Thursday, November 29, 2012

Without QE, Interest Rates Would Be Lower

Over at Mike Norman Economics, Mike Norman poses the question, “Would rates be higher if the Fed hadn’t done QE?” Before I get to his answer, let me acknowledge that this question has crossed my mind a number of times over the past couple years. The answer I have settled on is that rates would be lower and let me explain why. There is a broad misconception about what QE (effectively open-market-operations) really means on an operational basis. I’ve tried to explain this many times but Mike offers a succinct explanation:
In so doing the Fed changes the composition and duration of the financial assets held by the public. It's not stimulus, it doesn't enable gov't spending and it's not money printing. These are asset swaps, that's it, pure and simple.
QE reduces the default risk and shortens the duration of financial assets held by the private sector (i.e. public). Assuming risk preferences do not change significantly during this process, the private sector will likely counter QE by shifting other assets to higher risk and longer duration securities. The result is a smaller tradable supply of Treasuries and decreasing demand. Since a significant portion of QE has and continues to involve purchasing Agency-MBS instead of Treasuries, my intuition is that the demand effect trumps the change in supply. Without QE, the demand and supply of Treasuries would therefore be higher, with the larger demand effect pushing up prices and lowering rates.

A significant portion of Mike’s argument is worth highlighting (my emphasis):

when the government spends it adds to the level of bank reserves in the system and this accumulation of reserves causes the Fed to engage in monetary operations on a fairly regular basis (like, daily) to maintain reserves at a level that is consistent with whatever target interest rate they have decided upon. If the Fed were to allow reserves to build and build and build as a normal consequence of ongoing gov't spending, then the overnight lending rate (Fed Funds) would quickly fall to zero and all other rates out along the term structure would follow suit.
So the fact of the matter is the Fed has to work quite hard to KEEP RATES FROM FALLING TO ZERO ON THEIR OWN if the banking system were just left alone without its intervention. Those who say the Fed is keeping rates "artificially low" have got it backward. On the contrary, high rates or rising rates for a currency issuing nation are artificial.
The first statement in bold is often overlooked or misunderstood but critical to understanding monetary operations and its impacts. Clarifying Mike’s point, since taxation actually decreases the level of reserves, government spending in excess of revenues causes reserves to build. Scott Fullwiler addresses this issue in a fantastic paper on Interest Rates and Fiscal Sustainability:
When a deficit is incurred, in order for the Fed’s interest rate target to be achieved either the Fed or the Treasury must sell bonds in order to drain the net addition to reserve balances a deficit would create. If no bonds were sold, the deficit would generate a system-wide undesired excess reserve balance position for banks. (p. 17)
Based on this analysis, the conclusion is pretty clear:
The notion that rates would have been higher if the Fed had not done QE is false.

Related posts:

Fullwiler - "The main shortcoming of the money multiplier paradigm"
Bubbles and Busts: Why QE2 Failed, Part 1
Modern Money Regimes Redefine Fiscal Sustainability
Fed's Treasury Purchases Now About Asset Prices, Not Interest Rates
"Interest-On-Reserves Regime" Will Rule Monetary Policy For The Foreseeable Future


  1. Please see an interesting post on the subject:

    Long-term rates roughly follow the projected long-term path of the Federal Funds Rate but they also determine the price of bonds. For long-term rates to drop without any Fed action would mean that the market is absolutely certain of the FFR long-term path and of a depressed economy.

    Unless this path is verified, market players risk capital losses if short-term rates end up increasing (compared to the projected path). QE manages expectations by:
    1) Bringing capital gains to today by providing free profits to asset holders and
    2) Moves the interest rate risk to the Fed balance sheet (and income statement) by swapping long-term paper with overnight deposits which pay Interest on Reserves. Any unexpected interest rate hike will lead to higher IOR payments and act as a hedge for market players.

    I am not so sure this would happen without QE.

    See also here:

    1. Kostas,

      Thanks for continuing to contribute your ideas and providing such valuable links. JW makes a strong argument and I tend to agree with the view of inelastic expectations. On a related note, I actually discussed this issue in a previous post focusing on JW's other work and the contrary view of Jazzbumpa, over at Angry Bear, that the Fed follows the market in its actions:

      As for your comments, I don't think absolute certainty is needed for rates to drop without Fed action. All that is needed, IMO, is revised expectations about the Fed's future actions.

      You are correct that if these expectations are not verified, market players will likely experience capital losses. Many stock investors remain bullish because low rates are suppose to imply higher P/E ratios. On this basis, an unexpected rise in rates would create expectations of falling stock prices.

      Separately, I would argue against the profits today begin free, since the investment decisions entail the very risk you highlight.

      The presumption that IOR will be used to control interest rates going forward is one I also agree with. However, this action will help to repair bank capital but seems unlikely to alter demand for credit (which I take as far more important). As Warren Mosler points out int he comments of JW's post, the Fed is extracting ~$80 billion of interest income from the private sector each year.

      You make some very strong arguments but I'm not fully convinced (though open to changing that). I think QE may inadvertently raise the market's expectations of the FFR long-term path, creating a temporary floor under long-term rates.

  2. Dumb question but..

    If QE is an asset swap are the "assets" being swapped of equivalent value. If not isn't the asset swap a way of the central bank "making good" in monetary terms the over valued asset?

    1. Dave,

      Definitely not a dumb question, so thanks for asking.

      Throughout QE, the Fed uses an auction process to ensure the price of assets being bought and sold approximate market values at that time. The reserves provided are equivalent to the asset value as determined by the auction (i.e. market).

      There is some question as to whether the first QE purchases involving Agency-MBS, when the market was collapsing, reflected market prices (since liquidity was an issue). If the Fed purchased assets at above market prices, then you are correct that the Fed would be, in some sense, creating new/extra money.

      If this were the case, the Fed would ultimately be forced to recognize the losses on those assets, impairing its minute capital position. This is not to suggest the Fed would go bankrupt, only that the Treasury would provide a minimal capital injection or future payments to the Treasury (from Fed profits) would be reduced. Basically the Fed would be transferring the private losses to the public sector.

    2. Hi Joshua,

      Thanks very much for the reply, very helpful. Much appreciated.

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