Another edition of my diatribe on QE-II. Here I reply to Noah in comments who discussed debt deflation and also explain my guess about what happened going beyond the evidence.
Why does expected inflation matter (so that we should be pleased at an increase in nominal interest rates not matched by an equal increase in real rates) ? I can see how the real interest rate matters (no sign of an effect — literally I can’t guess if the change is up or down).
I can see how actual inflation can make a difference. But how does expected future inflation make a difference. One way is if someone has a 30 year fixed interest rate mortgage without the option to repay immediately (or a substantial penalty for early repayment). That person will consume less if expected inflation falls because the expected present value of interest payments will rise and they can’t refinance.
I am sure that there is at least one such mortgage somewhere (there is at least one of everything). I’m not so sure there are a thousand. My understanding is that there are two possibilities — fixed rate with option to repay and refinance and floating rate.
Now let me motivate the null hypothesis (that QE-II did very little as would QE-III). What if the interest elasticity of demand for 7 year Treasury notes is huge ? First we can’t tell this from looking at market prices — elasticity is a statement about the slope (and level) of demand not the market clearing price for slowly changing quantities. Second this means that reducing the amount of 7 year notes to be held by the public would have a small effect on, well first of all the price of those notes (which has gone *down* during the period of the QE-II purchases) and secondarily on everything else.
The point is that the QE-II experiment makes it possible to identify the demand curve for 7 year notes for the very first time. And with $600,000 less on the market, their price has gone down. This is proof of nothing (two data points with a large disturbance term can’t be). But it is just about all the relevant evidence we have.
Now what would we expect to see if this elasticity were very high ? Of course investors didn’t know that (like economists many thought QE-II would have a big impact). I would guess an increase in price when QE II is anticipated but actual purchases haven’t started, then a decrease in price when the actual purchases start and it turns out that they didn’t have the anticipated effect.
This is exactly what happened. A coincidence ? Very possible, but the 7 year nominal interest rate looks exactly precisely as it should if lots of people thought QE-II would work and they were totally wrong.
Look at the graph
Let me try adding a link tag to make it easier to go to the graph:
I happen to think it’s very difficult to take one event like QEII and deduce a cause and effect relation on some other variable of the global-financial-economy universe. Likewise difficult to state what the effect of this event is on the Aggregate Investor psyche, even after becoming adept at knowing what the Aggregate Investor is thinking.
I know real economists do this all time, and can even calculate “counterfactuals” in order to tell us how bad things would be if economists didn’t fix things all the time. But since I aren’t one, I just prefer to think of all that as witchcraft.
But I have been watching the bond, currency and stock markets thru all this. I think it’s useful to also consider the dollar index, tho that has the same problems of separating out possible cause and effect.
In early summer of 2010, the dollar index (half of it is vs the euro) had completed a rally likely driven by the PIIGS being in the news the first time. At this same time, double dip fears in he US became prevalent (Roubini put the chances at 50%). Europe did their kick the can down the road fixes on the PIIGS. As a result of double dip fears, speculation of a coming QEII was rampant in FX and the general biz news. The Fed started talking about it shortly thereafter. This all caused the buck to roll over and drop 10% or so over the early summer months.
The bond market is traditionally known as being the most astute forecaster of the economy, and true to form, the 10 year treasury yield fell to 2.6%.
All this occurred well before the August commence date of QEII.
As we got into fall, double dip fears subsided and econ data was somewhat perky. As one might expect, without even considering QEII, the bond market re-priced and 10 year yields went to 3.5%.
At this point, it might be tempting to some to conclude that QEII fixed the economy. But fortunately we can drive a stake in that vampire’s heart because now the data for Q1 is out (weak) and the latest Fed manufacturing reports have cratered around the entire country. We already know we have to wait 5-7 years (QE14?) until employment gets better and find out what country it will be in.
And the bond market is pricing the 10 year at 3.1!!!!
So my simpleton conclusion is that the bond market is doing what it always does…price interest rates in accordance with it’s forecast of economy.
The suspicious markets are the commodity markets and stock market. Leverage in these markets is approaching pre-crash levels again, and the exchanges and at least one large broker is starting to raise margin requirements. So that is the most likely place all our excess liquidity went.
For what its worth.
> Why does expected inflation matter
I can see why you would question its effect on current consumption. “If inflation starts taking off, I’ll consume more then.” Though I suppose one might commit to ongoing consumption now — say, buy a boat that requires moorage — in expectation. But that would probably be a small effect, macro-wise.
On choosing between financial vehicles I also agree. I remember my financial advisor recommending an investment as a hedge against future inflation. Again, I said “I’ll adapt then, if it happens.”
The big difference might be between choosing real investments vs. financial “investments” — investment spending versus saving. If I predict higher future inflation, I might do a bigger remodel, using cash, invest more in my education, or accelerate the business expansion I’ve been contemplating, figuring that the value of those real assets I’m creating will go up with inflation. They’re long-term hedges. In the case of the remodel and the education, at least, I get to enjoy them now — no cash value — no matter what inflation does. But higher inflation predictions might swing me some.
I might also borrow more, in expectation that the payments I have to make in future years will be of less real value.
But I think future inflation expectations are hazy at best, despite the stridency with which they’re often voiced, so it’s hard to say that any of these effects would be very big.
The current level of inflation is both 1. the immediate trigger for spending/investment as opposed to saving (and for choosing different financial vehicles for those savings), and 2. the best predictor most of us have of what inflation will be in the foreseeable future.