Monday, August 13, 2012

Fed "subsidizing" low interest rates on federal debt?

Occasionally, I have come across some strange reasoning by commentators, like this one, that indicate that they believe the Federal Reserve is subsidizing low interest rates on treasury securities.  First, I'd like to point out how that is not the case, then I want to ask "so what", if it were the case.

Let me first point out the obvious: open market operations in the treasury securities market is a conventional and long-standing means for the Federal Reserve to influence interest rates and, thereby, the level of economic activity. The main change at this point is that the Fed has more recently begun buying longer term treasury bonds, in part to demonstrate the Fed's seriousness in it's official position that it will support low interest rates for a considerable time.  That being said, the Federal Reserve has not been acting contrary to market expectations for interest rates, as is amply demonstrated by the fact that the Fed does not have to buy up all treasuries to get interest rates of approximately zero.  The way I see it, pretty much all investors would abandon the the bond market for treasuries if they did not think the interest rates justified, with the exception of speculators which would pounce on the bonds when they offered yields over zero, in the expectation that the Fed would drive rates to zero.

The Fed has not bought up all government debt, but look at this:

Interest rates on short to medium-term treasury securities have collapsed to near zero.  From 2009 to mid-2011, it looks like market participants were projecting rising interest rates, either through inflation or rising real rates.

But what if the Federal Reserve bought up all short-term securities?  The United States needs monetary stimulus.  If lower treasury interest rates are being subsidized by the Federal Reserve, the counterparties to the bond purchases would have extra money, which could be spent on other investments, like stocks or corporate bonds.  These would make it easier or less expensive for companies to invest on expanded capacity.

Some further assert that there is massive inflation on the way, like I discussed in "A less notorious lesson in Laffernomics".  Below is a graph of monetary base, M1 and M2:

There has been an enormous growth in monetary base since 2008, but it has not translated into inflation because the overall amount of money in circulation (as measured by M1 and M2) hasn't increased that much, so how is that going to translate into massive inflation?  Clearly if money velocity increases greatly, but the Fed does not reduce the monetary base, that would have large inflationary potentials.  Do those who forecast massive inflation seriously think the Fed's Open Market Committee is going to sit on its hands in those conditions?  As for inflation being a problem right now?  What do the facts have to say?

CPI shows deflation in the midst of the crisis, and a recovery to more or less normal inflation, but with no signs of problematic levels of inflation.  In fact, the tips spread, which is used to indicate expected inflation (in this case, 5 years ahead), shows that investors expect inflation to stay around 2% for the next 5 years.  The GDP price deflator shows more or less the same story.  Inflation may come when recovery comes, but only if people don't expect the Federal Reserve to keep a lid on it, by lowering or slowing the growth of the monetary base accordingly.

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