The confusion about QE2 has continued apace. I have previously written two longish pieces exposing QE2 as little more than a slogan, a policy that is not going to have any significant impact on US economic growth. (See here and here)
It is not likely to stimulate domestic spending, and if it is designed to crash the dollar in a last-ditch effort to turn America into a modern mercantilist nation, it will fail. Still, QE2 grabs the headlines, with the consensus worrying that it will (eventually) spark inflation. Me thinks not.
However, I have just seen an excellent post by Warren Mosler that is the clearest statement I have seen on the topic. (Go to his website here) I usually hate and avoid long quotes in a column, yet, Warren's arguments simply cannot be improved upon. For those of you who do not know, Warren is a hedge fund manager who specializes in sovereign debt. He knows his topic. I have known him for almost two decades and he has never failed to educate me on the intricacies of government bonds. Hence, I am going to quote liberally from his analysis (with his permission) while adding a bit of commentary. Everything in italics is in his own words.
Here is the main conclusion, stated as succinctly as possible by Warren:
QE is the Fed buying longer term treasury securities and is functionally identical for the economy to the Treasury having issued 3 month T bills instead of those longer term securities the Fed bought.
Got it? We could have saved a lot of unnecessary handwringing if the Treasury had just issued short-term debt in the first place. He goes on:
Now the more tricky part.
The yields on the approximately $13 trillion of various Treasury securities and reserve balances continuously gravitate towards what are called indifference levels. That means that for any given composition of reserve balances at the Fed and Treasury securities, there is a term structure of interest rates that adjusts to investor preferences at any given time. So, for example, with government providing investors with the combination of $2 trillion in reserves and $11 trillion in various Treasury securities, the yield curve will reflect investor preferences given the current circumstances.
What Warren means is that it is about price, not quantity. All the assets will find a “home” to satisfy preferences, as prices (yields) adjust. What about expectations of Fed policy? Yes that affects rates as follows:
That means if investors expect Fed rate hikes, the front end of the curve would steepen accordingly. And if instead they expect 0 rates for a considerable period of time, the curve would flatten for the first few years to reflect that.
Simple? Yes, as plain as the nose on your face. It is just the expectations theory of interest rates. Let us move on to Bernanke's “QE”: the purchase of more securities in an attempt to stimulate the economy.
If the Fed then buys another $1 trillion of securities, reserves go to $3 trillion and there are $10 trillion longer term Treasury securities outstanding. And to actually purchase those reserves, the Fed would have to drive the term structure of rates to levels where investors voluntarily are indifferent with that mix of offerings, given all the other current conditions.
The Fed doesn't force anyone to sell anything. It just offers to buy at prices (interest rates) that adjust to where people want to sell at those prices.
The Fed operates on price: to get markets to give up $1 trillion of securities it will need to offer prices to make them indifferent to what they are holding.
So even if the Fed owned a total of $10 trillion of securities, and there were only $3 trillion left outstanding for investors, if investors believed the Fed was going to hike rates by 3%, for example, the term structure of rates on Treasury securities would reflect that.
What I'm trying to say is that QE does not mean rates will actually go down. The yield curve is still a function of investor expectations.So once we add in expectations, the Fed is playing a game that it cannot necessarily control.
QE2 might not drive long term rates down. For those who remember their Keynes, there is something called the square root rule: the lower the long rates go the harder it is to drive them lower due to fears of capital losses. We are almost certainly at that point already. Warren goes on to explain technical issues:
But the yield curve is also a function of 'technicals.' This means the quantity of 30 year securities offered for sale, for example, can alter the yield of that sector more than it alters the yields of the other sectors. This is because, in general, there tends to be fewer 'natural' buyers of 30 year securities than 3 month bills. For most of us, we are a lot more cautious about investing for 30 years at a fixed rate than for 3 months at a fixed rate.
That is related to the “habitat” theory: we have preferred maturities that we like to hold. Again, a well-established position that is not controversial.
And it takes relatively large moves in 30 year rates to cause those investors to shift our preferences to either buy them if govt. wants to issue more, or sell them if the Fed wants to buy them back. On the other hand, there are pension funds who 'automatically' buy 30 year securities regardless of yield because they are matching the purchases to 30 year liabilities.
So altogether, the yield curve is function of both investor expectations for interest rates and the 'technicals' of supply and demand (desires by issuers and investors).
Yes, so it is all “so complicated”—like Shrek's onion once we peel back those layers. Impacts will be uncertain—it will depend on preferences and expectations.
And while there might be no amount of 3 month bills the Treasury could issue that would materially drive up 3 month T bill rates, relatively small amounts of 30 year bonds do alter the yields of 30 year securities. Insiders would say the 30 year market is a lot 'thinner' than the 3 month market.
So what is QE? Let us try to get to the bottom of it. As Warren explains:
QE is nothing more than the government altering the mix of investments offered to investors. The Fed's buying of longer term securities reduces the amount of longer term securities and increases the amount of reserves (effectively these are like one day securities). Interest rates, as always, continuously gravitate to reflect current investor expectations of future Fed rate changes and current 'technicals' of supply and demand. QE changes the technicals, and possibly expectations, and results in a yield curve that reflects those current conditions.
So all QE does is to potentially alter the term structure rates, as investors express preferences, given the securities of the varying maturities and reserves offered by the Fed and Treasury and all the current conditions.
Got it? It used to be called “operation twist”: the attempt to change long term rates relative to short term rates. Do you see why I call it a slogan? So what impact does QE2 have on the economy?
That brings us back to the question of what QE means for the economy, inflation, value of the currency, etc. Which comes down to the question of what the term structure of rates means for the economy, inflation, the value of the currency, etc.
QE is nothing more than a tool for changing interest rates by adjusting the available supply of securities of various maturities. And it's not a particularly strong tool at that. It's the resulting interest rates that may or may not alter the economy, inflation, and the value of the dollar, etc. and not the quantities of reserves and Treasury securities per se.
All of those who are focusing on quantities, such as the $2 trillion of excess reserves the Fed created plus the additional $600 billion of excess reserves the Fed plans to create just do not get it. It is about price (rates) not quantity. There is no danger of running off into Zimbabwe land just because the Fed might be able to lower long rates. Does the Fed understand what it is doing, or is it “clueless in Seattle” as many claim? Warren's conclusion:
It is clear to me that the FOMC does not fully understand this. If they did, they'd be in discussion with the Treasury about cutting issuance of bonds in the first place. And, additionally, If they wanted the term structure of interest rates to be lower, they would simply target their desired term structure of rates by offering to buy unlimited amounts of Treasury securities at their desired rate targets, and not worry about the mix between reserves and Treasury securities that resulted.
Which is what they did in the WWII era. And how they target the fed funds rate. With today's central banking and monetary policy with its own currency, it's always about price (interest rates) and not quantities.
Indeed! The easiest way to eliminate all the worries about government debt, and the debt burden, and the sustainability of the debt, and the burden on our grand kids is to simply stop issuing the debt. Our sovereign government does not borrow. It spends through “keystrokes” (as Bernanke has testified). Bond sales simply offer an interest-earning alternative to reserves. We now pay interest on reserves. QE2 is trying to drive bond yields down to the rate paid on reserves. By buying the bonds issued to drain reserves, to offer a higher interest rate than reserves pay.
Can anyone say “stop the nonsense”? Don't sell the bonds. Then we don't need the pinnacle of all stupidity: an alphabet soup of Congressional deficit commissions all worried about the sustainability of issuing more government debt. As Nancy said: “just say no”—to bond issues. Then we don't need no more QE2.
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