QE3: The long and the short of it

by on August 11, 2011 at 3:04 pm in Current Affairs, Data Source, Economics | Permalink

Long term rates and short-term rates are linked through arbitrage so a credible commitment to keep short-term rates low for an extended period of time can also generate a movement in long-term rates, as Justin Wolfers points out. According to Macroeconomic Advisors the effect can be quite large:

In principle, FOMC communications can be very powerful. If the FOMC could encourage the market to shift out its expectation of the time of the first rate hike by six months, the impact on the ten-year Treasury yield would be comparable to that of $760 billion of QE! Our analysis suggests that a six-month shift in the expected time of the first rate hike would have a significant impact on the yield curve.

1 brian August 11, 2011 at 3:18 pm

I am waiting to see how this works out. I expected to see bong yields rise with any real monetary expansion, as we saw with QEI and QEII, so seeing yields fall sharply after the fed announcement indicated economic weakness and a flight to safety as the driver of bond markets. But the last two days have seen yields rising consistent with the idea that long term low interest rates by the Fed is a backdoor QEIII. Maybe the initial drop in yields was due to confusion because of the circuitous route the Fed used to get expansionary monetary policy.

2 Norman Pfyster August 11, 2011 at 6:07 pm

Rising bong yields: must have switched to the higher-quality Columbian stuff. Or “shit,” as the Germans would say.

3 Roy August 11, 2011 at 6:16 pm

If only bong yields would rise… This might help us all think QEIII is working.

(I know I shouldn’t mock typos, I make too many myself, but I couldn’t resist)

I suspect you are right, this will be priced in and this will all prove as useless as the last effort.

4 Wonks Anonymous August 11, 2011 at 4:08 pm

This caused a minor tiff between Scott Sumner and Wolfers:

5 Bill August 11, 2011 at 4:43 pm

Totally agree with Bernanke’s credible commitment strategy for several reasons.

1. It removes pressure on him every month from the WSJ, trading partners whose currency is appreciating, persons hyper concerned about inflation, etc. to raise interest rates.
2. It forces China to react–Do I really want all these low interest Treasuries; maybe I should go out and buy something.
3. It leaves open other options–QEIII if matters worsen; removing interest on reserves, etc.
4. It secures our financial system–no run on the bank if the bank can get money from the Fed at .25%
5. It takes the Fed out of politics because the die has been cast, and there is no reason now to have Bernanke brought up to Capital Hill to be pressured by Ron Paul to tighten.

A unilateral first mover commitment stategy is a good one here, since there are players with opposing interests who would have tried each month to influence a monthly decision.

6 Andrew' August 11, 2011 at 9:11 pm

Update your Ron Paul model. Ron Paul certainly doesn’t give a crap what the other Republicans want.

7 Gabe August 11, 2011 at 5:20 pm

I don’t really think Ron Paul pressures Bernanke to tighten. He is more just questioning the legitimacy of the institution, central planning of the money supply, fiat money and fractional reserve banking.

8 Andrew' August 11, 2011 at 9:07 pm

I would guess Ron Paul wants a market rate (and I’ve heard him say this) whatever that may be. This is exactly what The Fed doesn’t want.

9 joshua the postlibertarian August 12, 2011 at 6:46 am

I’ve learned a lot about Treasuries and debt in the last few years but I’m still pretty ignorant.. does anybody recommend a good resource? I know enough to ask this question but not enough to know why it’s probably a dumb question: since long-term rates are higher than short-term rates, why would anybody buy a 2-year bond at .3% when they could just buy a 30-year for 3.8% and sell it two years later?

10 Yancey Ward August 12, 2011 at 12:56 pm

You can lose more principle than interest earned by buying a 30Y at 3.8% and selling it 2 years later if rates rise enough.

11 Scott Sumner August 12, 2011 at 8:53 am

The problem with this sort of analysis is that the bigger the QE, the sooner the first rate hike is likely to come. Rate hikes can be delayed for many reasons, including passive monetary policy that leads to a weak economy. Never reason from a price change.

12 Mike August 12, 2011 at 10:15 am

Joshua, the 30 year bond will have more liquidity risk and interest rate risk. And if you believe some people, greater credit risk.

Interest rate risk is the key thing a bond investor needs to worry about for treasuries. The composition of their portfolio sets the Duration – exposure to IRR.

When interest rates go up, bond values drop. With interest rates as low as they are, do you really want to have 30 year paper?

A pension fund which has a long tenor for its investments and required return can go for these higher yields and hedge IRR. It’s doubtful you can do this.

13 Mike August 12, 2011 at 10:20 am

Long and short rates didn’t seem so linked during Greenspan’s “conundrum.” While the link might exist all else equal, all else doesn’t remain equal. Markets and economies are not policy invariant.

14 steve August 13, 2011 at 5:35 pm

Bernanke just made another prediction. i.e. inflation will be low for at least the next two years. I wonder if this one will work out any better for him.

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