by Paul Kasriel, The Econtrarian
Whenever I forget to mute CNBC or Bloomberg TV, I invariably hear some wag explaining to us that the goal of the Fed’s policy of quantitative easing (QE) is to lower bond yields in order to stimulate borrowing by the non-bank public and thus, increase aggregate spending. If, in fact, the Fed’s paramount goal is to lower bond yields, then I suggest that it might want to consider quantitative tightening (QT). Why? Because, as shown in Chart 1, there is a positive correlation of not insignificant magnitude (0.57 out of a possible maximum of 1.00) between year-over-year changes in Federal Reserve outright holdings of securities excluding Treasury bills and the year-over-year change in the yield on Treasury 10-year maturity securities. In other words, since the Fed has been actively engaged in outright purchases of longer-maturity securities (i.e., QE), there has been a tendency for bond yields to rise when the Fed’s purchases of these securities increases and vice versa. The implication of this is that if the Fed desires that bond yields decline, it ought to reduce its holdings of securities!
If, on the other hand, the Fed desires that real economic growth accelerate, then it might want to pay more attention to the quantity of credit it creates and less attention to the price of credit, i.e., the level of interest rates. During most of the post-WWII era, the Fed has striven to directly or indirectly control the interest rate on the overnight cost of funds, the federal funds rate. The behavior of longer-maturity Treasury securities interest rates in relation to the behavior of the federal funds rate has often been a reliable leading indicator of the behavior of real economic activity. Specifically, if the yield on longer-maturity Treasury securities were rising relative to the federal funds rate, this has generally been a harbinger of stronger real economic activity and vice versa. This is shown in Chart 2. From Q1:1957 through Q4:2007, the correlation between the 4-quarter moving average in the interest-rate spread between the Treasury 10-year security and federal funds, advanced two quarters, and the year-over-year percent change in real GDP was 0.51 out of a possible maximum of 1.00.
The fact that rising bond yields tend to portend faster economic growth runs counter to conventional wisdom, i.e., what passes for informed analysis on CNBC and Bloomberg TV. What might explain this counterintuitive relationship between the current behavior of bond yields and the future behavior of real economic growth? When the demand for corn rises relative to the supply of corn, the price of corn rises. The same things holds true for credit. When the demand for credit rises relative to the supply of credit, the price of credit, i.e., the interest rate, rises. Private banks, experiencing increased loan demand, will begin to grant more credit. But the banking system’s ability to create more credit is limited by the amount of outstanding Federal Reserve credit. If the Federal Reserve is targeting the level of the federal funds rate and does not raise the target level of the federal funds rate in the face of increased credit demand in general, and banks’ demand for Fed credit in particular, then, in order to maintain the targeted level of the federal funds rate, the Federal Reserve must create some additional credit to satisfy the increased demand for credit from the banking system. This increase in Federal Reserve credit allows the private banking system to increase its supply of credit to the non-bank public, all of which results in increased spending in the economy. In sum, a rise in bond yields relative to the federal funds rate elicits an increase in “thin-air” credit, i.e., the sum of Federal Reserve and private banking system credit, which, in turn, results in a net increase in spending in the economy.
If the primary goal of the Federal Reserve were lower bond yields, as implied by the talking heads on CNBC and Bloomberg TV (not to mention some Fed officials), then I submit that the Fed should abandon QE and adopt QT, i.e., begin outright sales of securities from its portfolio. All else the same, Fed sales of securities would reduce the supply of Fed credit relative to banks’ demand for such credit. This would force up the federal funds rate. Banks would pass on their higher cost of funds to their loan customers, thus raising bank loan rates. In the face of unchanged non-bank public credit demand, the quantity of credit demanded by the non-bank public would fall as a result of the rise in bank loan rates. Both bank and Fed credit, i.e., total “thin-air” credit, would then contract, leading to slower aggregate spending. The slower aggregate demand growth would lead to a decline in the demand for credit, especially from businesses, a decline in inflationary expectations and, ultimately, a decline in bond yields.
Of course, the ultimate goal of the Fed’s current QE policy is faster growth in U.S. aggregate demand in order to bring down the unemployment rate. With banks and other depository institutions still not creating normal amounts of credit, QE is a policy that can augment the total supply of “thin-air” credit. The way to measure the degree of easing (E) in QE is by the measuring the quantity (Q) of combined Federal Reserve and depository institution credit being created, not the price of credit. Did we learn nothing about monetary economics from Milton Friedman?
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