Wednesday, November 28, 2012

Would rates be higher if the Fed hadn't done QE?

I heard some funny discussion recently between two, typically out of paradigm folks on what would happen to interest rates if the Fed didn't conduct QE. One said that rates would be lower because there wouldn't have been "stimulus." The other said rates would have been higher because the Fed was the principal buyer of the government's paper and without that buying rates would have shot up.

First, it's important to understand that QE is just another monetary policy tool and these tools are all designed, or I should say, capable, of doing only one thing and that is change an interest rate somewhere along the term structure. In so doing the Fed changes the composition and duration of the financial assets held by the public. It's not stimulus, it doesn't enable gov't spending and it's not money printing. These are asset swaps, that's it, pure and simple.

We also know that a currency issuing government, like the U.S. Federal Government, spends by electronically crediting bank accounts and there is no constraint on its ability to do this other than the occassional political constraint, like when we have to go through these ridiculous debt ceiling shenanigans every now and then. Furthermore we know that when the government spends it adds to the level of bank reserves in the system and this accumulation of reserves causes the Fed to engage in monetary operations on a fairly regular basis (like, daily) to maintain reserves at a level that is consistent with whatever target interest rate they have decided upon. If the Fed were to allow reserves to build and build and build as a normal consequence of ongoing gov't spending, then the overnight lending rate (Fed Funds) would quickly fall to zero and all other rates out along the term structure would follow suit.

So the fact of the matter is the Fed has to work quite hard to KEEP RATES FROM FALLING TO ZERO ON THEIR OWN if the banking system were just left alone without its intervention. Those who say the Fed is keeping rates "artificially low" have got it backward. On the contrary, high rates or rising rates for a currency issuing nation are artificial.

The notion that rates would have been higher if the Fed had not done QE is false. Nor can one say thay rates would be lower absent QE because there "wouldn't have been any stimulus." That's patently absurd. QE simply was the Fed's way of reducing the rate on some specific instrument (mortgages, longer dated Treasuries, etc.) in the hopes that such a move would have some desired effect on the economy, despite the fact that the causal relationship there is spurious.

11 comments:

frlbane said...

Those who say the Fed is keeping rates "artificially low" have got it backward. On the contrary, high rates or rising rates for a currency issuing nation are artificial. Mike Norman

Because the banks have a government enforced fiat storage and transaction monopoly (via government deposit insurance and a legal tender lender of last resort) they have far less need for reserves than they otherwise would have, no? So aren't reserve drains just pushing up artificially suppressed interest rates on reserves? One government intervention to counter the ill effects of another? In other words, a kludge?

Bullish_Bear said...
This comment has been removed by the author.
Bullish_Bear said...

The notion that rates would have been higher if the Fed had not done QE is false.

QE simply was the Fed's way of reducing the rate on some specific instrument (mortgages, longer dated Treasuries, etc.)



Uhhhhhhh.........what!?

Matt Franko said...

Mike,

I think rates would be a lot lower if they never did it...

This reminds me of how they supported the Euro back in 2008 with the swaps... and killed the short Euro trade ;)

They are monopolists and price setters and as they are buyers of bonds they seek lower bond prices to "get a good deal for the taxpayers" we've discussed this before with their ability to act as "scale down buyers" with a fixed amount of funds to buy every month...

http://www.newyorkfed.org/markets/tot_operation_schedule.html

I think we would already have a "Japan-like" interest rate curve if they would just step aside....

their current magnitude of the operation is not as massive as back in QE1 and has not caused a big sell-off like back then working with the short specs (who are now broke) to drive prices down, but it seems like it has been big enough to stop the bond rally in its tracks....

It looks like they are locking in a long term "income stream" for the Fed as the Fed gets it's operating funds out of the income stream generated by their portfolio...

The short term stuff they had (which they are selling) is yielding 0 if they rolled it all over without extending the duration of the portfolio they would be "out of money" to operate....

Once they get out, else equal I would think the bond rally could continue...

maybe they will stop all of this when they they get the portfolio converted over to the longer duration and higher coupons that gives them the interest flows that they are looking for....

rsp,

Broll The American said...

Completely off topic...
I'm currently fighting a losing battle against the zeitgeist of ignorance over on CNN/Money in the comments of an article called "What is 'Fix the Debt.'"

I could use some MMT support!

Matt Franko said...

Broll,

"What is fix the debt"

Here is their web page where we are now introduced to "Peterson Junior" who's daddy funded this clusterF--k and who is a New Democrat if you can believe it...

http://www.fixthedebt.org/who-we-are

Looks like as this is a feature on CNN they have co-opted Time-Warner now too... these morons are relentless.

rsp,

netbacker said...

Broll
I am there with you :) But most of the comments are just plain idiotic that has not point responding to.

Broll The American said...

@netbacker - Thanks for the backup! I doubt either of us convinced anyone over there.

Joshua Wojnilower said...

Great post and a topic well worth addressing. I completely agree that rates would be lower without QE and here's my take (http://bubblesandbusts.blogspot.com/2012/11/without-qe-interest-rates-would-be-lower.html):

QE reduces the default risk and shortens the duration of financial assets held by the private sector (i.e. public). Assuming risk preferences do not change significantly during this process, the private sector will likely counter QE by shifting other assets to higher risk and longer duration securities. The result is a smaller tradable supply of Treasuries and decreasing demand. Since a significant portion of QE has and continues to involve purchasing Agency-MBS instead of Treasuries, my intuition is that the demand effect trumps the change in supply. Without QE, the demand and supply of Treasuries would therefore be higher, with the larger demand effect pushing up prices and lowering rates.

Drew Stoller said...

Mike, you say rates would not be lower if the Fed didn't do QE1 (most importantly), QE2, Twist, and QE3, and you state the Fed's goal is to lower/altyer the term structure of government debt. However, I can't wrap this around my head: if you look at what rates and bond prices actually did during each QE type program, rates actually INCREASED/bond prices decreased. And those treasury sell offs were right at the bottom of equity/risk asset sell offs. It looks to me like the Fed is trying DESPERATELY to stoke inflation and therefore a market need for rates to rise with the hope the market will be forced to do that because of economic growth. Is that a wrong assumption?

David Goldstone said...

"it doesn't enable government spending"
This makes no sense. The interest payable on bonds is rebated by the Fed back to the Treasury. Hence QE reduces the deficit and thereby directly enables additional government spending. Furthermore expiring bonds are rolled over indefinitely so that the principal is de facto monetised.