Eugene Fama: QE Doesn’t do Much

Nobel prize winner Eugene Fama has done his homework on QE and seems to understand the basic accounting behind it that so many others misinterpret.  In this CNBC interview, Fama explain to Rick Santelli how the only thing being inflated by QE is the expectation that it has wide ranging impacts on the economy.  He explains that it’s a simple asset swap of a version of long debt for short debt and that there’s really no reason for this to impact the economy all that much.

He then went on to explain how winding down QE won’t likely cause an interest rate death spiral. Santelli, not surprisingly, was utterly shocked by some of this. My respect for Fama went up by about a million fold after watching this interview….

 

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Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services. He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance and Understanding the Modern Monetary System.

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Comments

  1. “There’s so much confusion in what you said, it’s difficult to answer.” – Said Cullen Roche to everyone who ever commented on Pragcap for the first time.

  2. Of course investors wouldn’t bid up perpetual assets because interest rates happen to be low for a period of time. That would be irrational and investors aren’t irrational.

    Sorry for the snark.

    Here is the rub, QE does nothing and something all at the same time. The nothing happens to be what the Fed wants to happen (upward pressure on incomes/nominal GDP) and the something (inflating asset prices) is outside of their model of the world (Fama’s too).

    Has anyone done a survey of investors that asks them to state what the goal of QE is?

  3. So are reserves really short debt? They don’t have a maturity attached. Retiring them is not as simple as letting them roll off as short term debt is. Not that I expect things to get out of hand, but reserves seem to have an indeterminate lifespan. It’s easy for the Fed to create them, but reducing them seems more difficult if there were more compelling opportunities to lend them out.

  4. So if QE doesn’t really do much, why would the Fed open itself up for so much criticism, culminating in calls to “end the Fed”?

  5. Interesting point about the maturity of reserves, or lack thereof. I think reserves do have a determinate life span that is related to whatever is on the other side of the Fed balance sheet. In the case of QE, for example, the Fed has a t-bond on the asset side and reserves on the liability side. When the t-bond matures, both the asset (the bond) and the liability (the reserve) are extinguished.

  6. Yes, why do it then? I think that in the end most people who think they understood it will have been proven to not understand it.

  7. They are there as long as the Fed wants them to be, and market participants know that and treat them as such.

    If you are saying the world is not as simple as Fama describes, then I agree with you.

  8. We should probably distinguish between required and excess reserves. The lifespan of required reserves depends largely on the needs of the banks. The lifespan of the excess reserves (which are mainly due to QE) depends on the Fed. To extend my example above, the Fed obviously doesn’t have to hold the t-bond to maturity. It could sell the t-bond, but the balance sheet effect would be the same, i.e. shrinkage.

  9. We will not monetise the debt, he lied.

    QE will never end, for it keeps the USGovt in funds.

    Spend, spend, spend, the Fed has our back.

    What could possibly go wrong. Nothing, unless one looks at dozens of other currency collapses throughout history.

  10. He’s wrong about the “upward pressure” on the short rate.

    That would be true if it were a pure market swap, but it’s not.

    It’s a swap of an administered rate (short rate on reserves) for a market rate (bonds).

    The short rate is based on an administered rate – almost entirely technical – the administered interest rate paid on reserves complicated slightly by some partial technical arbitrage glitches like GSEs not being paid interest on reserves. But that’s all basically non-market stuff.

    The bond market rate is what it is, with the Fed having a marginal effect on the demand side, but not an administered effect (it’s not the Second World War).

    The fact that they’re buying bonds has virtually no consequence for the short rate, which seems to be what he’s arguing. So it’s not a zero sum game in that sense. IF there is an effect on long rates, it’s definitely a net effect from the swap perspective.

    But give him marks for understanding that there are two sides to the Fed balance sheet.

  11. Fair point. In theory, wouldn’t the entire balance of reserves expire were the fed to let their whole balance sheet mature?

  12. That’s not quite right. As I understand it reserves are like cash and can last forever. If I sell you a bond and you pay with cash, the cash on my balance sheet is not affected when the bond reserves.

    However if you look at the marco accounts, a maturing t-bond can lead to a lowering of reserves by operating through the governments balance sheet. When the bond on the fed’s balance sheet matures, the proceeds go to the treasury, which then has less of a need to issue debt. By issueing less debt or even running a surplus, all other things being the same, the private sector’s finanicial assets will need to decrease, which will lead to a decrease in reserves.

  13. Not the entire balance of reserves, as a certain amount is required for regular banking operations. But I think most of the “excess” reserves would indeed expire.

  14. Fama’s assessment is not totally correct either. QE has a lot of effects, just not those that most people, not the Fed official, think.

    One practical effect is to subtract hundreds of billions of dollars from savings accounts, effectively taxing savers to give to borrowers. Another practical effect is more indirect and has to do with the moral hazard induced by cheap credit: both the government and corporations have the incentive to borrow freely for questionable investments. E.g. corporations have been buying back shares, a notoriously inefficient usage of cash, to prop up stocks, rather than investing in potentially productive activities or further reducing leverage. The government in turn keeps borrowing to support a bloated welfare state, which is also an unproductive form of spending.

    A more subtle consequence is that QE removes high quality collateral which can create problems for leveraged transactions.

    So, technically, yes, QE is a non-event. However, practically, it has a lot of unintended consequences.

  15. “If I sell you a bond and you pay with cash, the cash on my balance sheet is not affected when the bond reserves.”

    That is solely a private sector transaction that doesn’t affect anyone’s balance sheet (no debt has been created or extinguished). In the case of the Fed selling a bond, its balance sheet does shrink and reserves disappear.

    “When the bond on the fed’s balance sheet matures, the proceeds go to the treasury”

    The treasury is the one paying off the bond in the first place! And they will likely do so by issuing a new t-bond.

  16. We have entered the realm of lunacy…… maybe the “rare” solar eclipse this Sunday is arriving early. $85 Billion every month………

  17. “That is solely a private sector transaction that doesn’t affect anyone’s balance sheet (no debt has been created or extinguished). In the case of the Fed selling a bond, its balance sheet does shrink and reserves disappear.”

    Not really sure what you mean here. Sure the fed can shrink resereves if it wants to, but this has nothing to do with when the bonds on the fed’s balance sheet mature.

    “The treasury is the one paying off the bond in the first place! And they will likely do so by issuing a new t-bond”

    Yes, the treasury is essentially paying off the bond to itself, so it needs to issue less new debt than if the bonds were held by the private sector.

  18. Business Insider is mostly filled with ranting hyperinflationists, tea baggers and idiots who read Zero Hedge.

    Their opinions are all useless.

  19. Sorry, man. I wasn’t totally clear above. You are essentially arguing that reserves are like cash. I’m saying that reserves are not exactly like cash because reserves are a liability of the Fed. In the case of QE, the Fed creates reserves out of thin air to buy t-bonds (balance sheet expansion). Therefore, when the Fed sells the t-bonds, the process is reversed and the reserves disappear (balance sheet shrinkage). If the Fed holds t-bonds to maturity, the reserves also disappear.

    And the Fed holding t-bonds does not reduce the Treasury’s need to issue more debt. It doesn’t matter who holds the bonds. They must be paid off in the normal way, with deposits which are obtained either from taxes or issuing new bonds.

  20. If the Fed wants to shrink its balance sheet it will either sell the assets back to the market (another asset swap) or it will simply let the bonds mature which will result in a natural shrinking of their balance sheet.

  21. The only people who want to end the Fed are the ones who don’t understand that the Fed is an essential clearinghouse for the banking system. Maybe we should end QE and interest rate manipulation. But ending the Fed as a clearinghouse would be monumentally stupid.

  22. I’d actually be interested in hearing more about Fama’s view on QE because it’s weird for a rational agents and EMH guy to talk about how a lot of people are misinterpreting QE. If he’s right then people must be acting highly irrational based on total misinformation. This would seem at odds with some of his thinking….

  23. Well, in the last 4 weeks BI has published articles by me saying that the Fed isn’t owned by the banks, Austrian economics sucks, the Fed isn’t a scam and now this one that says QE doesn’t do much.

    I mean, if you’re the hyperinflationist or Austrian type then you pretty much think I am the dumbest guy on the planet after those series of articles….

  24. Agreed, replace nothing with very little and my comment is more to the point without hyperbole.

    The difference between you in Fama is that you recognize that “wildly overblown” can or maybe does lead to other problems and consequences. Or maybe “wildly overblown” could be the new name of the “portfolio channel effect”. That would make “wildly overblown” the intended policy effect.

  25. You guys are lot smarter then me .Please explain transactions
    A) Fed buys Tbond from Dealer bank and deposit $in Dealer bank reserves.Reserves ae bank money correct?
    B) Tbonds mature or Fed sell bonds.Proceeds go to treasury ?How is this effect Reserves? I must be missing something

  26. Exactly. I think the irrational interpretation of QE can cause other economic dislocations that can lead to bubbles and irrational exuberance, etc. That’s where Fama and I see things very differently.

  27. If the Fed is essentially a clearing house then why all the fuss over auditing its books?

  28. Who knows. The Fed gets audited by the GAO, the OIG and independent auditors. This idea that the Fed doesn’t get audited is absurd. It’s amazing how some of these myths about the Fed just don’t die. It’s like people are hanging onto Austrian economics no matter how many times they get everything wrong and just lie to people. It’s madness.

    http://www.federalreserve.gov/faqs/about_12784.htm

  29. The number one goal of QE is to cause future inflation expectations to go up (whether this is a rational reaction or not by investors) and thus cause current negative real interest rates. When at the zero bound the Fed hopes to make borrowing even cheaper for banks and corporations — currently not so much for Main Street. Especially in 2011 the Fed was able to force real rates to go extremely negative.

    Recently we saw a run up in yields beginning last spring when the Fed first mentioned “tapering” and leveraged income investors then unwound huge trades in a tight liquidity market. Tapering discussions by Bernanke baffled bond traders as they saw low real GDP growth and low inflation — why would the Fed pull back now? One could make a good case that the 10 year US note is currently trading in a true price discovery mode — real GDP at about 1.5-2% and inflation 1%. A 10 yr at 3% is probably where we should be.

    It seems perhaps that Bernanke has waved the white flag and realizes that the bond market won’t take the bait again of negative real rates. If that’s the case then the multiple expansion in the stock market is going to have a difficult time going up if the credit multiples stop expanding.

  30. I’m glad you recognize that bubbles are being formed. Nasdaq Composite is almost at 4000…. RUT over 32% YTD….yikes! SPX +24% YTD! It sure seems to me that bubbles are indeed forming in the stock market! But I suppose billionaire hedge fund managers (the ones that have connections) won’t have to worry, because likely the Fed and Treasury will “magically” clue them in right before the spigot will get shut off (while there’s still enough euphoria to sell into). ;-) I wish my last name rhymed with “pepper”…so I could “magically” be clued in myself….JMHO! ;-)

  31. I plead ignorance on the answer to that question – because I think that’s the only intelligent way of answering it. Nobody knows because it’s a counterfactual. We can only guess – and never be held accountable for our guess. It’s a very risky question and answer.

    But one point that I don’t see made very often:

    The Fed faces political risk in loading up its balance sheet with bonds – to the degree it may eventually raise short rates and threaten its own interest margins in doing so – i.e. to the point of making a loss – because of the mismatch between fixed rate assets and floating rate liabilities (reserves paying interest). The politicians would be all over that. However unlikely this is, it is a risk. Therefore, the Fed has its own political skin in the game when it loads up on bonds, and it will be in its own political interest to have an economic outcome where short rates don’t go up too quickly the future. And it controls short rates. So it’s making a bet on the economic outcome using political risk chips. And so it means business when it says it’s going to keep short rates low – and in some sense it’s betting the future viability of its own interest margins in doing so. If all this is true, then the market should discount lower rates for longer and built that into bond prices.

    Others may dispute that the politics has anything to do with it, but I think it adds an element of commitment to what they’re doing and the market may recognize that.

    Other than that, I have little to say that I haven’t seen elsewhere. You would think that reducing the supply of bonds might have some effect on price, but how much I don’t know. My guess is that alone isn’t the major factor, but I could be wrong there.

  32. I’d add that what the Fed is hoping for is a portfolio rebalancing effect. So they’re removing interest bearing risk free bonds and forcing the aggregate pvt sector balance sheet to chase return. This could not only drive up asset prices thereby improving pvt sector net worth, but could also entice investment.

    It’s really hard to say how impactful QE has been here though. If you look at corporate profits it’s quite obvious that there’s been a fundamental driver behind the stock market in recent year. And if you understand the Kalecki equation then you know the budget deficit has been the main driver there. So anyone who says the market is going up without a fundamental driver has been wrong for years and is just regurgitating some conspiracy theory they read on the same old tired sites spewing that stuff for 5 years.

    But it’s hard to say what the overall impact here has been. My guess is that QE has caused at least SOME stock market impact and some interest rate impact. But I generally think it’s been declining in efficacy as the years have gone by.

  33. Jay, I am a market guy. I’m no academic. I’ve lived an breathed bubbles for years. I’ve literally been in the thick of bubbles and the mentality that drives them. I know bubbles are a real thing unlike someone like Fama. Anyone who thinks govt policy can’t cause irrational market reactions has never been on a trading floor or traded a sizable portfolio when the shit is hitting the fan….This stuff’s largely behavioral. Ignore the behavioral aspect and you missed the real world aspects of much of it.

  34. I might analogize it to a commercial bank running a big interest rate “gap” position – with the manager of the position saying to the CEO – don’t worry, this is going to work out fine. Of course, one difference is that the manager doesn’t set the fed funds rate – but neither does the Fed lock in future fed funds rates today – its also taking a similar risk in running its own “gap” position (“gap” meaning long term asset sensitivity; short term liability sensitivity).

    P.S. Fama also missed the essential answer to Santelli’s question on exit – the answer to that question is that the Fed raises the funds rate target in order to tighten, and that the pace of the balance sheet runoff shouldn’t be an issue for the market (but it will be an issue for Fed profits).

  35. Should add that Fama in any event has a much better grip on this than Santelli… which shouldn’t be earth shattering news.

  36. Question, though, Cullen: You say (and I agree) that the Fed controls the short end of the curve and lets the longer end drift within reasonable bounds. But Fama clearly says the Fed has been unable to control the short end, because what they are doing should have pushed short yields higher (esp versus the long end), but they have collapsed instead. This, indeed, is what has happened. You’re take on this? Thanks.

  37. Cullen,

    I am not sure why you think it has no effect and things such as those. (Although you have said it has an effect somewhere else but I guess you are undecided which is good in a way because intelligent people are always so!)

    Check this Reserve Bank of India release on QE and the worry about depreciation pressure.

    http://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=29086

    Now you can argue that the market reaction was misguided and so on but everything is behavioural. You can’t selectively take out some and say fundamentally this has no effect while say the rest of your description is what it is because that is also psychology.

    Also, remember the S&P 500 candle from the last FOMC around 14:00 ET?

  38. See JKH’s comments. Fama is wrong there. The Fed is explicitly setting the short rate at 0.25% (with some minor various for complex reasons). He gets the interest rate functions wrong. But understands the basic accounting behind QE nonetheless.

  39. I agree. Big political risk in the exit strategy. And also unknowable behavioral effects. The idea of the end of the Bernanke Put could be as damaging as the idea of actually raising interest rates substantially even if they don’t.

    There are a lot of unknowns with QE which create risks here.

  40. Hi Ramanan. It’s not that I think QE does nothing. I just think its effects are overstated.

    I am curious though – have you written anything on this QE effect in emerging markets? I am admittedly ignorant on the effects there. I am more focused on domestic effects. Can you elaborate on why this is so negative for countries like India?

    Thanks for your perspectives. Just when I get too domestic I can always count on you to make me think broader!

  41. “If you look at corporate profits it’s quite obvious that there’s been a fundamental driver behind the stock market in recent year. And if you understand the Kalecki equation then you know the budget deficit has been the main driver there”

    – The only thing your thesis is missing is that pesky peculiarity of revenue growth vs EPS growth…….if the “fundamental driver” behind the stock market is the Kalecki equation (Gov’t Deficits=corporate profits)….then why hasn’t the top line grown at the same rate as the bottom line?

  42. Oh haven’t written anything specific to open economies. I do however think that it has had a big effect on US equities itself.

    About the open economy case – yes I think it has an effect there too. Although QE – when the OMO is done doesn’t change the private sector wealth itself, it changes the composition. So rebalancing this will occur at the international level as well because portfolio demands for investors depends is for all assets.

    In many such cases, one can argue like this: for an outflow, there is an inflow and so on. While it is true, these flows are “cleared” by prices of all assets and hence prices change.

  43. I did a quick survey of Fama’s view on QE. You might find it useful.

    Here goes:

    *Eugene Fama: If “anything will shake my faith” in efficient markets, it is quantitative easing*

    *Mr. Fama dismissed market concerns about the beginning of tapering of the five-year quantitative-easing program as a non-issue.*

    Citing the strategy of buying short-term debt in order to finance the purchase of long-term debt, he said: *“I don’t understand why everyone is paying attention to this tapering,”* Mr. Fama said.

    *“The Fed is using one kind of bond to buy another kind of bond,” he said. “What’s the big deal, and why is anyone taking the Fed seriously?”*

    http://www.investmentnews.com/article/20131013/REG/310139995

    All the hullaballoo about Fed tapering, quantitative easing and artificially low interest rates is silly. If “anything will shake my faith” in efficient markets, this is it, famed finance professor Eugene Fama told attendees at IMCA’s annual conference in Chicago, although his explanation for his belief left some advisors asking for more detail.

    “Why do people care?” asked Fama, who is known as the father of modern finance. To the amazement of some attendees, Fama maintained the Fed had little influence at all over interest rates.

    Conventional wisdom holds that the Fed can determine short-term interest rates but has limited control over longer-term rates. Fama wasn’t buying into it. “Short interest rates went down despite the Fed, not because of it,” Fama said.

    It’s true that Fed activity has made the term structure of the yield curve a little steeper than usual. As for the potential for tapering, Fama called it a neutral activity. The central bank would simply be selling one kind of bond to buy another.

    If the fears of all the hysterical folks wringing their hands over Fed activity were justified, we’d already have hyperinflation, Fama said.

    So what does Fed activity imply for portfolio decisions? Not much. “You’re stuck with it,” he said.

    http://www.fa-mag.com/news/the-one-thing-that-makes-eugene-fama-question-market-efficiency-15699.html

    Santelli asked specifically about the effects of the Fed’s quantitative easing program and the risks associated with it.

    “What they are doing… the effects are being greatly inflated by the accounts,” said Fama.

    “What they’ve doing is issuing a lot of short-term debt — $85 billion a month — and using it to buyback long-term debt with the goal of lowering the interest on long-term debt,” he added. “Now they take credit for lowering interest on short-term debt. But in fact what they’ve been doing should’ve raised rates on short-term debt.”

    Fama argued that the Fed was not affecting the economy that much.

    Santelli, however, continued to pursue the idea that there are risks associated with the Fed’s actions.

    “They’re basically neutral events,” said Fama. “I don’t think they do very much.”

    But Santelli kept pursuing this line of questions, and tensions began to rise.

    “Let me interrupt you,” Santelli interruped at one point. “If it’s no big deal, then why don’t all central banks just do this to the nth degree and make it a constant day to day week to week event where they purchase what’s issued, keep interest low, and just target a low rate forever. Why won’t that work then?”

    “There’s so much confusion in what you said it’s difficult to answer,” responded Fama.

    http://www.businessinsider.com/fama-to-santelli-qe-is-a-neutral-event-2013-10#ixzz2j9U3N5DT

    Eugene Fama On Inflation

    Finally, Fama offers some dismal thoughts on inflation. Starting in 2008 when it intervened following Lehman’s collapse, he says, the Federal Reserve has purchased $2.5 trillion in debt financed almost entirely by excess reserves at the banks. The monetary base was about $150 billion before the Fed began buying. The Fed has been paying interest on those reserves, theoretically to compensate banks for the “opportunity cost” of maintaining higher reserve balances at the Fed. That’s simply “issuing bonds to buy bonds,” and neutral, Fama says.

    http://www.forbes.com/sites/danielfisher/2012/12/02/eugene-fama-on-inflation-the-crisis-and-why-you-cant-beat-the-market-after-fees/

    Fama [= "guest"] on Finance

    Russ: Well, that’s a problem. Again, I wish Milton were here. I’m mystified by monetary policy generally, as anyone who has listened to these podcasts knows. Guest: Well, I am too. In the podcasts of this program that I’ve listened to, I’ve heard everybody talk about the Fed controlling the interest rates. That’s always escaped me how they can do that. Russ: Yes, I’m mystified by it myself. Guest: But I’m in finance, so you’ve got an excuse. Russ: When I interviewed Milton in 2006 and I asked him why there had been a change in public discussion at least of what the Fed does from changing the money supply to instead manipulating interest rates, his answer was: Well, that’s what they say but that’s not what they do. They like to say they manipulate interest rates because it makes them feel powerful. All they really do is change the monetary base. And in fact he said, if you look at M2, that’s the thing to look at. Guest: That’s the thing to look at if you want to know what’s happening to business activity. But it’s not something you can do anything about. Russ: I’m with you there. While we’re on that subject, do you have any thoughts on why the Fed is paying interest on reserves? Guest: Oh, absolutely. Because they know that if there is an opportunity cost from these massive reserves they’ve injected into the system, we are going to have a hyperinflation. Russ: So what’s the point of injecting the reserves if you are going to keep them in the system? Guest: Exactly. Russ: So what’s the answer? Guest: *The answer is: this is just posturing. What’s actually happened? That debt is now almost fully interest-bearing, all the liquidity that they’ve injected. So, they’ve actually made the problem of controlling inflation more difficult. Controlling inflation when they didn’t pay any interest focused on the base: cash plus reserves. But now the reserves are interest-bearing, so they play no role in inflation. It all comes to cash, to currency. How do you know? Currency and reserves were completely interchangeable; that’s what the Federal Reserve is all about. So I think they’ve lost it. Now what happened, they went and bought bonds, long-maturing bonds, and issued short-maturing bonds. It’s nothing. They didn’t do anything.* Russ: But they are smart people. Guest: Right. Russ: Ben Bernanke is not a fool. If you could get him alone in a quiet place with nobody else listening and say: Ben, what were you thinking? What do you think he’d say? Guest: I don’t know, but I wouldn’t believe it. *In the sense that at most he could have thought he could twist the yield curve. Lower the long-term bond rate. Now I’m looking at the long-term bond market–it’s wide open. Even though they are doing big things, they are not that big relative to the size of the market.* Russ: Yes, I am mystified by that as well. I don’t have an explanation. Guest: Let me put it differently. So, *if I look at the evolution of interest rates, is it credible that in the early 1980s the Fed wanted the short term interest rate to be 13-14%? Russ: No. You are making the argument that it’s endogenous; that they can’t control it. Guest: Maybe they can tweak it a bit; they can do a lot with inflationary expectations. That will affect interest rates. Turn it around–all international banks think they can control interest rates; and at the same time they agree that international bond markets are open. Inconsistent.* Russ: Correct. It reminds of this CNN reporter, credible insight into economic policy. He said: Macroeconomics generally–and fiscal policy, but he could equally as well be talking about Central Bank policy–he said: Politicians who think they can control the economy are like a little kid who is playing a video game; he hasn’t put the money in yet and he is watching the arcade game do all its bangs and bells and whistles and noises. Which is an advertisement for the game. And he’s pushing the buttons, and he’s attributing all the successes on the screen to himself even though he hasn’t put the money in yet because he misunderstands the underlying process that generates what he is seeing on the screen. There is some truth to that. Guest: There’s a lot of truth to it.

    http://www.econtalk.org/archives/2012/01/fama_on_finance.html

  44. Dr. Fama said the Fed’s QE purchases should have pushed the short rate up, but instead the short rate has fallen. He didn’t get a chance to offer his opinion why the short rate has fallen.

    So why has it fallen?

  45. He’s making a rather basic error there. Excess reserves drive the overnight rate down. The Fed has to prop up the overnight rate by paying interest on reserves. Here’s how the NY Fed describes this:

    “Recently the Desk has encountered difficulty achieving the operating target for the federal funds rate set by the FOMC, because the expansion of the Federal Reserve’s various liquidity facilities has caused a large increase in excess balances. The expansion of excess reserves in turn has placed extraordinary downward pressure on the overnight federal funds rate. Paying interest on excess reserves will better enable the Desk to achieve the target for the federal funds rate, even if further use of Federal Reserve liquidity facilities, such as the recently announced increases in the amounts being offered through the Term Auction Facility, results in higher levels of excess balances.”

    http://www.newyorkfed.org/markets/ior_faq.html

    So he actually has the operations partially wrong. But he’s way closer than Santelli is on all of this….Isn’t it sad when the understanding of QE is so bad that I applaud a guy who still gets it wrong? :-)

  46. Yeah, I give up man. All of these conversations just further reinforce my belief that trying to change people’s minds on this stuff is a big waste of time 99% of the time. I seem to be getting through to about 100 people and the rest think I am a lunatic.

  47. Thanks, I already know that…..I assumed you did too. I thought it was safe to assume that you already recognized the heart of the equation as it pertains to your point. Gov’t deficit is by far the largest variable in that equation for the past 5 years……do you disagree? To avoid a long comment on irrelevant (for the purposes of your point) technicalities; I shortened it to the basis……below is your statement, am i misinterpreting it?

    “If you look at corporate profits it’s quite obvious that there’s been a fundamental driver behind the stock market in recent year. And if you understand the Kalecki equation then you know the budget deficit has been the main driver there”

    What am i missing? Besides these technicalities, your response failed to address my point……if the fundamental driver of the recent stock market run has been “the budget deficit” then why haven’t revenues grown at the same pace as EPS? Seems pretty obvious to me that the surge in EPS has largely been cost cutting and financial engineering (buybacks, refi’s etc.)

    Eagerly awaiting you explanation.

  48. I’ve learned that once you accept that a T-bond is not a bond (that might have to be paid back, if not in the aggregate, at least in some degree), but a ‘financial asset’ with many of the same characteristics as money, then all of this makes sense.
    QE is indeed an asset swap, trading one financial asset for another. The asset was created at the point of deficit spending. After QE, then T-bond holder has the same position he did before he bought the bond, but the public has a deposit.
    Frankly, it is confusing to me that this doesn’t create reportable inflation. On the other hand, the cost of living is rising every year without a raise in wages, so perhaps it does. Or perhaps it just moves dead money into the economy, where it circulates for a while and then returns to the wealthy and becomes dead money again.
    I have two suspicions. One is that QE is merely a form of laundering in order to free up more money to purchase new bonds. Joe sells his T-bond to the Fed, gets a deposit, then buys another T-bond.
    The second is that once it is understood that T-bonds are not really backed by taxing power, but exist solely only their own, there could be some sort of panic.
    The second is that once it is understood the Treasury-Fed can create these financial assets (easily convertible to deposits) then politicians will start to wonder why we can’t create them and hand them out directly. Just give every family in the U.S. a 100k T-bond and let them convert it to a deposit in a QE type action.

  49. Interesting, Unless I’m mis-reading it seems Fama was calling for hyperinflation at one point……I wonder does Cullen adjust the 1000 respect points he awarded Fama earlier for this transgression?

    “Guest: Oh, absolutely. Because they know that if there is an opportunity cost from these massive reserves they’ve injected into the system, we are going to have a hyperinflation.”

  50. The move in the interest rate on the ten year during the taper tantrum was very large; a once in fifteen year move. Although correlation is not causation, it looked like the bond market was wobbling on the mere threat of a simple slowdown in the flow of QE, and much of the move up has not been reversed since then. It shocked the Fed, and only an academic could dismiss reality so glibly. This is the same kind of naive certainty that was given to the application of Gaussian probabilities to market analysis and VaR that almost brought down the TBTFs in 2008-09. Americans seem to have the collective attention span of a hummingbird.

  51. I guess that’ my big point though. The deficit has tapered and the private investment and dividend component has picked up the slack. Corporate profits aren’t strong, but the reason they’re maintaining some growth is because the pvt sector has healed in line with the deficits reduction. Did you read my link above? It might help clarify.

  52. Well, Fama is working from a -50,000 point level in my book to begin with because of all the EMH stuff and Chicago school biases so 1,000 points doesn’t do too much. :-)

  53. Cullen,

    I agree that earnings have a improved considerably since the bottom in 2009. But is the improvement 100% real and does it warrant 1100 S&P handles over the past 4 years? That is the real question. I am not saying we should be trading at 600, after all QE1 and changing the accounting rules re-capitalized banks and gave them some cheap “earnings”

    But companies when continually miss the top lines of their owned guidance we can safely assume the miss was that much bigger. Of course, the bottom line can and is being manipulated like never before. There is only so much cost cutting you can do and it is safe to say that 4 years later cost cutting is not the contributor it was then. So if you agree we are not comparing apples to apples as far as earnings are concerned, then the impact of multiple expansion in the market is that much higher.

    I am not sure how anyone can recommend investing in markets based on quantifying multiple expansion and future level of animal spirits. Furthermore the claim that QE forces people to take on more risk in the search for yield has mania written all over it.

    The “managers must find something to invest in all the time” argument sounds like herd mentality and momo trading. It feels as though the current investment environment has a lot of this and constantly needs a greater fool to continue. What if there isn’t a greater fool tomorrow? I guess we can’t run out of fools for a lot longer than that but is this even predictable.

    Basically companies are missing the same easy expectations they set for themselves at an alarming rate. Has there ever been a time where this trend was so prevalent? A few years back when the earnings beat rate was much higher and the economy was growing at a healthy 3% to 5%, was it really growing faster? Either it was understated then or it is ridiculously overstated today. How do we reconcile this???

    The market has become he greatest to big to fail institution in the world. How can we say it is anything other than that?

  54. You get through to more people than you think but not everyone has free time to argue with psychos in a comments section. Keep up the good work.

  55. p.s. they don’t have time to argue with psychos like Rick Santelli on t.v. either but that’s another story, hehe.

  56. Cullen. You seem rather impressed by Dr Fama and a bit dismissive of Rick Santelli.

    So, Dr Fama says that the reserves which are receiving interest are on the balance sheet and effectively offset the longer maturity notes so that it is simply a matter of cancelling one side against the other. hmmmm.

    Isn’t the problem that that the reserves belong to somebody else’s balance sheet. On the Fed’s balance sheet are short term IOUs (something like Federal Reserve Notes) issued to buy long term IOUs. There is nothing else.

    Also, look at the Treasury website’s current yields and see what you deduce about the yield curve and where rates are high and low. I would think that investors shortening duration/maturity risk is pushing the demand towards the front end of the giant ARM called our National Debt. How much interest should there be in a 30 years paying 3.72% (principal to be repaid in 2043)?

    http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/TextView.aspx?data=yield

    What would be the incentive in either an inflationary or deflationary scenario for anyone to give up liquidity for slightly higher yielding illquidity? If interest rates rise, the long maturity of the Fed holdings will drop about 10% for each 1% increase. If interest rates fall, the market value of the holdings may go up but what has to happen to cause this decline? And, if inflationary pressure creates negative interest rates, there still is no incentive to give up liquidity for these.

    Also, QE has new purchases monthly but what of the return of principal and interset on the portfolio? Where does it go?

    So, when the Nobel Laurete says that the Fed policy is not working as expected and he tries to be an apologist for the process, I might not see matters the way you do where your: “respect for Fama went up by about a million fold after watching this interview.”

    Actually, what seems to be happening is a slower playing out of the action in Adam Fergusson’s classic work “When Money Dies.”

  57. I haven’t seen this argument made before. It is an interesting one and I think very plausible. I really appreciate sharing it!

  58. Also, Cullen: having read your analysis of QE, I can see that you have a similar understanding of balance sheets as Dr Fama. You observe that QE is essentially “business as usual” for the Fed and I agree. But…………….. in the examples you give, the asset sold versus the cash received (by whichever party is selling to whichever party is buying) is clean and balanced. The fly in the ointment is that the Fed enables and funds the deficit and this is because the cash does not remain on the balance sheet. The balance sheet discussion must include the profit and loss statement which is a report card for the how successfully funds have been used.

  59. I agree with your thesis except for the “high quality collateral removal” – the Federal government is also issuing a lot more debt than normally. So one needs to see whether the Treasury issuance, net of Fed purchases, is declining, which is probably the case only in 2013.

  60. I will try a shot on the QE effect on 10-year rates:

    1. Rates were going down on their LT trend plus cyclically down on GFC fear in 2008
    2. QE instilled risk seeking (although the turning point was the change in FASB 157), so yields went up, but kept their LT downward trend, as it was a perfect carry trade for banks
    3. When QE ended in 2010 and 2011 the economy looked poised for a recession and yields went down (partially in anticipation of QE – who knows), but once QE started they went up again
    4. In 2013, after yields had reached what looks like an all-time low in 2012, yields became negatively correlated to stocks (something rare since 2000 – the start of the secular bear market of stocks). Then, consistent with this new correlation, they reacted poorly to the prospect of QE ending – a 180 degree change to previous behavior. Probably banks realized that the carry trade in Treasuries is over, a secular low in yields was reached previously. So currently QE serves to lower / keep yields low. I guess yields will decline one more time when the economy disappoints over the next 6 months or so, but the downward trend is over. Probably they will be on a very slight upward trend afterwards, but will not go very high.

  61. We have had a rash of studies (NY Fed, St Louis Fed, private guys, Fama, now) who say QE is mostly inert..Paul Volcker said QE had been neutralized by IOER…

    Fine..why not have the Fed target only US government securities and pay off, say, $8 trillion of the national debt? That would leave $8-( trillion outstanding, and about half of that owned by federal agencies…we would become a relatively deleveraged nation, easing burdens on future taxpayers…

    As long as the Fed rolls over on this debt, it is essentially a monetization of the national debt…

    Japan tried four years of QE 2002-6 and hit no inflation…

    It is regarded as a cardinal sin to monetize debt…but what if it works?

  62. I agree 100%. Add to that that EPS growth has been fuelled by share repurchases and that wages have remained stagnant, and one has to really question the sustainability of the recovery. US Debt has been growing twice as fast as US GDP, and the markets freak out for just a short sequester. Hmmmm ….

  63. “Actually, what seems to be happening is a slower playing out of the action in Adam Fergusson’s classic work “When Money Dies.””

    That is what I believe to be happening. The people who expect hyperinflation and the people who make fun of those that expect hyperinflation tend to miss a very important fact. When money dies most of the effect takes place during a very small period of time when confidence in the money printers is lost. A bankrupt country that is in trouble can appear to have a relatively sound currency and a working economy for years before the collapse comes.

    http://d1w116sruyx1mf.cloudfront.net/ee-assets/channels/cdd_default/GoldPriceInWeimarMarks.jpg

    I never had much respect for Fama because his EMH is obviously not reflective of the real world where knowledge formation has subjective elements and economic actors do hot have the same goals or time preferences.

  64. The argument about the Fed balance sheet won’t go anywhere because the two camps disagree what is happening when the Fed ‘buys’ an asset.
    One camp believes that when the Fed buys a T-bond (for example) it has ‘borrowed’ the money to do that and must of course pay it back to itself.
    The other camp believes the Fed creates the money electronically and has no need ever to pay it back.

    I think the first camp is conventional wisdom and spurs a lot of the angst about debt. I think the second camp is the practical reality, but once it becomes accepted, it opens up a new line of objections and all sorts of questions.
    Like, if the Fed can electronically create money, can I get some?!
    Really, the only debate about T-bonds is similar. One camp believes they are bonds that must be paid back, the other believes they are stand-alone financial assets.

  65. While everyone continues the debate on whether QE does or does not, the FBS continues to re-liquidity the banking industry balance sheet with it’s massive intervention of buying MBS…

    And, of course, real estate prices continue to fall and mortgage rates are still much too high, the original Central bank’s claims..

    Let’s not forget the million of loans which are upside down, inside out waiting for the next economic cycle down…

    The Fed’s motto – deleveraging to prevent hemorrhaging…

  66. - Fama is one of the “Chicago school” and that makes him less credible. Guess the Neo-classical school still has A LOT OF influence. I would say, too much influence.
    – Fama is right that the FED is not issuing (“printing”) money.
    – The FED is – like all the banks have been doing – issuing more credit. That’s why the balance sheet of the FED is growing.

  67. “The other camp believes the Fed creates the money electronically and has no need ever to pay it back.”

    How do you think that all those foreign speculators, corporations, and governments are going to react to the idea that the Fed will just keep creating the money that is used to back the purchasing power of treasuries? That is Gideon Gono’s Zimbabwe model. How did that work out?

  68. I understand the basic point in your balance sheet example: that when the Fed creates cash to buy securities, they are creating a liability/acquiring an asset of equal value. But isn’t that true of the purchase of anything at the margin? By definition, if markets function to discipline prices, the net assets of the buyer and seller will not change due to the transaction. However, when considered more than an infinitesimal quantity, QE does increase the demand for the securities that are purchased, and this will influence the price (i.e. distort the market price in the absence of QE). The effect of QE is on the implied rate of exchange of cash for securities (e.g. interest rate). So wouldn’t those who originally held the securities ultimately see an increase in the value of their assets at the higher price/lower interest rate following substantial QE?

    Isn’t the intention of engaging in QE+longer term interest rate targets an effort to get around the issue of zero-bound short-term interest rates; to push the expected nominal longer term interest rate down below the expected rate of inflation (negative real interest rates) because the longer term rate is based on the expectation of future short-term rates? And at least through spring of 2013, the Fed was successful in achieving negative rates (whether QE should have worked or not).

    If QE has little effect on longer-term interest rates, then why did the market react to the potential for tapering of QE in spring 2013 by pushing nominal 10-year rates up by over a percentage point? Or would you say that the markets reacted irrationally in response to the prospect of tapering of QE?

  69. “Fama is right that the FED is not issuing (“printing”) money.
    – The FED is – like all the banks have been doing – issuing more credit.”

    Since you can use credit to buy scarce goods and resources you still have the same problems. There is no free lunch in this world.

  70. I don’t know why people keep thinking that ending QE would cause an interest rate death spiral. THE LONG END OF THE CURVE CANNOT BE CONTROLLED (for any extended period of time)! After every single QE, yields on the long end of the curve have gone up, not down. This idea that QE causes yields to go down is absolutely absurd.

    Just think about it this way: what asset classes perform in an environment of deflation and no growth? Cash and government bonds. The only way you get to flat yield curves across the ZLB is by deflation/no growth/deflationary expectations/low-to-to growth expectations(see Japan). If you’re stuck in a deflationary/no growth environment, money is very tight so we should expect the yield curve to be inverted. How can you have an inverted yield curve at the ZLB? You can’t, so your yield curve will look flat. Even Fama seems to understand this.

  71. no matter how hard I try, I cannot understand the “it’s a simple asset swap”.

    -Government needs cash, issues bonds, banks buy the bonds and give the government cash
    -Fed buys the bonds from the banks for reserves that pay interest (interest paid in cash or more reserves?)

    So where is the cash that the banks are using coming from? Are they drawing it from their credit lines at the fed?

    Do the banks make money on these transactions? How?

  72. It’s even more complicated than that. Whatever anyone buys is a swap actually, so purchases in the ecinomy do not matter. They are free will exchanges and noone is better off, because nobody’s equity increases.

    No, now seriously. I guess Cullen calls QE a swap is because he assumes that the Fed pays the market (fair) price for the assets. But this would be really monetization if you ask me. It is a swap because it is reversible (in theory – in practice not very likely). So it is “printing of money” (reversible or not). But now Cullen comes to think that if you exchange something woth $100 for $100 nobody is better of (no equity change), so it is “only a swap”. Only a swap is also if you buy a car. So buying anything is only a swap and it does not matter.

    What actually happens with QE is that, QE is not with banks as the final buyer, but mostly with private investors. So QE creates in this case both reserves at the (middlemen) banks and deposits at the investors’ accounts. Thus QE increases M2 money supply without new loans being created. (this is the “money printing” part, if QE were only with banks, it would create only reserves, which are not part of the money supply of the private sector, but serve for interbank settlements or can be drawn as physical cash from ATMs to extinguish deposits).

    QE matters not because it increases someone’s entity (it does not if done at fair prices), but it increases M2. As a portfolio rebalancing effect, the prices of all assets rise on average by the corresponding amount (or maybe much more if it becomes a self-reinforcing irrational bubble as it currently seems to be the case). But it can also show up in higher goods prices at some point, although less likely currently due to the weakish economy, deflationary pressures of globalization and deleveraging etc..

  73. “Where is the cash that the banks are using coming from?”

    The same place it always comes from when banks buy any other type of financial asset. It comes from the banks’ own resources. Normally, the banks would be pretty highly levered when they buy Treasuries (i.e. not using much of their own capital and borrowing the rest). Sort of like you or I buying securities on margin.

    “Do the banks make money on these transactions?”

    Most of the time, especially when they are just holdings the bonds for a short time and basically just earning the bid/offer spread. But I’m sure they get offside occasionally but on their trading positions. Also, I think the primary dealers earn fees for participating in the auctions.

  74. I prefer to think of the Fed as trying to manipulate prices, but being unable to manipulate fundamentals. What the Fed is doing is kind of like a company that issues a stock buy back that might entice some people to buy more shares thinking the supply has been reduced, but misunderstanding that the fundamentals of the corporation are not necessarily going to change unless the company does something else. There is no “something else” with what the Fed is doing. So they can try to jam prices to the moon, but if their policies don’t have a corresponding fundamental economic impact then they’re just blowing bubbles.

  75. That idea implies a lack of demand for govt debt. There is no lack of demand for govt debt. We’ve seen that every time a QE ended. For instance, when QE2 ended yields tanked as demand for bonds soared. There’s zero evidence of a lack of demand for govt bonds.

  76. Of course, keep in mind, Fama thinks fiscal stimulus does less than not much, it does absolutely nothing. Here’s Fama in 2009:

    http://www.dimensional.com/famafrench/2009/01/bailouts-and-stimulus-plans.html

    “…The problem is simple: bailouts and stimulus plans are funded by issuing more government debt. (The money must come from somewhere!) The added debt absorbs savings that would otherwise go to private investment. In the end, despite the existence of idle resources, bailouts and stimulus plans do not add to current resources in use. They just move resources from one use to another…”

    That’s pure “Treasury view”, in its most unsophisticated form. Fama asserts that desired savings are automatically converted into investment spending, and that any government borrowing must come at the expense of investment.

    Anyone expecting great insights into monetary or fiscal policy from Eugene Fama are going to be almost as disappointed as if they expected Santelli to offer such insights. Fama is not a macroeconomist, he’s a financial economist.

  77. So long as the U.S. economy remains strong, it probably won’t be an issue, right?
    But, really, if the central bank accelerates its bond purchases, then the market has no say in the matter.
    It’s like when the Fed began purchasing Fannie Mae bonds selling at 60 for par. The Fed set the market.

  78. Cash is also a liability of the Fed. That’s why they are federal reserve notes.

    When a t-bond matures the treasury needs to pay the principal to the Fed. So the money is subtracted from the treasury’s account at the fed. So at this point on the fed’s balance sheet it just had a change in assets from the bond to the money recieved from the treasury. I am not sure if the tresuary’s account at the fed counts as reserves. I could see arguments going either way. If it does count as reserves than the maturing bond does cause a reduction in total reserves.

    However the next step in the process is that the fed pays back the profit it recieved from the bond to the treasury, which is why the treausry will consequently have to issue less debt then if the bond was privatly held.

  79. My main point is that the maturing of a t-bond will not affect the reserves that were used to buy it. Reserves will only be shrunk by the affects on the treasuries balance sheet.

  80. Mark,

    This goes back to our previous discussion. Did you think some more about it? Do you not agree that issuing the net financial asset in the T-bond during deficit spending is important? This adds a new financial asset to the private sector that did not previously exist. There is no corresponding private sector liability. Therefore, deficit spending actually improves the private balance sheet. This is only a negative if you’re the type who worries that the pvt sector balance sheet has been improved at the expense of the govt’s balance sheet. Which would be true only if you’re worried about the govt going bankrupt, which is absurd when you understand that the govt is a contingent currency issuer….Or maybe it’s a worry if you think, as Fama does, that all govt spending is malinvestment or something close (which is partially true, but not entirely).

    I think you and I would probably agree that all these govt policies probably matter a lot less to the real economy than people fuss about. After all, it’s the pvt sector that drives this bus 95% of the time. The govt is mostly just fiddling with various components of the economic machine at different times. But it’s not the driver and it’s certainly not the source of drive in the driver’s mind….

    I am babbling….But yes, I generally agree. Fama is not the guy to be listening to as an authority on these matters.

  81. Is there actually any evidence of these “huge” leverged trades out there?

    It seems to be conventional wisdom, but neither the financial sector or any other large part of the economy seems to be particlarly leverged to me.

  82. Suvy you’re right that they can’t control the long end of the curve for very long, but very incorrect on the direction of rates relative to QE starting or ending. Rates have gone up during QE (traders discounting a greater rate of future inflation added to expected real GDP growth) and have went down every time QE was ended. Lots of analysts of simple charts showing this effect.

  83. Agreed that the reserves that the Fed used to buy the t-bonds will not technically be the same as the reserves in Treasury’s account. However, that does not negate my main point, which is that the aggregate level of reserves will decline when the Tbonds held by the Fed mature.

  84. When the Fed tries to sell its long dated treasuries who will step up to buy them? If demand for treasuries goes down rates will HAVE to go up UNLESS the monetization of debt continues.

    And please note that if we use the 1990 methodology to measure inflation the CPI stands around 5%. It is 10% if we use the 1980 methodology. While the reported inflation levels are benign I do not know anyone who buys stuff from the BLS. Do you?

  85. “Do you not agree that issuing the net financial asset in the T-bond during deficit spending is important? This adds a new financial asset to the private sector that did not previously exist. There is no corresponding private sector liability. Therefore, deficit spending actually improves the private balance sheet”

    Yes but, historically the supply of U.S. private safe assets has been significantly larger than the stock of U.S. government safe assets.

    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1986945

    Consequently it is unlikely that the U.S. Treasury could create enough securities to fill the gap created by the shortage of private safe assets without undermining the safe asset status of Treasuries. Furthermore, empirically a sudden and permanent rise in the expected growth of NGDP leads to a rise in the supply of private safe assets and a decline of public safe assets.

    http://fmwww.bc.edu/ec-p/wp802.pdf

    http://people.wku.edu/david.beckworth/irfsblog.pdf

    Thus the resolution to the safe asset shortage problem is monetary policy catalyzing the private sector into recovery.

    “I think you and I would probably agree that all these govt policies probably matter a lot less to the real economy than people fuss about. After all, it’s the pvt sector that drives this bus 95% of the time. The govt is mostly just fiddling with various components of the economic machine at different times. But it’s not the driver and it’s certainly not the source of drive in the driver’s mind.”

    The Federal Reserve drives the *nominal* economy 100% of the time. That’s why it’s the only institution with both a stable price and maximum employment mandate. If the Fed does its job right, the *real* economy is delivered to its nominal destination completely oblivious to the fact the Fed is the one that’s actually driving the bus.

  86. The people who think it’s a consiracy just don’t understand how prices and living standards relate. The BLS used to use a cost of goods index. So a phone was a phone was a phone. This didn’t account for substitution or upgrades in quality of goods. This was a relevant view of the world 100 years ago when bread was bread was bread. But it’s an irrelevant view today. The impact of technological changes and the vast improvement and changes in consumer goods requires a new way of viewing inflation’s effects. Hence, the BLS uses a cost of living index at present. This much more accurately reflects the changes in our actual consumer goods and how they impact our lives.

    The people like Austrian economists and Shadow Stats are hanging onto that antiquated way of calculating CPI because they don’t understand what they’re talking about. The BLS has this right.

  87. Glad we agree there. And yes, I agree with you that, statistically, t-bonds as NFA play a smaller role than some people claim.

    I guess we just disagree on how the Fed can drive the real to the nominal. I agree they could in theory, if they acted more like a fiscal entity, but I don’t see the powerful transmission mechanism you seem to see. They just don’t seem to be enacting the tools at present to do so. And I do question how much an NGDP target alone would achieve. The Chuck Noriss effect isn’t enough in my opinion. Maybe I am still missing something.

  88. It isn’t just about safe assets. The deficit injects equity/income into the private sector, which sometimes is sorely needed.

  89. “The same place it always comes from when banks buy any other type of financial asset. It comes from the banks’ own resources.”

    Not exactly. The banks are heavily leveraged. That is why the taxpayers had to bail them out.

  90. Isn’t that what I said? Where I come from “highly levered” means the same thing has “heavily leveraged”. If not, my bad.

  91. I should also note – on that Fama quote – home slice is using a a loanable funds model which is totally wrong. He doesn’t get endogenous money at all. Thus the crowding out implication….

  92. “There is no “something else” with what the Fed is doing.”

    But there is. We usually call it counterfeiting and theft if ordinary people do it but it is quite permissible for the Fed to act in ways that we are not permitted to act.

  93. Cullen,

    Thanks for your blog, I really enjoy it.

    How does your “Kalecki model” accounts for the fact that the dividends are being funded buy unprecedented bond issuance?

    Profits are not growing but dividends and buybacks (which admittedly reduce dividends) are, as corporations appear to play the same “duration swap” game that the Fed is with QE.

    To that point, Fama mis-characterized the “duration swap” element of QE because the Fed is NOT issuing “short bonds to buy long bonds”, they are flat out monetizing bond issuance of all durations (including bonds issued a few days before), essentially swapping dollars (with zero duration) for any Treasury security. The moneyness of the swap is important because it enables liquidity that can be converted, leveraged, and reallocated in a variety of ways.

    The reason QE had a tremendous effect on all manner of assets is precisely because of the fungible nature of cash it injects. QE does more than impact interest rates because the cash can be easily converted or reinvested in any manner of security all over the globe. I think the record issuance and demand for all manner of bonds and stocks, is essentially a QE induced carry trade. In 2000, Bonds comprised 36% of the global investable market (17% US, 19% Int’l) and that has increased to 58% today (23% US, 35% Int’l). QE cash has bolstered not only housing prices and stocks, but is impacting collateral and international markets too.

  94. Sorry but there is no other explanation for the QE fiasco. The Fed is buying bonds because others would want a higher yield. The government owes $17 trillion in debt, several trillion to the SS, Medicare, and pension ‘trust funds,’ and has around $200 trillion in unfunded liabilities. Only speculators looking for short term moves and central banks would willingly buy debt from someone that will be forced to default. The Fed is buying treasuries because it HAS to not be cause it wants to.

  95. It’s not counterfeiting. You just need a license to act like the Fed. It’s called starting a bank. Of course, you could also issue your own “reserves” and trade them for t-bonds and MBS or whatever, but you need to find people who want those things. I doubt anyone would.

    It’s not really right to claim the Fed is counterfeiting. Especially when it’s a legal construct of the US Congress.

  96. “I think you and I would probably agree that all these govt policies probably matter a lot less to the real economy than people fuss about. After all, it’s the pvt sector that drives this bus 95% of the time. The govt is mostly just fiddling with various components of the economic machine at different times. But it’s not the driver and it’s certainly not the source of drive in the driver’s mind….”

    American federal, state, and local governments and government related agencies make up about 45-50% of total GDP so all this matters far more than some people think. Too many people are too compliant and listening to academics that have no clue about how real markets work. No wonder so many are caught by surprise when the supposed unexpected event, that was seen as inevitable by those that were ignored, comes along.

  97. “The BLS used to use a cost of goods index.”

    It goes far beyond this. There were two changes made by the methodology that severely understate inflation. I would rather place my money on ShadowStats being right than the bureaucrats at the BLS being right.

  98. I was responding to the ‘their own resources’ part. Sorry but I don’t really see much resources in the financial system that belongs to the equity holders. Much of the crappy holdings that used to be on the balance sheets before the Fed purchased them would have required write-downs that would have destroyed all equity. From what I see the financial system is bankrupt not only in the US but in most countries and the biggest threat comes not from private loans but from the ownership of supposedly riskless sovereign debt.

  99. Well, by that measure the US consumer snacking on chips and salsa is the big driver of the economy. It’s better to focus on private investment. That’s the thing that keeps the economy humming most of the time. All the spending around that just fuels this engine.

  100. The Fed can print money and create reserves out of thin air. Banks can’t do that.

  101. That’s not correct. Bank deposits are created endogenously. It’s a presto-change-o balance sheet transaction. Loans go up, deposits go up, loan asset goes up, deposit liabilities go up. That’s all! It’s that simple.

  102. “Rates have gone up during QE (traders discounting a greater rate of future inflation added to expected real GDP growth) and have went down every time QE was ended”

    This is exactly what I said and have said for a while.

  103. When the Fed stops buying longer term Treasuries, stocks are no longer subsidized. People will rotate out of stocks into Treasuries. I don’t know the short term impacts, but the longer term impacts are pretty straight forward.

  104. I love this theory because it’s contrarian and counter-intuitive.

    It also might be right. :)

  105. I used the term “resources” on purpose. I was looking for a broad word that would encompass a lot of things, but most importantly the strength of a bank balance sheet, i.e. borrowing capacity. The bank buys stuff (including Tbonds) usually by expanding its balance sheet.

    And bank balance sheets are currently very strong, and well capitalized in the US. Not sure how you could say that the US banking system is bankrupt.

  106. It’s hard to understand this logic (or actually lack of same). If anything, QE has increased money in savings accounts, not decreased it! A person who does an asset swap, selling a bond to the Fed and getting cash, generally puts it in a savings account. That’s a big part of why bank reserves have swelled, because individuals have sold bonds and put the cash in savings.

    Since it is a fact that QE has raised interest rates how can you argue about the moral hazard of cheap credit? The net effect of QE periods vs the intervening periods has been a net increase in all yields beyond 3 months. So it’s a fact that QE has raised interest rates.

    The problem here is that people don’t think and don’t look at the facts.

  107. Careful there John:

    Selling bonds doesn’t increase saving. It swaps types of saving. A t-bond is like a saving account. A cash account is like a checking account. Swapping the two does not increase the private sector’s aggregate saving. Therefore there has been no change in pvt sector net worth due to QE unless you believe there’s been huge capital gains changes.

  108. Fama is a smart guy, but he doesn’t get the fundamental basics of banking correct!

    He argues that the Fed has been issuing short term debt to get the proceeds to purchase long term debt and that should drive up the yield on short term debt. He sees it as the Fed needs to get dollars (via offering IOR) to purchase long securities (QE). This is the classic financial model of a bank, it needs to acquire funds before it can deploy said funds.

    But we know this is wrong! Everyone should work out banking with fiat currency in the limit of a single bank. All loans and all deposits are held at the one bank. Sure, our system is far more complex, but you have to be able to go to the single bank limit in any logical discussion of the monetary system.

    MR is the only model that I know of that is logically consistent in the required limit. That doesn’t mean it gets everything correct in the “real world”, but it means that every other model has to be rejected as logically flawed.

    Technically QE has been a non-event. It has raised long rates a bit when it’s in operation.

    Has it distorted markets via behavioral factors? I don’t know. The stock market, in fully normalized terms, is not high priced, but perhaps it is a bit taking into account economic growth probabilities.

    But the wacko media has dominated the discussion of QE, and markets do respond to what they think other people think.

  109. I tend to believe that. The Fed knows that deficit spending is going through the roof over the next decade, so by buying bonds now, it gets the market ready for what will happen next.
    Also for QE, I pretty much take the Fed at its word — it wants to buy bonds to drive down rates to deal with the coming rise in total debt being rolled over; and it would rather see people spending money or investing it in other ways rather than T-bonds.

  110. The Fed could buy all the debt, but it wouldn’t be monetization — it would be a swap of one kind of financial instrument for another. Right?
    The monetization comes at the point of deficit spending, when a financial instrument known as T-bond and now convertible into a deposit at the Fed is created.
    What would happen if the Fed bought massive amounts of T-bonds? Probably even more buying pressure on stocks and other assets. After all, nobody wants to own a depreciating deposit.

  111. “Technically QE has been a non-event. It has raised long rates a bit when it’s in operation.”

    Without QE the government would have to be prudent in its spending and financial institutions that took stupid risks would have been taken out and liquidated. The housing bubble would certainly not have been reflated and there would have been a slower transfer from poor people to the financial sector. So I would not say that it has been a non-event. If it was a trivial factor the markets would not go nuts each time there is a hint of ending it.

  112. I prefer to look at actual prices thank you. Go and check out what has happened at the Dollar stores, the fast food outlets, the coffee shops, education, insurance or rental markets. Most of the things I see are up in price. Food and energy are certainly up but those don’t seem to be counted. When airlines report prices no inflation is shown even though the food and drinks that were given away for free now cost extra, we have to pay for luggage and have longer wait times.

    But what is missed is that which is not seen. Given the huge advancement due to outsourcing and distribution gains we should have seen a decline in prices. But thanks to the Fed’s inflationary policies we didn’t get to enjoy the benefits of all that gain in productivity just as consumers in the 1920s failed to enjoy the benefits of productivity increases in the form of lower prices. Inflation is an increase in the supply of money and credit. It does not have to show up as higher prices in consumer goods right away. It can just as easily show up as higher prices for houses, gold, stocks, or bonds. What we are seeing is the greatest bubble in the history of the world and the Fed is scared out of its wits that the bubble will burst. That bubble is the UST market and when it finally gives up the ghost many of us will finally open our eyes to the criminal manipulation being done by the Fed and big banks but by that time most will be too far down to ever recover. What we seem to have is another Peter Schiff moment. All the ‘experts’ don’t see anything wrong but the few of the ‘nutcases’ are calling for a crash. Note that the last time around the nutcases were right and the experts were shown to be ignorant empty suits. I see no reason to believe that it will be different this time.

  113. That’s what I started to realize when I began to learn more about the monetary system. My problem is with using interest rates as a tool to micromanage the economy, which I find sickening.

  114. I agree, but Andrea’s point was with respect to “savings” that manifest in some measure in the MZM. To the Austrians and neo-Austrians savings are distinguished from NFA.

    When people swap Tsy for cash they increase savings in “money” and decrease it in NFA. It’s an asset swap for the individual selling the bond. But technically it generally increases savings in “money” and decreases savings in NFA (where NFA excludes MZM type assets).

    At the core of all of the confusion about money in economics is that most people don’t understand that money is worthless (e.g. you can’t eat it) It’s an accounting fiction, albeit one we would have trouble giving up. Money is important to you or me, but at the global macro economic level it has to integrate to zero at all times.

    I am not unaware of the tradeoffs between M1, MZM, NFA, and other FA’s and the irrational behavior of people around them. Although I understand this pretty well, I still keep at least a year of living expenses in M1 accounts, and another couple years in MZM accounts. So yes, I’m irrational like everyone else. But I sleep better with this balance. In most of our personal lives (micro economic) there is a difference between $1 in a M1 account and $1 in a Tsy. The Wealth Effect Ben hoped for is that someone is more willing to buy real services or production when they have $1 in M1 vs $1 in NFA. I think that’s a stretch for anyone who has routinely held NFA’s. Hence, I think QE has had a small effect.

  115. Nobody cares about the change of net worth. What we have is more money (M2) and less assets and goods. Ergo, prices rise. Its called marginal utility. Its in every textbook.

  116. Your logic is similar to the one that business investment is just a swap (no change in net worth, a BS expansion), so it cannot show up as a source of business sector profits in the Kalecki equation.

  117. I agree with you mostly, but there is more to it. Markets are also a “game” of “common knowledge, so everyone reacts to what everyone thinks that everyone thinks. Check the Epsilon theory blog about it.

    So now it is difficult to say in how much QE matters for its mechanic effects and how much due to this “game” being played. There is also the effect of wilfully allowing misunderstanding to persist in order to revive animal spirits by the Fed.

    Understanding the true effects is not very helpful for trading though, if everyone reacts as if the misunderstanding were true and plays the “game” (e.g. check also the theory of reflexivity and how to trade the false trend from Soros)

  118. It’s not a theory but an empirical observation. The theory would be on why this has happened. But in 2013 the relationship has changed: taper threat -> yields up.

  119. Actually in Japan they have managed also to have QE and falling yields, after an initial misbehavior. I guess the banks are playing a very levered carry trade in JGBs, relying on the BoE to hold their back so you could get inflation expectations of 2% with LT JGB yields of below 1% for some time.

  120. Why would you accept a taxable return of 3.5% per year when your costs are going up more than that and the issuer cannot pay back all of its loans and continues to run deficits? Now you could argue that people will try to play the very short term flight to liquidity but that seems like a dangerous game.

    Why is it that so many people who are smart cannot see the fact that the Fed is just following the playbook of the Bank of Japan and the Bank of Zimbabwe?

  121. I am sorry but I do not agree that the balance sheets are strong. The simple fact is that the value of many of the assets held by the banks are based on models and not on real market prices. There are trillions of derivatives out there and in many cases you have both sides of a transaction using mark to model accounting to claim profits. This is not a new story; we saw it just before the market correction in 2007 that few of the ‘experts’ saw coming. And let us note that you could have said the same about the Greek banks. Their balance sheets were sound as they had followed the advice of the Bank of International Settlements and loaded up with sovereign bonds issued by the Greek government. When the value of the sovereigns collapsed the banks’ positions were exposed for what they were.

    As I wrote previously, this seems to be another Peter Schiff moment. All the experts are lined up talking up the markets. During non-delivery months gold gets hit in the off hour trading as paper contracts are sold in huge volumes over a short period of time as foreign central banks say thank you and take all the physical that they can lay their hands on. Yet we have more and more agreements where countries decide to use currencies as payment for transactions that used to require the USD and there seems to be a growing movement to replace the USD’s monopoly as a reserve currency. We can choose to ignore the signposts or we can look at the fundamentals and try to figure out what they mean.

  122. I am glad that someone brought up Japan. The BoJ did what the Fed is now doing. How did that experience work out?

  123. The FED is just there to uphold private banks prerogative to create money out of thin air by supplying liquidity when needed.

    What must end is the private banks issuing power. Issuing power should return to the people. Democracy is only a facade as long as money creation is in the hands of private interests.

    It was THE major political battle of the 19th century. It got sealed and buried when the present system was enacted.

  124. The US government isn’t a democracy, it’s a Federalist Republic. When the Constitution was written up until the 17th Amendment, Senators weren’t even directly elected, they were appointed by the state legislatures. Honestly, I think there’s a good argument we should go back to that. I don’t think Senators should be running campaigns to get reelected; I don’t like it.

  125. From what Fama says, unwinding QE will cause long term rates to rise.

    The implication of them doing QE is that at the time they seek to unwind, if they ever bother, is that short term rates would be likely to have a natural tendency up (because economic activity will have picked up and capacity utilisation including labour will be tending towards constraint) and their activities in unwinding should tend to raise long term rates. They can control short term rates to at least some extent by simply reducing the interest rate paid on reserves so it becomes unattractive for the banks to hold excess reserves. The banks then redeem reserves and buy long tem securities which they fund short to take advantage of the normal shaped yield curve as they have done for about 80% (guess based on experience) of the time since the mid 60’s.

    Taper of rate of increase of the balance sheet seems to be the most likely first stage and maybe it will just happen without foreshadowing and will happen very slowly at first so that people say after the event “well, that didn’t cause a problem”.

    I think the fiscal consolidation from the next round of sequetration cuts could be the bigger issue because of the accounting identity between the surplus and deficits of G(ov’t), P(rivate) and E(xternal).

    What are the forecast sequesters over each of the next 12 months?

  126. Maybe the answer is in a combination of funding the deficit, the USD/RMB exchange rate, and the yield curve (level and shape) and we are all looking at things too simplistically.

    US unemployment can only be reversed if the net profit of offshoring jobs is marginal and so not worth the political and economic risk.

    US demand will pick up when more people living in the US are working. The numbers working have been increasing since before the last census, with a short period of fall as the census staff were laid off.

    Falling USD (and Euro) against RMB and rising Mexican, Chinese, and other LDC wages are key to less offshoring of US jobs.

  127. “What must end is the private banks issuing power. Issuing power should return to the people. Democracy is only a facade as long as money creation is in the hands of private interests.”

    Why would I trust the government more than the free market? The private banks would not be able to create money out of thin air as the Fed does. It would have to issue notes that are backed by something tangible like gold or silver because nobody would trust anyone with the power to counterfeit. The issuance of money is too important to be left in the hands of government or government protected institutions.

  128. The republic died a very long time ago. The US has a social democratic system like most EU countries.

  129. The banks are limited in how much credit they can create and they need deposits in order to create credit. The Fed isn’t limited and does not need deposits.

    In a market system no bank would be allowed to issue pieces of paper and call them money unless those pieces were backed by something like gold or silver that would impose discipline on the inflation process.

  130. How do you encourage capital formation when the political parasites use the regulatory and tax environment to transfer wealth from investors to rent seeking vote sellers? The US seems to have a casino economy that depends on gambling on artificial stability created by liquidity injections. That is not a sustainable model.

  131. You mean it’s better that it lies in the hands of private interests? You feel more at ease with this tremendous power in the hands of unaccountable big banking families?

    Let us recall what former statesmen and politicians said:

    “History records that the money-changers have used every form of ruse, intrigue, deceit, and violent means possible to maintain their control over governments by controlling money and its issuance.” – President James Madison

    “I sincerely believe that banking institutions are more dangerous to our liberties than standing armies. The issuing power should be taken from the banks and restored to the people to whom it properly belongs.” – President Thomas Jefferson

    “If congress has the right under the Constitution to issue paper money, it was given them to use themselves, not to be delegated to individuals or corporations.” – President Andrew Jackson

    The Government should create, issue, and circulate all the currency and credit needed to satisfy the spending power of the Government and the buying power of consumers.

    The privilege of creating and issuing money is not only the supreme prerogative of Government, but it is the Government’s greatest creative opportunity.

    By the adoption of these principles … the taxpayers will be saved immense sums of interest. Money will cease to be master and become the servant of humanity.” President Abraham Lincoln

    “Whosoever controls the volume of money in any country is absolute master of all industry and commerce… And when you realize that the entire system is very easily controlled, one way or another, by a few powerful men at the top, you will not have to be told how periods of inflation and depression originate.” /President James Garfield

    And the man who put the final nail in the coffin…

    “I am a most unhappy man. I have unwittingly ruined my country. A great industrial nation is controlled by its system of credit. Our system of credit is concentrated. The growth of the nation, therefore, and all our activities are in the hands of a few men. We have come to be one of the worst ruled, one of the most completely controlled governments in the civilized world. No longer a government of free opinion, no longer a government by the vote of the majority, but a government by the opinion and duress of a small group of dominant men.” President Woodrow Wilson

    And on the other side….

    “The few who understand the system will either be so interested in its profits or be so dependent upon its favours that there will be no opposition from that class, while on the other hand, the great body of people, mentally incapable of comprehending the tremendous advantage that capital derives from the system, will bear its burdens without complaint, and perhaps without even suspecting that the system is inimical to their interests.” Rothschild 1863

    “I am afraid the ordinary citizen will not like to be told that the banks can and do create money. And they who control the credit of the nation direct the policy of Governments and hold in the hollow of their hand the destiny of the people.” /Reginald McKenna, as Chairman of the Midland Bank, addressing stockholders in 1924.

    “Banking was conceived in iniquity and was born in sin. The Bankers own the Earth. Take it away from them, but leave them the power to create deposits, and with the flick of a pen they will create enough deposits to buy it back again. However, take it away from them, and all the fortunes like mine will disappear, and they ought to disappear, for this world would be a happier and better world to live in. But if you wish to remain slaves of the Bankers and pay for the cost of your own slavery, let them continue to create deposits.” /Sir Josiah Stamp, President of the Bank of England in the 1920s, the second richest man in Britain.

    Now, you are telling med that you prefer private bankers to hold issuance power?

  132. “You mean it’s better that it lies in the hands of private interests? You feel more at ease with this tremendous power in the hands of unaccountable big banking families?”

    I think that it is better if market forces kept everyone contained rather than to have an unaccountable monopoly. I take it that you do understand that your country had banks when there was no Federal Reserve System and that even with all of the government meddling the markets kept credit expansion under control because any banks that overissued bank notes lost specie.

    “I sincerely believe that banking institutions are more dangerous to our liberties than standing armies. The issuing power should be taken from the banks and restored to the people to whom it properly belongs.” – President Thomas Jefferson

    I tried to find the original source of this quote and could not find a speech, book, letter, or journal in which the great man said it or wrote it down. Can you please provide a citation please? If you can’t you might want to question its validity.

    “History records that the money-changers have used every form of ruse, intrigue, deceit, and violent means possible to maintain their control over governments by controlling money and its issuance.” – President James Madison

    LOL…From what I remember of your history, James Madison pushed for the formation of, and signed the Act that created The Second Bank of the United States, a central bank that was created to pay off politically powerful merchants who held devalued government paper that could not be redeemed in specie. Given what he did Madison is hardly a credible voice against banking. Note that Maddison’s critics were right. The bank turned out to be little more than a paper-making machine that helped to create the 1819–21 depression. If my memory is right the big problem was the political influence of many of the were stockholders in the state banks. Because they were very influential politically the President of the Second Bank of the United States did not insist on payment in specie for paper issued by the state banks. Like your current Fed head he wanted to keep the banks lending. When the process was no longer possible to keep going the depression came.

    “If congress has the right under the Constitution to issue paper money, it was given them to use themselves, not to be delegated to individuals or corporations.” – President Andrew Jackson

    Now you are getting somewhere. But Jackson is on my side of this debate. He argued against politically connected bankers or a central bank being able to inflate by issuing unbacked notes. He was the person who argued against the renewal of the charter for the First Bank of the United States and killed off the Second Bank of the United States.

    Jackson wanted ‘hard’ money and there is no reason why the private banks could not provide it in a free market. No bank would dare overissue notes because its competitors would come in and demand specie as payment. If there were collusion and all banks inflated together new entrants would be able to step in and dominate the market by siphoning off the reserves into their own vaults and forcing the issuers to cut back or go under. The market is far more capable in providing discipline than regulators who get rewarded when they retire by getting payoffs from those that they regulate.

    “The few who understand the system will either be so interested in its profits or be so dependent upon its favours that there will be no opposition from that class, while on the other hand, the great body of people, mentally incapable of comprehending the tremendous advantage that capital derives from the system, will bear its burdens without complaint, and perhaps without even suspecting that the system is inimical to their interests.” Rothschild 1863

    The Rothschild banking dynasty made its money by lending to governments that paid them back by their taxing powers. Once again, you are given evidence for my side of the argument. I do not see public debt as legitimate and cannot see why it should be paid by those that never borrowed it. A government is not the people and has no authority from the people to borrow to fund wars, corporate or social welfare programs or anything else for that matter. Under market conditions loans would be paid off by those that took out those loans and the government would have no ability to grant special privileges to its friends or bankers.

    “The privilege of creating and issuing money is not only the supreme prerogative of Government, but it is the Government’s greatest creative opportunity.

    By the adoption of these principles … the taxpayers will be saved immense sums of interest. Money will cease to be master and become the servant of humanity.” President Abraham Lincoln

    Lincoln destroyed the purchasing power of the currency by choosing to print as much money as he needed. Like a typical Whig he was a corrupt mercantilist who did not care very much about the harm that he did to ordinary individuals and acted to protect the big money private interests.

    You may want to look up Jay Cooke, a friend and backer of Lincoln’s Treasury Secretary, Salmon P. Chase. Cooke managed to get a monopoly of government bond underwriting and helped promote the highly inflationary greenback but his greatest damage was done when he persuaded Chase to create a national banking system that did away with the relatively successful state system of banking and replaced it with a centralized system ran by Washington politicians and Wall Street institutions.

    The greenback wiped away savings as it created massive inflation while the new banking system made possible the creation of the Federal Reserve System, which managed to wipe away more than 95% of the purchasing power of the dollar and created the all fiat all the time, Federal Reserve Note.

    “Now, you are telling med that you prefer private bankers to hold issuance power?”

    Yes. But only if there is a free market where government corruption cannot manipulate events.

  133. You guys are so cheap, whatever Austrians say is wrong, without much thought to it. Andrea meant actually that QE has punished savers and benefitted borrowers (by cementing low rates and pushing up assets, I guess). And you immediately start with some conspiracy theories what Austrians would have thought. Lazy thinking…

  134. I think SPX +24% is unsustainable. What was it, a vacuum with air rushing in or a government printing magic money to throw at stocks or both?

  135. The FED DOES NOT control/determine (both short term & long term) interest rates !!! That’s done by a force called “Mr. Market”. And the FED follows what the markets wants rates to be.

    See what happened in 2012 & 2013. The FED bought tonnes of T-bonds but in spite of that rates went higher.

    Have you seen e.g. the Euro going higher against the USD in the last months ? That’s the result of foreigners buying less T-bonds.

    Remember, the USD is the world’s reserve currency and that means the FED & US gov’t is up against not 300 milion people but 7 billion people. If/When all those people don’t wnat to buy t-bonds anymore then interest rates WILL go higher, no matter what.

  136. “The FED DOES NOT control/determine (both short term & long term) interest rates !!! That’s done by a force called “Mr. Market”. And t

    Your sort of hedging here with your *both short term and long term* comment. Obviously the Fed can set the overnight rate where it wants, you seem to grant us that. The question I guess is how much role does this play on long term rates? I think its pretty clear the Fed could target short term rates as it does or target long term rates by standing ready to buy as many long term bonds as it takes.

    “the FED follows what the markets wants rates to be”

    Oh really? So your telling me bondholders dont “want” a safe return of 5% or 8% or 10% now? They want these low returns right now cuz they just want to make it easier for the govt to borrow their money? What nice guys those bond holders are!

  137. Nope. Bondholders look at price risk. And the highest price risk is with the 30 year yield and the least price risk is with T-bills.

  138. Have you ever traded bonds? Have you ever talked to anyone who trades millions of dollars of bonds every day? Bond traders watch the economy so they can anticipate and try to front-run Fed policy. The Fed watches the economy and tries to anticipate what future interest rates should look like. The reality is that neither bond traders nor the Fed control long rates today. In theory, the Fed could control them, but they let them float. As a result, the state of the economy effectively sets long rates and the Fed and bond traders just try to anticipate what the economy will do. Who has MORE control? I’d say the Fed. Long rates are largely the result of the future expected path of short rates….

  139. “Nope. Bondholders look at price risk. And the highest price risk is with the 30 year yield and the least price risk is with T-bills.”

    You claimed that the rates are what the market wants, the fed just gives them what they want.
    Why dont the lenders to the govt “want” 5% or 6% or 8% now? There must be some truly altruistic bond traders who want to make govt borrowing such a deal. They must really want them to borrow!

  140. So you expect that somewhere in the (near) future short term rates will go higher ?

    I don’t. I expect short term to remain VERY low for – at least – into 2016 while at the same time long term rates are bound to go through the roof.

    Bond traders look at the ability of a financial entity to serve its debts. And one of those entities is the US federal government.

    And it seems foreigners are “waking up and smelling the coffee”. They’re selling their T-bonds. Didn’t you notice that the FED bought 103% of all T-bonds issued ?

  141. Just be patient. Rates are bound to go higher. I thought for a long time (since say 2006) that rates would go higher. I admit I was wrong for a long long time.

    But now even T-bond bulls called Gary Shilling (a bond bull since say 1981) & Robert Prechter (a T-bond bear since mid 2012) have turned negative. And that are 2 tell tale signals one shouldn’t ignore.

    And rising rates are EXTREMELY DEFLATIONARY !!!!

  142. From my understanding, the expectations hypothesis of the term interest rate rarely holds empirically. Mehrling even talks about it in the class.

    However, if you view the currency as an asset, the value of a currency is just the net PV of the future real interest rates. I’m sure there’s a way you could start with the value of a currency and work backwards to what long end interest rates “should” be.

  143. If rising rates are deflationary, doesn’t that automatically push long end rates down? What asset classes perform best in a deflationary environment with low growth? Cash and government bonds. So if rates start to rise, people are going to flood into government bonds, which will push yields back down.

  144. Nope. Deflation is the destruction of credit & its counterpart debt. (like e.g. T-bonds).

    What has happened since 1981 is T-bond price inflation. (=prices going higher).

    I define inflation as the situation where the purchasing power of cash goes down. Deflation is the opposite, where the purchasing power of cash/money goes up against e.g. stocks, bonds, real estate.

    So, rates going higher lowers the price of a bond (think Greece, Spain) and that’s therefore Deflation.

    Once rates go higher and bond prices have gone lower no one wants to hold t-bonds any more. (=bond market collapse)

  145. Fama’s comments recognize a thing A LOT OF people don’t want to believe. “Mr. Market” determines interest rates and NOT the FED.

  146. I don’t think you understood what I’m saying. You’re not thinking about feedback. If interest rates on the long end shot up by 5% tomorrow and we had deflation of 2%, that’s a real interest rate of 7% on the bond. The present value effect on asset values would send the price of stocks and real estate plunging while bonds become cheaper and more attractive. Bonds become a better investment and those sitting on lots of cash rotate from equities and real estate back into bonds.

    Deflationary and negative growth environments occur when there’s an inverted yield curve while inflationary environments occur with a steepening yield curve. There’s a very good reason for that. If debt is being destroyed, the yield curve must be inverted because there’s a premium that people will pay for short term cash. Don’t forget about the survival constraint! Everyone must meet it.

  147. Not really. Most infrastructure(like roads), education, even taxes, and all sorts of other stuff is handled by the states. Since every state has two Senators regardless of size, the states have a lot more power than you give them.

  148. Not really. For the first two months after they started their monetary policy, JGB futures were halting limit down virtually daily. Yields are still above where they were in April too.

  149. I’m betting on hyperinflation in Japan by the way. Trust me, I’m no fan of ridiculous “money printing” and government debt. Markets are very good discounting mechanisms, so the slightest amount of inflationary pressure will push up long end yields as traders begin to discount the inflationary/growth pressures of “money printing”.

    I find deficits and large government debts very dangerous, but that doesn’t mean central banks can actually control long end yields by “printing more”.

  150. Uhhh….I do almost all of my shopping. We’re not having very high inflation, not even close.

  151. You are still ignoring my question.
    Why do our bond traders want rates around 3% now instead of 8%? If I had millions saved in govt bonds I would “want” 8% instead of 3%.

    So explain why they want 3% now. Do they just not want to make more money? There must be something other than their wants driving things it seems to me

  152. A matter of Demand & Supply. Not only are there investors (buyers of debt) but also sellers of debt (debt issuers e.g. corporations & the gov’t). These together determine rates. And when demand for capital goes down then (as a result of e.g. increased productivity) – on average – rates go down.

    But buyers of debt have a choice between short term debt & long term debt. And the balance between the 2 determines the yield curve. In a recession short term rates go lower faster (steepening yield cuver). In a recovery short term rates go higher faster than long term rates (=flatning yield curve).

  153. Not at all. Senators are no longer appointed by the state and get much of their funding from interests outside of the state. Power has been centralized in Washington and has been taken away from the state capitals.