When the Federal Reserve buys up Treasury bonds to keep interest rates low, is this risky? Paul Solman answers a reader’s question on the potential consequences and explains why this Federal Reserve practice — known as “quantitative easing” — may not achieve its goal of lowering long-term or short-term rates. Photo by Paul J. Richards/AFP/GettyImages.
Paul Solman answers questions from the NewsHour audience on business and economic news here on his Making Sense page. Here is Thursday’s query.
Ross Snow, San Francisco, Calif.: What are the longer-term consequences of the Fed’s policy of buying up Treasury bonds to keep interest rates low? Is there a big risk concerning that in our future?
Paul Solman:All policies entail some risk. Or, to put it another way, the only law absolutely protected from repeal is the law of unintended consequences.
On the other hand, there’s no way to avoid risk – in life or in economics. Economics is, at its core, the discipline of decision — making that rigorously weighs future costs against future benefits. But because ours is a probabilistic world, all projections of the future, no matter how rigorous, entail uncertainty – and thus risk. To slightly paraphrase Mick Jagger, you won’t always get what you want.
So, to your question: what happens when one arm of the government — the Federal Reserve — creates money (electronically) and then lends it to another arm of the government — the U.S. Treasury — to keep interest rates low and thereby stimulate the economy? Shouldn’t the creation of money stimulate inflation as well? Isn’t that a steep cost? Is this risky?
Well first, there are two classes of interest rates: short-term and long-term. The Fed can manipulate short-term rates. But long-term rates? Not so clear.
Therefore, when someone asks if the Fed is running a “big risk” by keeping interest rates low, the question is: which interest rates, short-term or long-term?
A big risk of bargain basement short-term interest rates is that they encourage speculation. Vehement on this subject is David Stockman, a veteran of Congress, the Reagan Administration and Wall Street, who thinks the Fed’s low short-term interest rate policy is not just risky, but — well — here’s how he put it in an interview I did with him this week that will air on PBS NewsHour soon:
“It’s crazy; it’s lunacy. You can’t have [rock bottom short-term interest rates] for seven years. You know what that does? It is simply a bonanza for speculators who can borrow the overnight money and then buy something that they can speculate on.
You’re creating a system of bubble finance where interest rates are so low that people can speculate that an asset value will go up. So you put it up as collateral, you borrow against the collateral, you take the money and you buy more of the asset. You then take the rising asset, you borrow against it again …This is what’s going on in the world.”
Meanwhile, Stockman and others say non-speculators who put their money in short-term investments like a bank deposit or money market account are punished with no return at all.
But most investments are made for longer terms such as a mortgage to buy a house, a 10- or 30-year Treasury bond, a student loan, a municipal bond to build a bridge or school, A corporate loan to build a factory or a car loan, even.
These are all long-term loans, subject to long-term interest rates. What’s the risk of Fed intervention here? To be blunt, would the Fed be able to keep them low even if it keeps lending the U.S. government money in massive amounts?
The way it does this lending is by creating electronic money and using it to purchase long-term Treasury bonds — so-called “quantitative easing.” “Quantitative” because it’s creating such a quantity of new money; “easing” because the purpose is to bring down long-term interest rates and thereby “ease” the ability to borrow money for long-term investments, especially by businesses, who would then hire more people, who would then spend more, etc.
The crucial and usually unreported point is: Long-term interest rates have seemed almost impervious to the Fed and what it’s been doing.
Consider this curious fact: When the Fed first announced its first round of “quantitative easing” back in December of 2008, it bought mortgage-backed securities and bonds issued by the quasi-governmental housing agencies, Fannie Mae and Freddie Mac.
The idea was to bring down mortgage rates from their then-current rate of 6 percent (for a 30-year fixed rate loan). If the housing lenders could borrow money more cheaply because lenders like the Fed would provide it, they could pass on lower interest rates to home buyers.
In March of 2010, the Fed finally ended the program. Mortgage rates had indeed come down a bit — down to 5 percent. So perhaps that was an indication that the Fed’s plan had in part succeeded. But the Fed was about to stop buying, presumably figuring the housing market was about to return to normalcy. The risk: that mortgage rates would go up.
“When the Fed stops buying and cedes the playing field to private investors,” CNN reported at the time, “they will almost surely demand better return for their risk.”
“‘Rates are going to be higher than they are now,'” said Brinkmann.” (CNN was quoting Jay Brinkmann, chief economist for the Mortgage Bankers Association.)
“How much higher is the question,” concluded CNN. And that was the only question most observers were asking.
So, what happened to mortgage rates after the Fed stopped buying? To the shock of everyone who thinks the Fed determines long-term interest rates — that is, just about everyone who comments on such matters — the rates went down. And down. And down some more — to today’s 3 percent or so.
That was the record of QE1 (the policy, not the boat). QE2 began in the fall of 2011. With the economy still a-swoon and unemployment unacceptably high, the Fed announced it would begin buying bonds again. But this time, the Fed would buy not mortgage securities but Treasury bonds: US government debt. Massive amounts of it. Interest rates would go down. The economy would revive.
But again, let’s look at the numbers — what actually happened. In November of 2010, when QE2 kicked off, the interest rate the Treasury paid to lenders in order to borrow money for 10 years was 2.67 percent. So when the “lender of last resort” — the Fed — stopped buying Treasuries at the end of June, 2011, the interest rate on the 10-year bond had to be lower, right? Okay, you take a guess: how much lower? What, in other words, was the effect of the Fed buying “Treasuries” to lower U.S. interest rates?
Actually, the effect was, as they say in the world of medicine, “paradoxical.” On June 30 of 2011, the interest rate the U.S. Treasury had to pay to borrow money for 10 years was 3.18 percent. The interest rate had not gone down, but up — it had gone up substantially.
And now, at last, we have QE3. It was formally announced on September 13 of 2012. The 10-year interest rate at the time? 1.75 percent. The 10-year rate today? 1.63 percent. A slight change at best.
The punchline with regard to the all-important long-term interest rates should be clear: the Fed’s influence is debatable.
Final question, then: if the Fed isn’t determining long-term interest rates, who or what is?
Playing off posts on this page by economic historian Jim Livingston, let me offer this possibility: that the world has what Fed chairman Ben Bernanke dubbed, in 2005, a “global savings glut.” In short: too much capital, chasing too few investment opportunities.
It’s an argument for another day, another post. But think about it.
Maybe the business sector of 2013 doesn’t need capital (stored wealth) the way it did in the past. No more railroads. No more steel mills. No more coal mines. In their place, software companies, which require relatively little investment to start and even get up to speed.
Again, this is a thought for another day. But it’s worth considering when blaming the Fed for taking undue risks.
This entry is cross-posted on the Making Sen$e page, where correspondent Paul Solman answers your economic and business questions