Friday, June 28, 2013

QE is not the cause of low long-term interest rates

I just read a post by Ryan Avent on Free Exchange where he discussed the theories of why long-term interest rates are low. He cites right-wing sock puppet Tyler Cowen as suggesting that it's all basically about the quantitative easing (QE) program. The proof? After the Fed recently revealed their plans to end the current program of QE, long term interest rates jumped up.  I see it quite differently.


The theory that makes the most sense to me is that, as Paul Krugman has said many times, long-term rates are basically reflective of what investors believe the future short-term rates will be. Average these out and you've got a long-term rate. What this rapid rise indicates is that market participants expect short-term rates to rise more dramatically in the next ten years than had previously expected. My guess on what's driving this is the position that QE will be ended, despite the Federal Reserve not hitting an unemployment rate of 6.5% or lower and, even more astonishing, after seeing inflation drop below 1%! Obviously any reasonably rational investor will see that the Federal Reserve is getting trigger-happy.

Monetary policy with short-term rates at around 0% is constrained. The only way to deliver lower real interest rates is to increase inflation expectations. The Federal Reserve committed to keeping monetary policy accommodative for a considerable period, even at a cost of somewhat higher inflation (2.5%). If inflation is expected to pick up, everyone has more reason to buy things sooner, to lock in the lower prices. The Fed has decided to pick up its toys and go home, rather than continuing to provide the support this economy really needs. In this regard, the Fed's announced change in policy sends the wrong signal and they've lost some credibility.

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