And by debt, I mean the national debt, all of it. (Or at least all that people were willing to part with, at reasonable prices…)
I know you’re thinking “inflation!”, but consider a couple of data points:
[ul]
[li]The Fed has approximately tripled its balance sheet in the last few years, from about one to three trillion, without a whimper or growl from inflation.[/li][li]When the Fed purchases bonds, no one gets any richer: the Fed swaps one asset (bonds) for another (dollars). [/li][li]The national debt clock would be reset to “0”.[/li][/ul]
Is it worth it to save Big Bird?
Or would inflation go to a million% (despite not having budged until now)?
It depends. If the economy is in a liquidity trap and the federal government is raising taxes and slashing spending (google “fiscal cliff”), then I’d expect the answer would be, “Insufficient stimulus to make a difference”. Disinflation and eventual deflation would ensue. During normal times of economic expansion, I’d guess the effect would be “Accelerating inflation”.
It’s sort of like asking how hot it would become in a house if you turned the furnace on for 30 minutes straight. It depends on the season, the weather, the insulation and the existing indoor temperature.
The value of bonds – including those on the Fed’s balance sheet – is based in part on the expected inflation rate, especially for the long-term bonds whose extended maturity exposes them to more inflation risk. Right now, there is no problem. Expected inflation remains low, while the world remains highly risk averse, which stabilizes the value of the bonds. And in fact, inflation expectations remain low precisely because the Fed is poised to hit the brakes immediately if inflation starts to creep up too fast. They can at any moment start selling bonds to pull cash out of the system. The Fed can easily buy trillions by pushing buttons on their computers because they are fully prepared to sell again.
But if the Fed is prepared to buy all the debt, and they are for serious about it, and the world knows they are for serious about it, then inflation expectations skyrocket and the value of the Fed’s balance sheet drops to essentially nothing. US Treasuries are simply not worth anything if the Fed holds all of them. That means the newly created money is out there permanently, with no way to suck the dollars out of the system again.
And that means disaster.
They wouldn’t even get near to buying all of the debt. The whole system would fall apart first. Just disaster.
It is simply not true to say that the various quantitative easing actions taken by the Fed to date have not caused inflation. In fact, it is essentially a fundamental objective to the program to cause inflation. There is of course more than one calculation of inflation depending upon what you are trying to measure though.
Just think about it logically though, the Fed is purchasing debt with the stated intention of driving interest rates lower. This pushes investors out of investing in Treasuries and mortgages into riskier assets. These riskier assets include things like corporate debt including high yield debt, equities, real estate, and commodities. If you can borrow at 3% instead of 6%, don’t you think you might be more inclined to buy a house? If you make a zero percent return buying treasuries don’t you think you are more likely to put your money in the stock market or the bond market? Take a look at commodities, equities, bonds, gold, and tell me that there hasn’t been an increase in asset prices as a result of QE.
But why would anyone buy debt as an investment with the absurbly low interest rates? Unlike a few years ago, the interest rate remains fixed for the term of the bond. The reason for that question is if the debt is not being bought for high returns then what alternatives are there to move into? Blue chips? Corporate bonds?
Secondly, would the Feds buyout go along with a Balanced Budget Amendment? If not then the debt begins again with the next session of Congress and the debt buying starts all over again.
Well, once everyone has all these dollars to invest, that were “safe” in T bonds, bills, and notes … oboy, an investment spending spree! DJIA leaps to 20K!
Yeah, I don’t buy it. Accounting tricks don’t solve debt crises.
Well, the Fed’s balance sheet is about three trillion, up from one trillion a few years ago. Of the part owed to the public, they own twenty or thirty percent. (Even though they’re not actually part of the public, the part they own seems to be counted that way.) So they own a pretty good chunk of what’s out there.
Of course, you could be right. Maybe there’s a tipping point out there. But what leads from Fed buying bonds —> inflation? Is it low interest rates? Because rates have been low for years. Is it excess reserves? Reserves have gone up by approximately a million percent. Expectations? Surely there’s more to it than that. People who are expecting it just go on expecting it. But it doesn’t occur.
Is it possible the Fed controls the brake, but not the gas? That it can stop inflation, but not make it appear?
Why do you say Treasuries aren’t worth anything if the Fed owns them?
No one is pushed out of owning treasuries: the same number are owned either way, which is all of them.
I do think people are more likely to buy houses when interest rates are low. But it doesn’t follow from that that low interest rates cause high inflation.
There really is a clear connection between Fed actions and market response.
The Fed holds about 2.6 trillion of securities of which only about 1.6 trillion is Treasuries, the rest being agency debt – think Fannie and Freddie, very similar in function but technically not the same – and some MBS. They also have various other assets. Fed holdings are about 14% of debt held by the public.
It is complicated.
It is largely based on expectations.
As a foundation, it would help if you really understand this post from your other thread.
“People”? Who are these “people” expecting inflation?
There are people who expect the earth will blow up this year, 2012, but they’re not really having an effect on the market. There are people who rub gold Krugerrands against their nipples every night to try to stave off nightmares where the prices of everything are higher tomorrow than they are today, but they’re not really having an effect on the market.
If we want to avoid selection bias and try to gain some insight about what those people with the most to lose collectively think about future inflation, we can look to the market as a source of information. The Fed has 10 year normal Treasuries, and 10 year Treasury inflation-protected securities (TIPS). If inflation is moderately bad, the people with TIPS won’t lose their money. That means that the normal Treasuries offer a higher interest rate than the TIPS to protect against that expected risk of loss. And if we look at the interest rate spread between the two, we can actually get a rough market forecast of inflation. Right now, the normal 10 year is running at 1.74%, while the TIPS is running at -0.81%, giving a spread of 2.55%. (Notice that TIPS has a negative interest rate. That means that the “real” interest rate right now is still negative.)
That is far from perfect, but it’s a decent guide to expected inflation, and significantly better than trying to guesstimate in our heads what people are thinking. Expected inflation is not very high. The Fed has deliberately pushed it up, but in a relatively careful manner so far.
If you graph the spread over time, you can clearly see it increasing roughly in line with QE1 and QE2. Inflation expectations increase based on Fed action and expected Fed action.
No. That is not possible.
People who can create monetary base can increase prices. Thus it has always been, for all of recorded history. The world didn’t mysteriously change yesterday evening to change this. There are legal protections to try to protect economies from irresponsible money, but if a central bank really lets loose, it can still flood the economy with as much money as it wishes.
I didn’t say they aren’t worth anything if the Fed owns them.
I said they aren’t worth anything if the Fed attempts to buy all of them.
The reasoning for that is already laid out in my previous post. Inflation expectations will skyrocket, and the value of all bonds will plummet to almost nothing. The Fed balance sheet will collapse, taking away their ability to remove cash from the system. We don’t have to guess about Fed influence on markets. We can literally see it every time they give a surprising announcement at a press conference.
Now in an ideal world, it would be obvious to everybody that money is still too tight and that the Fed could do more to help with that. But it isn’t obvious because this stuff is complicated. People get stuck on interest rates and the current size of the monetary base, as if that stuff were actually important out of context, and so they forget about expectations and long-term trends. Yes, the Fed could and should do a little bit more. But although more action is both possible and recommended, that does not mean that the Fed should actively pursue a plan that would blow up the entire monetary system. That would be a bit much.
The interest rates are low because people are buying them. They’re sold at auction and traded in an open market. When many people want them, they bid the price up, and the interest rate, as a result, goes down.
I took that last caveat to mean that they weren’t really going to buy all the debt. So nothing would blow up.
And if core inflation expectations went to 4% on their way to 4000%, the Fed take a deep breath for a couple of days or quarters and watch as the recovery ensued. They could stop inflating when they felt like it.
My problem is that I’m a little wary of this expectations mechanism. I don’t disagree with anything Hellestal said: it’s just that the extent to which the Fed can manipulate inflationary expectations when interest rates are basically zero is unclear, because it hasn’t been tried (c. 3 months ago - maybe the test is in process right now, given the recent Fed shift).
Mostly gold-bugs, Austrians, and other right-wingers. But there were mainstream types predicting it too, at one time.
The fact that the government can sell debt at negative real rates suggests it has the upper hand, rather than the bond vigilantes, doesn’t it? IOW, they take the price that’s given, rather than making it. It also suggests - doesn’t it? - that the government should be selling more debt. Since it will be paying out less, in real terms, than what borrows now.
It depends on what they buy, doesn’t it?
If the Fed literally dropped money from helicopters, you’d expect prices to rise, as people rushed out to buy stuff.
But that’s not what they do. They buy highly liquid private sector assets in a heavily traded open market, at market prices. In other words, they trade one kind of government liability (bonds) for another (dollars).
If I get some free money, you might expect me to go buy some stuff. But if I exchange one asset for another of equal value, there’s not much incentive to buy stuff I wasn’t going to buy anyway.
Now if the Fed started buying $100 worth of bonds for $200, that would be helicopter money. But if they buy $100 worth of bonds for $100, it’s not.
Fwiw, I actually don’t think there’s much more the Fed can do. Interest rates can’t fall much further, and short of giving away free money, they can only affect the ratio of perfectly liquid assets to slightly less than perfectly liquid assets. Which isn’t going to do much.
If you show up at the office one day wearing a clown suit replete with make-up and a red nose, throw a custard pie at your boss, and then dry hump the copier, they might not necessarily believe you when you show up the next day suit-and-betied and cosmetic free, claiming that you are perfectly fine and ready to work seriously.
If the Ben Ber-Nanke went to a press conference to announce a policy that was clown-suit insane, such as buying all of the debt, there would possibly be a point-of-no-return moment right there. Probably not but… possibly. There is no reason to believe a crazy person who suddenly claims to not be crazy anymore.
The way to build credibility is by saying that you’re going to do something sensible, and then doing exactly what you said.
This is probably somewhat unfair, but that sounds to me something like, well, “I’ve never pushed a pencil off this particular desk so I don’t know for sure what will happen if I do.” In my estimation, we’ve seen enough of these sorts of pencils fall to get the idea.
Take the graph I linked in my response to you in the other thread. This is an awesome graph. It shows the former wild volatility of the US interbank market, and then a sudden calm. That calm does not require constant supervision from mom and dad, but just a warning that they will step in to pacify the situation if things get too far out of hand. If the Fed has a target of between 0 and 0.25%, and the price of 30-day Treasury bills has dipped to the point that the yield has increased to 0.30%, then there is an immediate arbitrage opportunity. People can buy cheap now, knowing for certain that the target is enforced, which means that they can sell high in the very near future.
The market pushes itself back without any additional work from on high.
The Fed didn’t reduce the volatility by fully active management. They reduced volatility by saying that they would be more active in their management, and then arbitrage took care of most of the work. Not all, but most. For another example, we saw the same thing happen on the Swiss foreign exchange market, where they immediately influenced their exchange rate with the euro by… making a press conference. They told the world they were fully committed to influencing the exchange rate, and that announcement was all that they ever did. The market took care of the rest. The last graph from the last update is particularly awesome, too.
The fact of the matter is that we see swift market response to Fed announcements, and that by itself means that the markets are changing their expectations of economic conditions, including inflation. Of course, for inflation to actually change, it’s a multi-step process and not so direct as influencing 30-day Treasuries and interbank lending. Nevertheless, each step is painfully clear. If they were to announce, say, a 4% inflation target, you’d better believe that the 10-year bond would take an immediate hit (with yield increasing), that equities would spike the same day, that measurements of velocity would also show a spike, and that growth in nominal spending would be significantly stronger from that quarter on. Every single market screeches in unison about this, and they all scream INFLATION, obviously and incontrovertibly. The markets respond right from the time Bernanke is at the podium speaking into the microphone.
(With a policy statement as clear and unequivocal as a higher inflation target, the increase in velocity could possibly be so strong that it might be necessary to decrease the size of the monetary base in order to successfully maintain the higher inflation target without overdoing it. I’m not saying that would be guaranteed, but it could maybe happen.)
What matters for bank lending is not just the interest rate today, but the expected interest rate out into the future.
That means that what matters for the monetary base is not just the amount of the base today, but the expected growth of the base out into the future. Creating a trillion new dollars today that you can easily destroy tomorrow is fairly mild when you get right down to it, whereas creating a trillion new dollars permanently is something else entirely. And without very clear guidance about central bank intentions, people don’t know which is which.
There is a fantastic argument for that, and I’m fully 100% in favor of more good public investment, especially now that it’s cheap. Yay public goods! Boo to bridges falling down!
But I’m also in favor of good monetary policy.
We don’t have good monetary policy right now. (Though, in fairness, we’re moving in the right direction on that front and we’re about a billion times better than the ECB.)
Not especially, no.
Monetary base is very different from anything else.
Those assets are very different.
They are very very different. Base money is extremely different from long-maturity bonds, and notably different from short-term bonds.
First, and very important, base dollars aren’t a liability in anything but a fictional accounting sense. I have discussed this with you before, at some length. I remember. But I guess I’m prepared to do it again because I recently thought of a different and better way of explaining the uselessness of double-entry accounting when we’re talking about a central bank’s balance sheet with the modern monetary base.
Second, and just as important, the Fed doesn’t just exert control with its purchases. It also influences market expectations, including inflation and nominal spending (NGDP) expectations, which means they can strongly influence behavior with a single press conference, even if they don’t buy a single thing. This is the point I talked about with Measure for Measure, with some fascinating examples. I also talked about this with you in the much older thread.
There is enormous incentive. Overwhelming incentive. Gargantuan ogre-like incentive, beating you over the head with its incentive club screaming its incentive chant in the middle of the World Incentive War 3.
The only way to not see this, the only way, is to be so caught up in accounting ledger entries that we miss what actually happens in the markets, what empirically happens, what we can actually see happening, when the Fed makes a surprising announcement or commences with its purchases. The markets respond to those Fed actions, to those incentives. They see the ogre’s club and they try to dodge, and they do so despite the fact that selling something to the central bank means debiting one entry and crediting another entry in an equal amount on the assets column. That equality on the books is nothing like what happens in the real world.
Those assets are startlingly, profoundly different.
Since QE began sometime in 2008 crude oil, natural gas, and coal have all fallen in price from their mid-year peaks. It is true that prices have corrected from their recession troughs though. But they are all still lower than they were in 2008.
Most food groups are lower too. Dairy, for instance. Home prices are moribund. Wages are stagnant. Basic ingredients like fertilizers are down. I see no inflation at all.
Gold is up as a fear gauge but copper is well off its peak and is a better measure of economic activity due to its usefulness.
Not only is there no inflation - there won’t be any for years.
Well, there is health care, which is exploding at a huge rate of — around 8% yearly, IIRC. Which is bad but hardly makes up for the stagnant prices elsewhere.
Prices were in a trough because of the recession. Then the Fed took action. Now prices are back up to regular levels again. I thought that was exactly the point he was making.
None at all? Cumulatively, prices in the broad indexes are about 5% higher than they were in 2007. The inflation rate isn’t particularly high, but as long as it’s positive, then prices are going up.
If we pick and choose, we can always find exceptions. We need a broad price index to avoid selection bias and see general trends more clearly.
