QE, Rising Yields, and the Right Way to Taper

Matthew O'Brien of The Atlantic gives us the 41 most important economic charts of 2013. The figures come from various contributors, including me. My figure is borrowed from chief economist Michael T. Darda of MKM Capital and shows that long-term treasury yields generally have risen under the QE programs. This pattern runs contrary to the stated objectives of the Fed and is also inconsistent with those who claim the Fed's large scale asset purchases (LSAPs) are draining the financial system of safe assets. Fortunately, there is a way to make sense of these developments.

The chart I borrowed from Darda came from a longer note that had other interesting charts and comments. I thought you might like seeing the rest of them, especially his thoughts on how to taper without tightening monetary policy. Here is Darda:

Most observers continue to (falsely) believe that QE works by lowering long rates and flattening the yield curve. However, a quick look at the data suggests this is not the case.

Others believe that QE is akin to “debasing the dollar,” but this too is false. The dollar has been stable at a low level for the last five years. Commodity prices haven’t responded to QE in a consistent manner because China’s growth trajectory, not QE, the dollar or developed country nominal GDP growth, has been the primary driver of commodity price trends in recent years.

We find many of the criticisms of the Fed/QE to be totally off-base. To wit: allowing the financial system to collapse in 2009 (instead of initiating QE1), allowing deflation to emerge in 2010 (instead of implementing QE2) or having the full force of the fiscal cliff/sequester hit in 2013 (instead adopting QE3) are not persuasive alternatives to QE/forward guidance, in our view.

The Fed has had a meaningful effect on financial conditions and has placed a floor under inflation expectations. Thus, the U.S. has avoided double dip recession and deflation despite the stiffest fiscal headwinds in six decades (unlike Europe in 2011 and the U.S.A in 1937 when premature monetary tightening capsized business cycles before full recovery was at hand and unlike Japan during the 1990s and 2000s when a too-tight BoJ blithely presided over monetary deflation).

Concerns about financial stability/over leverage are vastly overblown, in our view. Household leverage ratios have collapsed over the last five years even though the Q3 flow of funds data will likely show a new-all time high in inflation-adjusted net worth, thanks to rising nominal asset values and moderate nominal income growth (relative to flat or falling debt levels). Moreover, there is no evidence of a broad-based leverage or credit problem, unlike the early 2000s. The broadest measures of money (that include the shadow banking system) are growing at about the pace of NGDP. With unemployment/underemployment/long-term unemployment still a problem and inflation near record lows, the Fed is correct to focus on growth.

With inflation ~100 bps below the Fed’s target, and forward-looking inflation breakeven spreads below 200 bps at the five year horizon, the FOMC has to be careful not to send an inadvertently hawkish message if/as begins to taper asset purchases. One way to accomplish this would be to use forward guidance on the monetary base, promising that previous additions to the stock of high powered money will be permanent at least up until the point at which the Fed’s 2% inflation target its met (or is expected to be met). The same exercise could be done for a NGDP or price level path target. If this was done and viewed as credible, the demand for base money would ease and the Fed could end QE without endangering the recovery/failing on its inflation target. To some degree, this is already occurring. We note that even though long bond yields have risen in recent weeks, two year note yields are firmly anchored, meaning the market believes the Fed will not hike short rates over the next two years despite what appears to be a high likelihood that tapering will begin sometime between December and March. A steepening yield curve and easing financial conditions are consistent with a pickup in growth (which is what the Fed wants).

I find his proposal to do forward guidance on the monetary base rather than interest rate targets to be interesting. I look forward to more discussion on it.