The Federal Reserve’s Quantitative Easing is Raising Inflation Expectations
I suspect the Fed can begin and may well have already begun some QE type stuff. They won’t announce it until later and I don’t believe they will have done so in a big way. But, if they announce on Nov 3 that they already are doing QE, this could be beneficial to asset prices – because I think that’s what they’re concerned about.
–The Federal Reserve Wants Inflation, October 2010
I wrote this paragraph one month before the Federal Reserve announced its second program of quantitative easing. I want to be clear that this program has no direct effect on the real economy as banks are not reserve constrained; adding reserves via quantitative easing does not increase the amount of loanable funds available for creditworthy borrowers. Rather, banks make the loans first and then worry about the reserve requirement afterwards, borrowing reserves in the inter-bank market if necessary. The only way that QE affects the economy is through its psychological impact in changing private portfolio preferences because of expected low rates followed by expected future inflation and the resultant policy tightening.
It works like this:
long-term interest rates can be expressed as a series of short-term interest rates, such that if you know long-term rates, you can calculate expected future short-term interest rates. This is important because it tells you what people believe the Federal Reserve is likely to do with interest rates in the future.
So, if the Fed signals that it is prepared to keep rates low today despite rising inflation, interest rate expectations will shift downwards for the near-term, but inflation and interest rate expectations will shift upwards further out in the future. Future rate hikes will be seen as likely and market participants will shift their private portfolio preferences accordingly, steepening the yield curve. That’s how the so called bond vigilantes work in a reflationary environment. That’s what’s happening right now – and generally speaking, it’s good for stocks, neutral for short-duration bonds and negative for long-duration bonds.
Here’s how Jim Bianco put it in a post at Barry Ritholtz’s site:
While Bernanke’s assertions are tenuous when viewed from a November 3 start date, note that in the passage above he said, “since we began the QE2 program in August … [t]he bulk of the increase in interest rates has been in the real side“.
While many want to use November 3 as the official start of QE2, note that the Federal Reserve first began buying bonds in August to hold the size of their balance sheet steady. It was on November 3 that the FOMC agreed to expand the their balance sheet via QE2.
Bernanke used August as his starting point of QE2, so we will also use it…
Since August, both of these tables show the 5-year inflation break-even rate is up more than nominal yields. This means all of the rise in nominal interest rates since last summer can be attributed to higher inflation expectations. This is exactly the opposite of Bernanke’s contention that “the bulk of the increase in interest rates has been in the real side“. In fact, none of the rise in yields since August has come from higher real rates.
Get it? "[N]one of the rise in yields since August has come from higher real rates." It’s all about increased expected inflation. See my post "Gross: Central Banks are Robbing Bond Holders and Fuelling Inflation" for a review of what US government bond holders think of this policy.
The real question is whether the inflation that bondholders are expecting will actually lead to rate rises. Bond vigilantes can sell Treasuries in expectation of future rate hikes. (Remember, long rates are simply a chain of expected future short rates.) However, if the Fed remains on easy street for an extended period, what I call permanent zero, then eventually the vigilantes are going to have to say uncle. This is the tug of war now going on. You have serious asset and commodity price inflation that has begun to feed through into consumer price inflation – first in food and soon across the board. Central bankers like Ben Bernanke and Mervyn King are telling us this will pass. If it doesn’t, then they will be forced to either hike rates or accept stagflation. The bond market vigilantes are selling bonds in expectation that the central banks will hike. Who wins this battle?