Tuesday, December 7, 2010

Asking the Wrong Question

Randall W. Forsyth dreams he is doing the 60 Minutes interview with Ben Bernanke and comes up with this exchange:
Bernanke: "What we're doing is lowering interest rates by buying Treasury securities. And by lowering interest rates, we hope to stimulate the economy to grow faster,"

Forsyth: "So, why are interest rates higher now after QE2? The key 10-year Treasury note yield is up to nearly 3% from 2.50% just after the Federal Open Market Committee announced the policy change in early November. Mortgage interest rates have climbed to three-month highs and applications fell the most this year in the latest week. So, what's the problem?
Part of the problem is Bernanke and the Fed itself. They should not be creating the perception that a successful QE2 is one that will keep long-term interest low for a sustained period.  As I have noted several times now, this is terribly wrong.  If QE2 is successful, then we would expect treasury yields to rise!  A successful QE will first raise inflation expectations.  This alone will put upward pressure on nominal yields.  However, expectations of higher inflation are in effect expectations of higher nominal spending.  And higher expected nominal spending in an economy with sticky prices and excess capacity will lead to increases in expected real economic growth.  The expected real economic growth should in turn increase the real yields.  It is that simple.  Randall W. Forsyth, therefore, is asking the wrong question. What he should be asking is why inflation expectations have not gone up anymore.  If anything, QE2 is much ado about nothing.  

1 comment:

  1. If QE2 ends up being much ado about nothing, then I will not even try arguing for a QE3. Instead, I intend to argue against QE2 and QE3 by arguing for an explicit level target for aggregate nominal income (about 3 percent). Of course, such a target would probably mean expanding the monetary base at present, but unless you at least seem to be arguing against The Bernank and the Fed, nobody wants to know what you have to say at the moment.