The first chart plots nominal yields on U.S. Treasuries since September 1 to the present. Seems like there has been a significant increase in nominal yields since QE2 was announced at the November 2-3 FOMC meeting. 5-year notes are up 63bp and 30-year notes are up 30bp.
Now, I know what some of you might be thinking. First, you might be thinking how it is possible that these yields are rising when QE2 was expressly designed to bring these rates down. Well, as Minneapolis Fed president Narayana Kocherlakota explains here, the idea was to lower the long-run real interest rate; i.e., the nominal interest rate net of expected inflation. For this to be true, the nominal rate increases above should be consistent with declines in the real interest rate; and to ascertain this, we need a measure of inflation expectations.
The following chart plots a market-based measure of inflation expectations (the so-called, TIPS spreads--cheesy tutorial available here).
What we see in the chart above is that since QE2 was announced, inflation expectations have moved up by less than the rise in nominal interest rates. What this means is that long-term real interest rates appear to have increased since QE2 was announced in early November. Interestingly, many of my banker friends tell me that this is good news (too much rum in the eggnog, no doubt).
How does one make sense out of all this? Well, here is one story. Evidently (so I am told), the desired impact of QE2 may have manifested itself largely in the period leading up to its official announcement. It is true that the market was widely expecting some sort of quantitative easing. And nominal rates did largely decline, or remain roughly stable, in between FOMC meetings. At the same time, inflation expectations started to rise significantly, having the desired effect of lowering long-term real interest rates. Fed types like to think that this action has stimulated the U.S. economy (certainly, the stock market does not appear to be complaining).
Since early November, nominal rates are climbing higher...with inflation expectations remaining more or less stable (well...some measures do appear to be creeping up). So long term real interest rates appear to be rising. And this, evidently, is a bullish signal, since long-run real rates largely reflect expectations of real growth in the future. Of course, whether the Fed's QE2 policies actually had anything to do with these higher future real rates is debatable. But in any case, it's something to mull over. Pass that eggnog!
David:
ReplyDeleteI agree your conclusion that rising nominal yields may be a sign of recovery and have made the same case here, here, and here. Given this understanding, I have been frustrated with the marketing of QE2 by the Fed--including Bernanke--that it is all about driving down long-term interest rates. This marketing is making the wrong impression that QE2 success is dependent on the Fed keeping long-term interest rates low for a sustained period. Thus, many critics point to the rising nominal yields as evidence that the Fed is failing. But as you note above, rising yields may be a sign that QE2 is actually working.
Yep.
ReplyDeleteAnd rising *real* yields may also be a sign that expected real GDP growth is rising.
As David Beckworth, Scott Sumner, me, and others keep repeating (after Friedman), nominal interest rates are a very poor measure of the tightness/looseness of monetary policy. If we want to use an interest rate, it should be the gap between the nominal rate and (the natural rate plus expected inflation). Expected real GDP growth might be a (poor) proxy for the natural rate, following an Euler equation approach.
Let me jump on the bandwagon of people who have blogged about this issue. In this post I argued that the Fed only needs to make a "credible threat" to lower interest rates, and if the threat is believed, then rates may be stable or even rise. QE2 amounts to credible threat: it says to investors, "Y'all better get a recovery going, or this will have the effect of reducing your future returns." If they respond to the threat as intended, then it doesn't need to be carried out -- and in the case of QE, it automatically doesn't get carried out.
ReplyDeleteUrrr. I just belatedly noticed the original post made the point about real growth. Sorry. (It was early morning).
ReplyDeleteAndy's way of talking about credible threats is good. Still not the exact perfect analogy though. Because the threat, if credible, leads to an action in the exact opposite direction to what would happen if you carried out the threat. I can't think of a perfect analogy.
Oh yes, suppose you hooked up the power steering on a car the wrong way around (one of my commenters said he had actually done this!). You try to turn the wheel left, and the PS kicks in, overpowers your hands, and turns the wheel right.
David Beckworth: Yeah, you make good points, I think. As do Andy and Nick. Let me mull this over a bit.
ReplyDeleteBy the way, I presume that none of you subscribe to the proposition that long-term real rates appear to be rising for reasons quite independent of monetary policy?
David,
ReplyDeleteI'll take the bait and offer another interpretation, from some banker friends who don't think it's bullish.
Another story is that real rates were bid down in anticipation of a size of QE2 of over a trillion dollars. When the actual number came out at half of what was expected real rates went right back up.
That said though, I suspect that you think that long-term real rates may be rising for reasons entirely unrelated to monetary policy.
I also suspect, though can't admit (even to myself), that I agree with you.
The rise in rates over the past few days has been primarily a fiscal policy issue, and much of the earlier rise was the result of positive economic news that was probably not primarily the result of QE2. As we old-fashioned types say, there was an exogenous shift in the IS curve, but QE2 also served both to move along the curve and to shift it. (I guess I can't continue being too old-fashioned, since AFAIK monetary policy doesn't shift the IS curve in the original Hicks model. You have to throw in some expectation effects and maybe some sunspots.)
ReplyDeleteI'm puzzling about the analogy here. I think my "credible threat" is in some sense literally true, although "threat" is not the word one usually uses. But if you want to get in the paradoxical aspect, think of it like a union's threat to strike, and take members' income as analogous to interest rates. If the threat is carried out, their income goes down (at least temporarily). If the threat is successful, their income goes up.
"By the way, I presume that none of you subscribe to the proposition that long-term real rates appear to be rising for reasons quite independent of monetary policy?"
ReplyDeleteA very real possibility of multiple sovereign defaults.
Re: inflation expectations. Why is the TIPS spread the go-to indicator for such expectations? It measures expected "CPI" inflation, but it doesn't measure expected "asset price" inflation. The modern westerner doesn't race off to buy apples/furniture/stoves when the currency is expected to be debased, they buy stocks and commodities. So while the TIPS spread is flat since Nov 3, both S&P and gold futures have broken to new highs. In my books that's a pretty good indicator of growing inflation expectations.
To bring down interest rates we need to bring down inflation, which we all know to be a function of expected inflation. There are a lot of fears about inflation in the mid-term future and this is causing a spike in gold prices, among others. It's interesting that QE is trying to bring down interest rates but at the same time could potentially be stoking fears about inflation and thus be pushing interest rates up.
ReplyDeleteDavid Andolfatto can be a real pinhead at times.
ReplyDelete