Tiresome QE III and bond rates update
I have an embarrassing confession to make. I forgot the date QE III was announced.
I decided to graph the 3 year Tresury constant maturity interest rate. The logic is that I don’t believe the current FOMC can plausibly precommit to policy more than around three years from now. Most members’ terms end in January 2016. Bernanke’s term ends 2014 and there is no way Republicans will allow an up or down vote on reconfirmation (I guess he will be acting Fed chairman for a while). So I made a graph from Sept 1 2012 on. I didn’t remember that QE III was announced on September 13th. I looked at the graph. I had no idea whenthe huge signal about future monetary policy became public.
To make the graph less boring and more like my older discussion, I added the 5 year constant maturity rate. This shows a modest decline on the 13th entirely reversed on the 14th.
The reason I am back on this topic (aside from the fact that I am obsessive) is that I am very sure I haven’t explained properly why I look at exactly these numbers. I am trying to assess the forward guidance effect of QE III and not at all the portfolio balance effects. This means that I absolutely am not claiming QE III was a flop. I don’t think that, I think it is working very well. I try to explain myself after the jump.
By forward guidance I mean signals about future conventional monetary policy, that is signals about the future target federal funds rate. Basically, one argument for QE is that it is a dramatic way to convince people that the FOMC will keep the federal funds rate below 0.25% for a long time. This can affect output right now in large part because if they keep the rate low until inflation rises medium term real interest rates will be lower. The Krugman Woodford solution for monetary policy in a liquidity trap is to credibly commit to causing higher inflation therefore causing higher expected inflation right now.
But this works by changing forecasts of future conventional monetary policy, that is future short term rates. Medium term rates are equal to the expected geometric average short term rate plus a risk premium. The risk premium could be negative in theory, but it is generally positive as is shown by the fact that the yield curve slopes up. Given a three year rate of 0.37 % short term rates expected for the next three years must be very very low. Note the current 3 month rate is 0.1% not exactly zero. My view is that the FOMC has reached the limit of what it can achieve via forward guidance. Abstract models consider the case of no precommitment and total precommitment forever. But they are depending on the current FOMC signalling what future FOMCs quite probably with different members will do.
In any case, to me the data are clear. Expected average short term rates over the next 3 and 5 years were very very low before QE III was announced. Then they didn’t change. There is no sign that bond investors’ views about short term interest rates during the term of current members of the FOMC changed at all.
Again this does not mean that QE III had no effect. Massive purchases of MBS are not just a signal of future monetary policy. They change the amount of mortgage default risk which private agents must bear. This should increase the price (reduce the yield) of MBS. This should make issuing mortgages more attractive and promote refinancing and home construction.
All of this can cause higher expected inflation not because of changed forecasts of conventional policy (the federal funds rate) but because of the direct effects of the massive QE III purchases.
For those who have read this far, I stress that this is a pointless purely academic dispute. I agree with Woodford and Krugman that QE III is much better designed than QE II because a) the Fed is purchases MBS not Treasuries and b) the Fed says it will continue to purchase MBS as long as necessary. They think improvement b is more important than improvement a. I think improvement a is more important than improvement b. But we agree about what the Fed should do which is both buy risky assets and signal in any way it can that it will accept higher inflation.
update: Bruce Krasting asks why I wrote that QE III is working. It is partly because, after some frustrating googling, I know that MBS yields are at a record low (but I don’t know how much they decreased). It was mostly because I knew that the 5 year TIPS rate (the market real interest rate) dropped sharply after QE III was announced. But when I went to Fred to make the graph, I discovered to my surprise and dismay that the 5 year constant maturity TIPS rate has gone up again and is only about 17 basis points below it’s September 12th close.
I think QE3 is not working and is actually a tightening policy. It is removing interest income from the economy (FED earns the income on securities purchased). All the QEs may have removed as much as $200 billion.
QE may fiddle with long rates at the margin, but who cares when nobody with underwater mortgages can take advantage of the rates.
QE3 is another gift to the rich and banks, and a detriment to the economy. Only fiscal policy, and debt relief for regular folks will get things moving again.
http://www.ritholtz.com/blog/2012/09/quantitative-easing-helps-the-big-wheels-and-hurts-everyone-else/
Regarding inflation – it will not cause inflation. It just won’t.
http://www.huffingtonpost.com/warren-mosler/it-must-be-impossible-for_b_1096118.html
QEIII is working well??
What evidence is there at this point to support that conclusion?
QE is not one way street. You measure the results when it is put on, and then you have to measure the consequences when it is reversed.
We are still putting it on. The tremendous pain that this will cause when it is reversed is years away.
You should look at this article from Bloomberg today. They say that QE just makes bankers fat. You like that result?
http://www.bloomberg.com/news/2012-09-25/fed-helps-lenders-profit-more-than-homebuyers-mortgages.html
Bruce, I’d say we did not suffer much pain after QE1 or 2 ended.
I wasn’t aware that QEI or II “ended”. In fact they have not ended at all. The Fed says that the size and duration of their balance sheet is what matters.
The size has not been reduced, the duration has been extended (Twist) and now the Fed’s balance sheet will expand again.
Consider the words from Plosser:
“The Fed’s most recent actions carry with them significant risks,”
The central bank may “be forced into selling assets in the open market” when it needs to reduce stimulus, he said. Policy makers “must be aware of the consequences,” from their decisions.
http://www.bloomberg.com/news/2012-09-25/fed-helps-lenders-profit-more-than-homebuyers-mortgages.html
Thanks Bruce, be that as it may the logic around QE seems twisted.
Lets play with a scenrios:
If program is being wound down, inflation critics should be celebrating and projecting lower long term interest rates since the Fed is no longer “monetizing” debt. Some of these same inflationary critics are now claiming that rates will rise with the end of QE2.
If the fed winds down, the treasury could just issue super short term debt, lowering the supply of 10 and 30 year bonds. The Fed has to buy that to reach their short term rate targets.
It could be unwound slowly, only when the economy recovers (and I do not think it will significantly recover with the deficit declining).
For me, I feel QE is contractionary, and unwidning expansioary. This may sound weird, but its not when you feel QE is reducing interest income from the economy. One example is pensions. Long rates down is less income to pensions, and higher contributions by workers – thus lowering their take home pay.
I totally agree with you that QE is a drag due to reduced income from capital. (Its killing Social Security)
But I don’t agree with your conclusion. Additional QE has “positive” consequence through monetary transmission. When it is ended, and the reversal begins, it will be contractionary.
My problem is that the “positive” results of more QE are very very small at this point. The risks of continuing to print money on the other hand are large, and growing.
I wrote that QE III was working because the announcement was followed by a sharp drop in the 5 year constant maturity TIPS rate. This implies increased expected inflation. However, I went back to Fred to make a graph of the TIPS rate and discovered that it had gone back up to merely 10 basis points below the September 12 close. So I was hasty and didn’t update my information. I will update the post to add the TIPS graph.
A better measure of the portfolio balance effect would be the MBS yield. I blush to admit that I haven’t found a good time series of a reasonable index of MBS yields. I do know from frustrating googling that they are at a record low and about 3% but I don’t know what they were.
The really key variable is the mortgage interest rate. This is not an asset price on a double auction market so it should change sluggishly. Data are available weekly. the Conventional 30 year mortgage rate dropped 6 basis points in the week after the QEIII announcement. Compounded over 30 years that isn’t so tiny, but really on that we have to wait and see.
So Bruce and Robert the key to measuring success seems to be:
Lost Interest Income + Benefits of lower long rates + Unwinding costs = positive or negative benefit
I am a little worried that each of the above is not being added together in many analyses.
Krasting
don’t worry about it killing Social Security. it may affect the Trust Fund, but the Trust Fund is ultimately not important to Social Security. What matter is the income of workers from which pay as you go taxes provide income to retirees.
That income could go down… if the economy goes to hell and stays there, or a Romney type wins the election and the percent of GDP going to the super rich increases… but within very broad limits SS would still function for what it was created for.. allowing workers to save a portion of their income so they can afford a basic retirement… even if both workers and retirees had to do with “less.”
If the Trust Fund disappears, it would just mean that SS would have to return to full pay as you go, with the next generation paying a little higher tax a little sooner than they expected… but they will get the money back when they retire.
@Mcwop
Decreased interest payments benefit future borrowers. It is true that future savers are hurt, but interest income is highly skewed to those with high incomes. For example, in 2009 (the most recent year for which we have complete data) 31.5% of all taxable interest income went to the top 1% according to Piketty and Saez.
But I must admit, your deepfelt concern for the rich bondholders is truly heartwarming.
you all got any idea when QE3 gonna start?
fed’s balance sheet has contracted the past two weeks, and reuters reports their holdings of mortgage bonds are down
@mcwop what Mark Sadowski Said
One man’s interest income is another man’s interest paid. There is a difference though. People don’t like to bear risk. So if they shift from high expected yield risky portfolio to a lower expected yield safer portfolio, they don’t suffer as if they jut lost the difference in expected returns for sure.
This is very very important. In fact rather surprisingly, it means that the Federal Government can pay off its debt without bothering anyone by bearing risky assets.
You don’t like QEIII because it reduces the federal deficit (I agree this is a bad thing right now) and because it helps banks. Who does it hurt again ? It is certainly good news for bond owners. They can just keep their bonds and suffer no loss or sell them for a higher price than without QEIII and gain.
unwinding costs ? What might they be ? The Fed will unwind when we are out of the liquidity trap so it can avoid lowering aggregate demand by keeping the target Federal funds rate lower than it otherwise would. The fact that QE is the currently the Fed’s only instrument is due to the extraordinary circumstances.
Yes there will be trading losses due to price pressure (I think the main gain is driving up MBS prices when buying they will go back down when the Fed sells so it will lose that. However it will probably continue to get huge profits from borrowing at 0,25% and saving at 3%. Which is larger ? (you ignore the second)
Of course if the housing market totally tanks again, there will be a huge public sector deficit (including Fed losses). This is what we call an automatic stabilizer and it is another benefit of QEIII. QEIII means Fed profits (at the expense of private investors) if the economy grows and we don’t want consumption to crowd out investment, Fed losses if housing invetment tanks if we want high consumption of nonurables and services to make up for the lost demand for new houses.
So why only now ? Why doesn’t the Fed always buy MBS ? Damned if I know (it would be even better for the Fed to buy stock but that’s not legal)