Thursday, April 19, 2012

Fed's Treasury Purchases Now About Asset Prices, Not Interest Rates

Earlier today Arnold Kling at EconLog questioned a Keynesian view of the bond market in a post titled Interest Rates: The Strange Interlude. Kling points out the currently held Keynesian view that “there is a shortage of safe assets.” Describing the current economic troubles around this shortage suggests that governments should increase deficits in order to supply the market with enough ‘safe’ assets to fulfill demand. In response to this view, Kling asks (bold-mine):
if the markets love government debt and crave safe assets, then why does the Fed have to buy such a large share of what the Treasury issues?
What struck me about this question was the notion that the Fed has to buy a large amount of Treasuries to hold interest rates low. The implication in this statement is that if the Fed did not buy Treasuries at the current price than other investors would not step up to meet the supply. I take a slightly different approach to questioning the Fed’s actions (which I posted as a comment on the site).

I think one could argue that the Fed's purchase of Treasuries is not solely about interest rates. By removing Treasuries (safe assets) from the private sector, the Fed is encouraging investors to purchase the next closest 'safe' assets.

If the Fed was not doing various forms of QE, it's possible the private sector would have taken up the slack to keep rates low. However, in that case, money may have shifted to Treasuries instead of stocks and other categories of debt. The result would be low rates but also a lower stock market (reduced wealth effect).”

From my perspective, the Fed has been implicitly trying to boost asset markets and confidence through QE because it’s ability to influence real economic growth has been limited since reaching the zero bound on interest rates. The hope is that feeling wealthier will encourage the private sector to increase consumption and provide a short-term boost to the economy that gets growth back on track.

Kling later comments that:
For Keynesians, the low interest rates on U.S. securities are a sign from the markets that it would be a good idea to issue more debt. The rest of us doubt that the Fed could hold interest rates down forever.
Ignoring for a moment the very real potential downside of expanding government, my reply would be this: even if the Fed can hold interest rates down forever, will they be able to prop up other asset markets (e.g. stocks) forever? The Greenspan put lasted for quite a long time but ultimately failed miserably. Will the Bernanke put fair any better?

(Note: I remain long Treasuries)

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