@frances_coppola @wonkmonk_ He depresses Fed Funds to ZLB, and when using QE raises short term bond rates. Two separate interest rates.
— Ben Jackman (@btjaus) January 27, 2013
And to support his argument, he produced this chart:
(click here for larger version)
Now, this does indeed appear to show QE causing bond yields to rise, not fall. And I admit this did make wonder briefly whether what we have all been told about QE - that it works by depressing real interest rates along the yield curve, thus encouraging diversification into riskier assets - was actually correct. But I didn't wonder about this for more about than 5 minutes. You see this chart is not quite what it seems. Seeking Alpha (whose chart it is) has been somewhat selective in their choice of start and finish dates. Here's a more extended version of the same chart:
(click here for larger version)
I haven't fitted a trend line to this, but I think it is obvious. There is a clear downwards trend from 2008 to 2013. The peaks that Seeking Alpha attribute to QE don't change the trend. So QE does not cause permanent increases in bond yields.
It does appear to cause temporary ones, though. My monetarist friend stated that raising inflation expectations was the whole point of QE, and therefore rising bond yields would be a sign that it was working. But this doesn't seem to fit with the evidence. Higher inflation expectations would arise because of the expansion of the monetary base caused by the creation of new money to fund asset purchases. When asset purchases stop, as they did in March 2010 and June 2011, the chart shows that bond yields drop down to the trend line. But QE wasn't unwound, and the purchased assets didn't expire - on the contrary, the Fed has a policy of replacing any purchased assets that mature. So the expansion of the monetary base remained the same after the end of asset purchases. It didn't get any bigger, but it didn't reduce significantly either:
(source: St. Louis Fed - click here for larger version)
Therefore one would expect bond yields to remain elevated after the end of QE. But they didn't. They fell - fast. In fact they fell back to the underlying trend, which was significantly lower and falling. Over the period during which there have been three rounds of QE, 10-year gilt yields have dropped from over 4% in 2008 to 1.88%. Since US core inflation is around 2%, that is actually a negative real rate. The index-linked yield confirms this;
(click here for larger version)
So if the point of QE is to raise inflation expectations and thereby change the path of future nominal interest rates, it has been a spectacular failure.
But that isn't the point of QE. It is an unconventional tool used when interest rates themselves cannot be cut any further because of the zero lower bound, and it is intended to depress (not raise) real interest rates along the yield curve. From Michael Woodford's Jackson Hole paper, 2012:
The declared intention of the programs has been to lower the market yields (and hence to raise the prices) of longer-term bonds (not necessarily limited to the particular types purchased by the Fed), with a view to easing the terms on which credit is available to both households and ﬁrms in the US. Their eﬀectiveness in this regard is a matter of considerable debate.The rising price of Treasuries is supposed to nudge investors towards riskier investments, depressing the yields on those too and therefore cutting corporate borrowing costs. And falling yields not only on US Treasuries but on other bonds as well suggest that QE could be doing exactly what was intended. But Woodford points out that there might be numerous other reasons for this effect, including one particularly significant one (my emphasis):
But this should not necessarily be attributed solely to the Fed’s purchases of longer-term securities over this period; the period is one in which a continuing series of bad news has progressively increased the likelihood that market participants are likely to attach to the possibility of a protracted period of feeble economic growth and low inﬂation (or even deﬂation), and of course the FOMC has progressively extended farther into the future the length of the period for which it anticipates keeping its funds rate target in a band just above zero. Hence it is plausible to suppose that expectations regarding the length of time that short-term interest rates are likely to remain low have generally increased since the fall of 2008 (when it was not yet even obvious that the zero lower bound would be reached).In other words the principal influence on bond yields is not inflation expectations but the anticipated path of short-term interest rates as indicated by Fed statements and behaviour. Longer-term bond yields are on the floor because the Fed is indicating that short-term interest rates will remain near zero for the foreseeable future. Unbounded QE supports this policy stance and therefore helps to keep bond yields low: to the extent that it raises inflation expectations, the effect is weak and short-lived.
This is rather in contrast to my monetarist friend's view of the same paper. He claimed that Woodford was arguing for increased QE in order to raise the future path of nominal interest rates. This is frankly baffling. Why on earth would the Fed do QE to raise the future path of nominal interest rates at the same time as signalling that those same interest rates would remain on the floor for the foreseeable future? Surely QE is intended to support the monetary policy stance, not contradict it?
But then, as I noted at the start of this post, my monetarist friend doesn't think short-term interest rates and bond yields are related. Unfortunately that is not what Woodford says, and Woodford's evidence is considerable. And the relationship Woodford identifies between short-term interest rates and government bond yields makes logical sense, too. At the shorter end, government bonds and interest-bearing cash deposits are substitutes. At present interest rates on cash deposits are effectively zero, and the Fed is indicating that those rates will remain at or near zero for several years to come. Expectations of interest rates above zero are therefore moving out to the long end, pushing down bond yields along the curve.
Really what Woodford is saying that the main channel through which the central bank influences market rates is signalling ("expectations"), and that policy tools such as QE support this channel rather than being alternatives to it. Communication is everything - which explains the emphasis that Mark Carney placed on it at Davos.
In fact Woodford's paper does not argue for unbounded QE to raise expectations of future interest rates at all. What Woodford DOES argue for is unbounded QE as a policy tool to support a central bank NGDP target. This is because of his concern that inflation targeting actually contradicts the aims of low interest rate policy: it is not credible simultaneously to indicate that interest rates will remain low indefinitely AND commit to an inflation target. Confused signals like this undermine monetary policy and render it ineffective. However, it seems to me that the Fed is being somewhat flexible in the interpretation of its inflation target anyway: it appears to have shifted the emphasis to reaching full employment.
So QE should be used to support the stated monetary policy stance. But even then Woodford is lukewarm about it (my emphasis):
"A more logical policy would rely on a combination of commitment to a clear target criterion to guide future decisions about interest-rate policy with immediate policy actions that should stimulate spending immediately without relying too much on expectational channels. Neither a program of expanding the supply of bank reserves nor a program of expanding the central bank’s holdings of longer-term Treasury securities is a good example of the latter kind of policy..."And he concludes the paper with a strong call for an increased role for fiscal policy in coordination with central bank monetary policy, and commends the UK's Funding for Lending (FLS) scheme as a step in the right direction:
"The most obvious source of a boost to current aggregate demand that would not depend solely on expectational channels is ﬁscal stimulus — whether through an increase in government purchases, tax incentives for current expenditure such as an investment tax credit, or subsidies for lending like the FLS...."For some reason, with all the hoo-hah there was at the time about Woodford's support for NGDP targeting, this "heresy" was completely overlooked. Woodford is hardly a monetary hawk.
Because the UK's financial sector is severely damaged and the direction of regulatory change is unsupportive, I am not convinced that the FLS scheme will be all that effective: I suspect it will further inflate an already overblown housing market rather than improving business finance, which is what is really needed. But Woodford is right that it is the first serious example of coordinated monetary and fiscal policy, and right to indicate - as many others have - that fiscal policy is the key to ending the current stagnation.
Monetary policy has not completely run out of steam yet, and we certainly haven't seen the last of QE. But if you want a bazooka, look to the fiscal side.
UPDATE. Since most of the comments so far have homed in on the temporary yield hikes rather than the long-term trend, I thought I would add my views on those hikes. Temporary hikes that don't affect the long-term trend would normally be regarded as "noise", but in this case they do seem to be aligned with QE on/off. However, they are clearly mispricing, since they don't affect the long-term trend. There is no way they can be regarded as indicating that QE is INTENDED to raise yields. It is an anomalous effect. Whether the cause is carry capture strategies due to raised inflation expectations, as Izabella Kaminska suggests, or Michael Sankowski's idea that traders are bringing forward purchases to benefit from guaranteed sale and high prices, the raised yields can only be a temporary phenomenon and are bound to unwind over time. Neither QE1 nor QE2 was really long enough for the mispricing to unwind.