Monday, August 26, 2013

The Fed’s Bubble Trouble (excerpt)

The talk of the town at this past weekend’s Jackson Hole monetary policy conference was a paper presented by Arvind Krishnamurthy and Annette Vissing-Jorgensen on Friday. At the annual FRB-KC symposium, the two academics argued that the Fed should taper its purchases of US Treasuries while increasing its purchases of mortgage-backed securities. That certainly is a novel variation on the QE tapering theme that has been unsettling financial markets since May 22, when Fed Chairman Ben Bernanke first raised the subject.

Adding to the influence of the two economists is that Bernanke mentioned another one of their papers in a footnote of his presentation at last year's conference. In his speech back then, the Fed Chairman focused mostly on QE, also known as "Large-Scale Asset Purchases (LSAP)" in Fed jargon. He admitted that it’s unconventional and has been mostly a “process of learning by doing.” It’s worth rereading his comments in light of recent developments. Most noteworthy is the following quote:

How effective are balance sheet policies? After nearly four years of experience with LSAPs, a substantial body of empirical work on their effects has emerged. Generally, this research finds that the Federal Reserve’s large-scale purchases have significantly lowered long-term Treasury yields. … Three studies considering the cumulative influence of all the Federal Reserve’s asset purchases, including those made under the MEP ["Operation Twist"], found total effects between 80 and 120 basis points on the 10-year Treasury yield. These effects are economically meaningful.
Here’s the rub: The 10-year Treasury bond yield has spiked by 116 basis points from this year’s low of 1.66% on May 2 to 2.82% on Friday. That happened mostly as a result of all the Fed’s chatter about tapering QE. Oh well: Easy come, easy go. I presume that Bernanke must view the backup in yields as economically meaningful! QE was an experiment from the beginning, as Bernanke admitted. If the Fed does phase out QE, it will most likely have to provide more monetary stimulus through forward guidance, as discussed below.

The sharp increase in yields caused by the QE tapering talk suggests that the Fed's bond purchases inflated a big bubble in the bond market. As I’ve noted previously, the 10-year yield normally tends to trade around the y/y growth rate in nominal GDP. The jump in yields is normalizing this relationship. The Fed’s tapering talk has caused investors around the world to taper their holdings of bonds. That’s starting to poke holes in other bubbles as well, particularly emerging market bonds, currencies, and stocks.

Today's Morning Briefing: Bubbles Popping. (1) A novel variation on QE proposed at Jackson Hole. (2) Learning by doing at the Fed. (3) A year ago, Bernanke said QE lowered bond yields by as much as they just rose on QE taper talk. (4) Banks, foreign investors, and bond funds all selling bonds. (5) QE pumped air into bond and EM bubbles. (6) Since last FOMC meeting, bond yield up 22 basis points. (7) Rising mortgage rates hit housing. (8) FOMC minutes suggest tiny tapering in September and lower threshold for jobless rate (maybe). (9) “The Butler” (+). (More for subscribers.)

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