For the past decade, the finance world has been fixated on unconventional monetary policy. Here's the mechanism in a nutshell. Replacing government bonds with interest bearing reserves reduces the supply of duration in the market place, this lowers bond yields because a scarcity of long-dated assets pushes up the prices of longer-term securities. For a time, I was fascinated by this research. I dug deep into the measurement of the effects of the so-called 'scarcity channel.' I read lots of papers and crunched the numbers myself.
Of course, the scarcity channel is at odds with any arbitrage-free model of the term structure. That is:
1) Long rates are merely the expected geometric average of future short rates.
2) The market is efficient at pricing bonds, thus, over the long term, nobody can earn more than the short term risk-free rate whether they hold securities or money market instruments. (Or some portfolio with bonds of multiple tenors and cash)
In the real world, some segmentation exists in the capital markets. Certain investors find it particularly costly to hold securities outside a limited range of maturities. This might allow for some supply and demand effects to exist in certain sections of the yield curve. Also, the compensation required by investors to take on duration risk rises in times of uncertainty, mainly because the path of short rates becomes less clear. For this reason, the yield on the ten-year note was around 350 basis points for much of 2009 and 2010. It just wasn't clear yet how long rates would stay at zero.
For the reasons above, it is certainly plausible that QE lowers long term rates both via the scarcity channel, and by removing duration risk from private sector balance sheets during times of financial or economic stress. And it would be naive to assert that the effects of QE or the supply of long term debt are zero. (Although some efficient market fundamentalists have claimed this.)
That said, traditional monetary policy, is traditional because historically it has worked. At least insofar as central banks have been able to tightly control interest rates regardless of the supply of government debt. The past week has borne this out. Despite the US Treasury posting record deficits, longer-term interest rates fell as the Fed signaled that it would likely stop hiking rates. Strikingly, despite a much higher debt load, and a strong economy, the 10 year note yields110 basis points less today than in 2009 when the US economy was on life support. Oh, and Japan.
Some may claim that this is all very convenient for me. I am a fiscal dove who is sympathetic to MMT and its historical antecendents. However, I seriously investigated the effects of QE, which operates on the idea that excess long term government debt drives up rates. Thus, loose fiscal policy financed with long bonds could be seen as a form of reverse QE. Indeed, buying into the power of QE requires one, for consistency's sake, to be concerned about the level of long term public debt. I approached this issue with an open mind. I thought the effects were larger, but today, given bond market pricing action, I am convinced that forward guidance is what really matters. Deficit hawks do themselves no favors by ignoring the lessons from QE and its small effects. In fact, by relying on such flimsy arguments, deficit hawks are letting the doves soar and make much stronger claims than they otherwise would.
At some point, the evidence just becomes overwhelming. Forward guidance is a much more powerful tool than QE. The debt doesn't affect interest rates in any meaningful way when money markets are working normally. And if sudden market segmentation develops, the Fed can do QE or the Treasury can do debt buybacks financed by issuing the securities that end investors actually want to hold. It's time to move on from the faulty claim that government debt meaningfully drives up interest rates.
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