Wednesday, January 26, 2011

QE2 and Rising Yields, Again

Late last year I was making arguments like this one about how QE2 would work:
[T]he recovery view begins with notion that a successful QE2 will first raise inflation expectations.    The increase in  inflation expectations, however, also implies higher expected nominal spending (i.e. higher future nominal spending means higher future inflation).  Higher expected nominal spending in an economy with sticky prices and excess capacity should in turn lead to increases in expected real economic growth.  Finally, this higher expected real economic growth should increase current real long-term yields.  Given the fisher equation, this understanding implies that the rising long-term nominal yields are occurring because of both higher expected inflation and higher real yields.
Thus, contrary to the sales pitch made by Fed officials that QE2 would lower yields, we should expect to see yields ultimately increase if QE2 is successful.  Below is an updated figure on the 10-year expected inflation and 10-real treasury yield. (Click on figure to enlarge.)

[Update: the labels on the graph were original reversed and now have been fixed]
To the extent the sustained rise in real yields is reflecting an improved economic outlook, can we not attribute some of that improvement to QE2?


  1. Most agree that QE2 was signaled to markets by Ben Bernanke in his late-August Jackson Hole speech. Since then, the change in real 10yr yields has been immaterial (about 14bps).

    What was the impact of QE2 on real 10yr yields? Perhaps two factors offset each other: on the one hand, QE2 helped finance an increase in net Treasury issuance (depressing yields); on the other hand, it likely raised growth expectations (raising yields). The rise in inflation expectations since August could be cited as evidence of either factor.

  2. David -

    You are making too much of the last 12 months. I still say look at the long chart. Yields are well within a 30-year down-sloping channel (log scale.)

    To be meaningful, the yield must break out and stay out of the channel. It's way to early to tell. The channel bottom won't hit zero for at least another decade.

  3. David,

    Real yields were heading down until late October, early November. This decline, as I understand was because of economic weakness. Thus, QE2 changing of real growth expectations did not occur until this time. If we use that starting point real yields have gone from around 0.50 bps to 1.22 bps. That's impressive. Of course, QE2 may not be the cause of that reversal.

  4. Jazzbumpa:

    Good point on keeping a broader perspective. Even if this is the beginning of an improving trend, something could still happen that pushes yields back down(e.g. Eurozone breaks up).

  5. David,
    Are you sure that real rates are rising? Nominal yes. Are they (nominal rates) exceeding the rate of inflation in the same time frame? And the question is whether we are seeing effects of monetary policy, or of external factors, such as a signal from the new fiscal policy makers that Congress is going to cut spending and possibly exacerbate the excess money demand disequilibrium? I know you swore to exorcise the demon, but I think you need to give in to temptation.

  6. Nanute:

    The bottom red line in the figure is the real interest rate from TIPs. There are some liquidity premium issues with them, but for the most part the yield from TIPs securities are the bond market's ex-ante real interest rate. In the figure above, it is the 10-year real yield.

    On your second question, yes there are probably other factors contributing to its increase. All I am asking is whether the marginal improvement--it is far from a full recovery-- suggested by the rise in the real yield can be attributed in part to QE2.

  7. David,
    I should have looked at the chart closer,before commenting. I think what it shows is that the market is expecting a rate of inflation of around 2% for the next ten years. It's a start, but I don't think it is enough to stimulate growth to the point where unemployment will be impacted positively. You could argue that the results are attributable to QEII.It will be interesting to see how the market reacts to the near certain reduction of spending at the federal and state levels of government. And the question will be can the Fed have a counter effect on fiscal policy of the magnitude being discussed by the "chicken little" wing of the Republican Party.