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Tuesday, September 8, 2015

Fed Tightening Matters - Not Quantitative Tightening

The idea of "quantitative tightening" is floating around -- the idea that foreign central bank sales of U.S. Treasurys will raise yields in the same way that "quantitative easing" (QE) purchasing allegedly lowered yields. Since I do not think that "quantitative easing" did anything (see disclaimer), it is unsurprising that I am unimpressed with such a theory. However, even if you accept the premise behind quantitative easing, "quantitative tightening" has little to recommend it. There is a world of difference between a foreign central bank buying bonds versus the local central bank.

Since "quantitative tightening" has been debunked elsewhere, I will be brief.

When "QE" Worked

Although I doubt that Federal Reserve purchases of Treasurys accomplished anything (other than keeping journalists busy and causing hard money types to jump up and down), I need to note one qualification. During the earliest phases of the Fed expansion of the balance sheet, the Fed purchased risky assets from the private sector. I have no doubt that such operations achieved their objective. Furthermore, the Fed purchased mortgage-backed securities (MBS), which probably tightened spreads.

I do not view the initial policy success as having anything to do with the size of the Fed's balance sheet, rather the fact that they moved in to purchase risky assets that they normally did not touch. This is just a version of "lender-of-last-resort" operations. I would not classify such purchases as being "quantitative easing", rather "qualitative easing." However, other analysts will lump the two concepts together under the same term, and you end up with a pointless debate about terminology.

The key to this distinction is that the Fed has an effective open-ended ability to purchase assets in U.S. dollars. All that it needs to do to affect pricing is to wade into the market, and make it clear that it is defending the prices of the assets it is lending against. Weaker players can unload their positions, and liquid players will have an incentive to step into the market (so as to avoid being arbitraged by bureaucrats at the central bank). The pricing effect is largely independent of the size of the purchases, although such purchases need to be some minimum size in order to reduce the liquidity stress of weak-handed players.

Foreign central banks do not have this open-ended ability to backstop the U.S. dollar market, and so their purchases cannot have the same effect.

Why "Quantitative Tightening" Does Not Matter

Foreign central bank sales of Treasurys will not have a significant effect on yields for two reasons:
  1. If Fed purchases on Treasurys had any effect on yields, it was largely through a signalling mechanism about the timing of Fed rate hikes. Foreign central banks are not selling because of their Fed-watching prowess, and so the sales provide no useful information.
  2. For every seller, there is a buyer. Foreign central banks are selling dollars because the foreign private sector is trying to buy dollars (either to pay back USD loans, or else to purchase USD assets). The net supply of funds from the foreign sector is unchanged, all that is happening is that there assets are being shuffled around amongst the various entities.
The only mechanism by which central bank sales will matter is if you believe that central banks were price-insensitive, and were willing to hold Treasury bonds at extremely lopsided relative prices versus other USD-denominated assets. That is, they stupidly bid up the price of Treasurys versus other assets, and that relative-pricing will shift back as they withdraw from the market. I am willing to admit that this sounds slightly plausible, but we need to keep in mind the reality that central bank bond portfolios tend to have quite short duration. There is no reason to believe that the 5-year Treasury (for example) is grossly mispriced versus fundamentals. (Or at least that is what the bond bulls would argue.)

The decent Payrolls number last week probably aids Fed policymakers in their quest to raise rates. Although foreign turmoil is causing grief elsewhere (such as Canada's technical recession), the United States slow growth trajectory has so far remained stable. As I noted earlier, the real question facing the bond market is: when will the second rate hike occur?

See Also:

(c) Brian Romanchuk 2015


  1. Could a rate hike have a positive effect on "growth" due to increased interest paid?

    1. Yes, it's possible. I have written a few articles on what I called "interest rate effectiveness", which covers that possibility. I am agnostic about that debate, as I think it depends upon the context. For a country with a housing bubble which is still underway (Canada, for example), the effect of higher interest rates would outweigh the income effects (not that rates are rising here). In the United States, where the housing bubble already popped, interest rates are less significant.

    2. Credit just draws use of money forward. You have to keep up with the service.
      My preferred method of dealing with housing bubbles is a tax on the "location, location, location" - land value tax. Buildings and improvements would be exempt.
      To a fundamentalist Georgist like me even go as far as rising the land value tax to 100% and handing out a small citizens income "funded" by it (slightly smaller than "collected" say 80%) to compensate others from excluding others from the location.
      That would abolish land bubbles and title deed "property rights" completely and also be fairer on young people (such as myself.)
      After the attitude change to private property rights banks would be able to focus lending on buisnesses rather than on land.
      I think there would need to be a fundamental change in attitude of the electorate for this EVER to happen in the UK though :)
      (Stop reading the Daily Mail, for starters!)

  2. Brian-

    Dont forget the other key determining factors wrt interest rate changes.

    Private sector Debt and composition (lots of variable rate debt is a surefire road to bankruptcy if rates rise high and fast enough)

    Public sector liability level and composition. The effects of raising rates from a fiscal POV are significantly different in Canada with its ~60% Govt CDs to GDP level and Japan with its ~200% Govt CDs to GDP.

    With the Fed owning such a relatively large percentage of longer dated Govt CDs in the US, a rate increase to 5% within 5 years would mean something like a 2% of GDP increase in fiscal deficits (maybe $500 B per year in 2020). Thats significant and Japan the effect would probably be twice as large, although Im not sure what % of Govt CDs the BOJ "owns" at this point. On the other hand, foreign ownership of Govt CDs would probably result in very little domestic expansion via exports, foreigners have a lower propensity to consume???

    Food for thought.

    1. It would take time for a rise in rates to dramatically change the interest spending. Most governments have a weighted average maturity of debt of at least 5 years. The old debt has to mature in order to change the interest cost. We would need to see a sustained uptrend in yields.

      Since higher interest rates are typically associated with higher nominal GDP growth, the increased interest costs will not seem as significant.

    2. Brian-

      according to the TSY, there are $5 trillion in US Govt CDs that are in the 2 yr or less maturity category: (PG. 25)

      So a 5% increase will be around $250 B in additional interest spending within 2 yrs. I also used 2020 as the year I mentioned in my comment above. I stand by what I wrote.

      I was simply pointing out to the first commenter that there are many different variables that effect the impacts interest rate changes will have. Your reply to his comment was good (as usual) just incomplete. There is no blanket comment or analysis that can be made about interest rate changes.

      Interest rate increases will slow the economy
      Interest rate decreases will speed up the economy.

      Both of these statements are false, (no matter how many time mainstreamers tell us that these are economic truisms) because the whole thing is entirely context dependent.


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