The Fed’s Box: Quantitative Easing and Rising Long-Term Interest Rates

Once upon a time, people took rising interest rates as evidence of tighter money. Then, circumstances and growing sophistication led to recognition that rising inflation and/or rising inflationary expectations would show up in higher interest rates, especially longer-term rates. Then, apparently, everyone decided that rising long rates could ONLY be explained by easy money and inflationary expectations. They forgot about the tight money possibility. Sophistication crowded out the obvious.

This has shown up recently in what is called "quantitative easing," where the Fed continued to expand the money supply after short-term interest rates hadbottomed out. Specifically, the Fed started purchasing longer-term securities (mainly 10-year) as well as mortgage-backed securities with the goal of pushing down longer rates in general and mortgage rates in particular. It appeared to work for a while, with both 10-year bonds, and mortgage rates falling. Then those rates began backing up, which led virtually everyone on cable TV to conclude that inflationary consequences were the culprits.

This may well be the correct explanation, and it may even be a complete explanation. But, I doubt it, especially the complete part. What am I thinking?

First, monetary ease has not been nearly as great as everyone assumes from hearing others say it. The spike in the monetary base is largely the result of a build-up of "excess reserves." The early rapid growth in measures of money has largely been reversed. Given the collapse in the velocity of money and other deflationary forces in the economy (mainly housing and everything related to it), I don't think monetary expansion has been excessive.

Second, in focusing on credit rather than money, the expansion in Federal Reserve credit has not fully offset the contraction of credit in other areas, such as the commercial paper market. Total credit is down, not up.

Third, the banking system is still under stress, especially many banks below the too-big-to-fail 19 with over $100 billion in assets that took the "stress test."

Fourth, Treasury borrowing to finance the explosion in the budget deficit has grown accordingly. Other things equal, more borrowing by the Treasury not offset by reductions elsewhere puts upward pressure on interest rates.

What all this adds up to is the possibility that massive Treasury borrowing combined with a not-too-easy monetary policy is behind the upward pressure on longer-term interest rate.This is an alternative to the thesis that rate increases were driven by inflationary expectations. However, the two explanations are not mutually exclusive. They can operate together. I tend to think that not-to-easy monetary policy and massive Treasury borrowing accounts for more of the rise in rates than a rise in inflationary expectations. But, even I'm wrong about the "more," those factors are still likely to have played a significant minority role.

Comments (3)

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  1. Nemo says:

    You forgot to mention one other possibility:

    Credit risk.


  2. I think rising inflation expectations are a much better explanation for why bond yields are up, and the bond market itself offers the proof. 10-yr Treasury yields are up 160 bps from their low at the end of last year, while 10-yr TIPS yields are down about 10 bps over the same period. That means that the expected annual inflation rate over the next 10 years has risen by 170 bps, which is more than the increase in 10-year Treasury yields.

  3. Katalina says:

    Yes the mortgage rates flloow the 10 year bond. So you can go to yahoo finance and click on the ten year bond and you will be able to compare that to interest rates. We watch it for our loans in float waiting to lock them for our clients.