Tuesday, December 14, 2010

Jeremy Siegel Gets It

Jeremy Siegel is making the case the case that rising yields indicate the Fed's policy is actually working:
The recent surge in long-term Treasury yields has led many to say that the Fed's second round of quantitative easing is a failure. The critics predict that QE2 may end up hurting rather than helping the economic recovery, as higher rates nip in the bud any rebound in the housing market and dampen capital spending. But the rise in long-term Treasury rates does not signal that the Fed's policy has backfired. It is a sign that the Fed's policy is succeeding.

Long-term Treasury rates are influenced positively by economic growth—which encourages consumers to borrow in anticipation of higher incomes and causes firms to seek funds to expand capacity—and by inflationary expectations. Long-term Treasury rates are affected negatively by risk aversion: Seeking a safe haven, investors pile into Treasury bonds, running up their prices and lowering their yields. 

The Fed's QE2 program has raised expectations of growth and inflation, sending long-term Treasury rates up. It has also lowered risk aversion, which implies rising long-term rates. The evidence for a decline in risk aversion among investors is the shrinkage in the spreads between Treasury and other fixed-income securities, the strong performance of the stock market, and the decline in VIX, the indicator of future stock-market volatility. This means that expectations of accelerating economic growth—and a reduction in the fear of a double-dip recession—are the driving forces behind the rise in rates. 
More and more observers are picking up on this notion that rising yields may be reflecting an improving economic outlook. As I have noted before, this is a welcome reprieve from the common but wrong view that QE2's success is dependent on the Fed maintaining low long-term interest rates.  The correct story goes something like this: higher expected inflation from QE2 should increase expected nominal spending and in turn raise expected real economic growth (given sticky prices and excess capacity).

Here is the latest figure on the 10-year expected inflation (red line) and the 10-year real yield (blue line) from the TIPs market. It continues to show an upward march for real yields. 

Update: Underscoring the view that rising yields indicate an improved economic outlook, Catherine Rampell notes three good economic reports came out today (retail sales, small business optimism index, and ppi) and that economic forecasts are being revised up.


  1. maybe its in fact the market front running the fed to the longer maturities. thus the flattening. duh.

  2. I agree that rising yields actually indicate that QE2 is working.

    But I also have sympathy for all the people who get "confused," because, of course, you have had hoity-toity Fed people themselves saying that one mechanism through which QE will stimulate things is by lowering long-term rates, supporting housing prices, and so on and so forth.

    Bottomline, it would sure help if the Fed would clearly and succinctly communicate (a) the mechanisms by which its policies are supposed to work and (b) the sign-posts and markers (e.g., asset price movements) for people to look at to ascertain whether things are going as intended.

    Right now we have the utter IRONY of QE2 working exactly as it was intended (thank the lord) and the "experts/pundits" getting downright angry because what they're seeing is not what they expected to see, and, of course, what they expected to see is simply no more and no less than what they were told to expect by the very people who are implementing QE2.

  3. Excellent blogging.

    Sadly, everything is partisan politics now. Some say QE2 raises interest rates, but then are mute about $900 billion in federal fiscal stimulus ala tax cuts.

  4. Anonymous:

    Excellent comment! You nailed it--the Fed has only itself to blame for the confusion.

  5. David -

    You say Jeremy Siegel gets it. I say, "Meh - there is nothing to get.

    Take this quote: "Long-term Treasury rates are influenced positively by economic growth"

    And then have a look at long rates since Reagan.

    Quite a story it tells, IMHO. Yr over Yr GDP growth has been sliding over that entire period. Most recent decade has been dismal. The current modest rise in rates could well mean nothing at all. Siegel might be on to something - but not in the way he expects. You have to look at more than a 1 yr chart.


  6. you can believe that QE is working if you want, but try telling that to a businessman who is faced with paying almost a percent more for a planned expansion, or a potential home buyer who is suddenly faced with the prospect of paying a percent more for a home loan...

  7. And here's Martin Wolf: To understand what is going on, we need to distinguish the role of shifts in real interest rates from that of shifts in inflation expectations. Fortunately, inflation-indexed bonds allow us to do just that. In the US, the recent rise in nominal rates is explained almost entirely by the rise in the real rate, not by a rise in implied inflation expectations. To be precise, the rise in real rates turns out to explain 76 per cent of the jump from November 30 2010 and 83 per cent of the jump from November 4 2010.... Do these jumps in long-term interest rates mean that the Fed’s quantitative easing programme has failed? Absolutely not. The Fed’s aim is to make rates lower than they would otherwise be and so raise economic growth and eliminate any threat of deflation. Rates are still remarkably low. They are rising because of a jump in real rates that almost certainly reflects improved prospects for growth. I would imagine that the Fed is pleased with the picture it sees before it....

    Are long-term interest rates likely to rise still further? Definitely....

    In all, what has happened in bond markets is encouraging. Rates are rising, as depression psychology dwindles. With luck, the recovery is going to take hold. Hurrah!

    I suspect you will argue he doesn't get it? On the one hand Wolf argues that the Fed is trying to lower long term rates to lower the threat of inflation, and on the other hand he expects long term rates to rise further. Is he talking about real or nominal rates? He doesn't say, and it does matter.

    Count me amongst the confused. Is it not safe to say that unless real growth, and narrowing of the output gap occur, inflation expectations or targets can't be achieved? Furthermore, if the expansion continues without job growth where's the upside?

  8. David,
    Please forgive me for not addressing you in the first person. Poor etiquette on my part.

  9. i find it amazing that people look at a two month data series and project into the future about expectation, which just change two months ago. um, any ideas on what could alter the expectations? or is it expectations of expectations? or onlike onward. none of you get it.

    money creation does not create wealth. it robs wealth from the holders of money.