early enough in advance of the next recession, rather than wait for a recession and then use QE?
Why is real question not “How much future pain do we have to endure from QE to have more short term unsustainable production and employment?”
You speak as if inflation is not the cause of the recession you believe inflation is suited to deal with.
As long as it’s small enough, its effect on rates is much larger than its effect on NGDP.