Yields rise, and the US government must now service a higher level of debt, pushing the deficit higher. US is forced to re balance spending, stifling growth and economic activity in order to keep debt in line.
I'm not sure how this causes yields to rise. The short term interest rate is determined by the FED. If China sells off enough treasuries that the interest rate on them jumps to 1.0% then the FED will probably just buy more treasuries until the interest rate hits the zero lower bound again at 0% interest. This would stimulate the economy.
Correct, the Fed determines short term interest rate through Federal Funds Rate (FFR).
The treasury instruments we are discussing here are mainly 5-10 year notes and bonds. Thus the yields on these instruments reflect long term interest rates. The market, not the Fed, determines long term interest rates.
The long-term interest rate used to be much more closely correlated with the FFR. We see that it has decoupled significantly during the past 10 years and is now moving somewhat independently of the FFR. The Fed is stuck at the lower 0 bound and has no power over long term interest rates anymore. Janet Yellen has noted this publicly herself. [1]
What you are describing - the Fed purchase of more long-term US treasuries - is another wave of Quantitative Easing. The problem with QE is that, while it gives the financial system more liquidity, that liquidity has not passed on to the end consumers. So the Fed would be adding (potentially overpriced) liabilities to its already massive pile of debt in order to have a somewhat negligible effect on long-term interest rates, and to probably have no effect whatsoever on economic activity within the US. In short, it would be taking on more risk for relatively little reward.
Thanks, I missed in the original article that it mentioned 10 year notes. I assumed they were short term notes.
My understanding is long term interest rates = expected short term interest rate over the long term + premium for locking up money for a long time.
(if not then arbitrage would occur)
Assuming the premium for locking up money remains constant. The FFR over the next 10 years determines the 10 year interest rate. In this case the selling of Chinese long term debt shouldn't have much of an effect on long term interest rates except through the channel of changing the future expected FFR.
Yellen said
“The Federal Reserve’s control over longer-term interest rates is more indirect and more limited than its influence over the level of the federal funds rate.”
She is talking about how the Fed still has control over long term rates through the expectations channel mentioned above. Imagine Janet Yellen came out today and said they would not raise rates from 0% for 5 years no matter the economic conditions. Long term rate would fall as people would expect a lower FFR going forward.
Treasuries are sold at auction, so supply/demand factors in as well. Since treasuries have little to no credit risk and they're highly liquid, people are generally just concerned with inflation. As roymurdock said, the FFR has minimal impact on long term rates. Here's Bernanke saying the same thing:
"The Fed’s ability to affect real rates of return, especially longer-term real rates, is transitory and limited. Except in the short run, real interest rates are determined by a wide range of economic factors, including prospects for economic growth — not by the Fed."
http://www.brookings.edu/blogs/ben-bernanke/posts/2015/03/30...
Long-term interest rates = Expectations of Short-term interest rates + Expectations of future economic growth + Expectations of future inflation + Uncertainty
You're not really locking money up as (under normal circumstances) you are free to sell the treasury at any point after purchase.
The Fed has already distorted the market enough as it is; they are looking for a way to return to normal market conditions - hence the debate around when to finally raise the FFR and short term interest rates. Hypothetically the Fed can announce whatever it wants, but realistically it is extremely constrained in its actions at the moment.
Arguably, the most immediate risk from the Fed’s policies is that banks could use those newly created excess reserves too quickly. Banks now have an additional $2.6 trillion in excess reserves, which means that they can create up to approximately $26 trillion in new money.[21] In other words, banks now have the power to create more than twice the amount of money currently in the U.S. economy, thus heightening the risk of future inflation.[22] As the economy improves, the Fed may have to pay higher interest rates on these reserves to keep banks from dramatically increasing their lending. Paying higher rates, all else being constant, would exacerbate any “losses” suffered by the Fed, thus increasing the political problems discussed in this Backgrounder.
For those same political reasons, there are risks to the Fed simply holding all of these assets indefinitely because interest rates are expected to rise in the future. If those rates rise, the Fed would suffer “losses” due to paying higher rates on its liabilities than it receives on its assets, again putting the central bank in a difficult political position. Also, as the world’s largest debtor, the federal government is highly vulnerable to an interest rate shock that could make the federal budget deficit much worse. A rule of thumb is that every one percentage point rise in interest rates increases the budget deficit by about $1 trillion over a decade. The safest course of action, therefore, is to start undoing the QE policies by selling off these securities.
Securities sales are typically associated with contractionary monetary policies, but because these reserves are excess reserves, and since they have done little to increase economic activity in the first place, removing these reserves should not have an adverse impact on the economy. Nonetheless, the Fed should minimize any negative effects by announcing a deliberate plan to sell the bulk of these securities over, for instance, the next six years. The Fed can also partly offset (or sterilize) these sales with its normal temporary open-market purchases of short-term Treasuries.[23]
Even if long term interest rates are determined by the factors you mention. How does China selling bonds increase long term interest rates? Increase in expectations of growth or inflation? I could maybe see that both of those could be increased from a devalued dollar. But if that's how China is increasing long term rates it seems weird to think that inflation + economic growth would cause the US to service a higher level of debt pushing up the deficit and causing the U.S. to stifle growth and economic activity.
There is a relatively liquid market for bonds. Let's say I issue a bond today. I set the interest rate at 3% per year for 10 years. A lot of different people buy those bonds (for ease of math, assume that an individual bond is $100). If they do nothing, every year that someone owns bond they'll receive $3, then at the end of ten years they get the extra $100 back.
Let's say that one day later someone wants to sell all the bonds that they bought. Naturally more sellers than buyers for a market means that the price will drop. So the bond now costs $90 to buy. However it will still pay the (new) owner $3 per year and $100 back at the end, so it's effective rate of return is now above 3.33% [The actual rate is higher since you get more money back than the $90 you put in, but this is a good lower bound for the new rate of return].
Now I come back right after this price drop occurred and realize "Oh crap, I need to issue more bonds today!" If I try and set the same terms on the new bonds, nobody will buy them, since they could just buy the ones I issued in the secondary market and make more money for the same risk. As a result, I have to increase the interest rate I pay for future bonds I issue. Thus China selling bonds increases the long term interest rates.
Note that it may not increase long term interest rates in the long term, though :-)
So the general thinking is 10 yr treasury bonds reflect the economies consensus around what the long term interest rate is.
Another general consensus in economics is that the interest rate is determined by the supply and demand for loan-able funds.
Therefore if China sells so many bonds it increases the interest rate on 10yr T-Bonds. It has either shifted the long term interest rate in the U.S. by reducing the supply of loan-able funds or it created an enormous persistent arbitrage opportunity in T-Bonds.[0] Both of these seem very unlikely to me. 40 billion a month is just too small to make a difference.
I had never heard of Heritage before I read the article I posted, but I'm inclined to trust actual economic analysis and a clearly rigorous understanding of the situation over Krugman's little mantra.
From the little I've read of Krugman, I'm baffled as to how he received a Nobel prize. His opinion pieces in the NYTimes are TERRIBLE and seem to be written with one goal in mind: start as large of a flame war in the comments section as possible. That, and promote his books or whatever he is selling these days.
Also, you'd be a fool to just straight out ignore something because someone told you to. The least you could do is read and understand it to form your own opinion - then you can make an informed decision on its worth, rather than blindly following a pundit.
Yea, the Heritage Foundation is a right wing think tank known for very biased views. It's essentially an academic sounding mouth piece for the GOP establishment. It used to be more legitimate, but it's an outright political organization these days.
It just seems weird to worry about inflation and runaway depreciation when we are in an environment that has seen disinflation and dollar appreciation.
> but I'm inclined to trust actual economic analysis and a clearly rigorous understanding of the situation
You won't find that at Heritage, they do propaganda water carrying not serious economic research. Heritage is another incarnation of the scientists that worked for tobacco companies. The econmists that work at Heritage aren't paid to do real economic analysis, they're paid to support Heritage's policy positions with something that looks like real economic analysis.
> From the little I've read of Krugman, I'm baffled as to how he received a Nobel prize.
Uncontroversial pick, was one of the favorites.
> His opinion pieces in the NYTimes are TERRIBLE and seem to be written with one goal in mind: start as large of a flame war in the comments section as possible.
His opinions throughout the financial crisis have stood up as well as anyone elses, certainly much better than Heritage with their constant claims of QE leading to inflation.
> That, and promote his books or whatever he is selling these days.
'Don't trust anyone who writes books' is not a strong argument. Better advice might be, don't trust economic analysis that validates the preferred conclusions of the organization that paid for it.
> Also, you'd be a fool to just straight out ignore something because someone told you to.
This assumes my only reason for ignoring them is because someone told me to. No, I ignore them because they've time and again exposed themselves as hacks. Krugman's 'little mantra' is simply an easy to remember form.
> The least you could do is read and understand it to form your own opinion - then you can make an informed decision on its worth, rather than blindly following a pundit.
You'd be a fool to waste your time with parties who have already shown themselves to not be good faith participants. An informed person doesn't need to read your article from Heritage to know what it says about QE. It says QE is bad and will lead to inflation and perhaps other badness. An informed person knows this because that is what Heritage always says about QE, even years after they've been wrong over and over again. Informed people might be glad that they did not invest their money in line with Heritage's constant predictions that QE will lead to inflation.
> I'm baffled as to how he received a Nobel prize. His opinion pieces in the NYTimes are TERRIBLE and seem to be written with one goal in mind: start as large of a flame war in the comments section as possible.
The fed doesn't experience risk. It has full control over the size of its balance sheet. There may be other problems with QE4 in the form of Operation Twist II but risk to the Fed isn't one of them.
Also your claim that "the liquidity is not passed on to end consumers" besides being debatable, doesn't answer the claims made by the parent poster. If the Fed so chooses it can prevent yields from rising, which means that the US government will not have higher interest costs.
In sum, the entirety of your argument comes down to the something, something hyperinflation which your heritage link makes explicit. We've heard that story before. There's no reason to think it will be any more accurate this time than it has been for the last 50 years.
Every entity in the world experiences risk. If you can't identify it, you're not trying hard enough.
The Fed can prevent yields from rising through another round of QE. The tradeoff being that it will have to push even more money into the system, undermining confidence in the US economy's ability to operate healthily without serious Fed & government intervention.
I never mentioned hyperinflation because I don't think that's a realistic outcome of more QE. I don't think something, something hyperinflation is a good way to summarize my argument, but it is sure is patronizing, I'll give you that.
Can you provide an argument that explains why we would want more QE at this point?
I understand that. However what I don't understand is how the price of the treasury bond falls when there exists a buyer in the market that has an insatiable appetite for treasuries and a Scrooge McDuck sized wallet(The Fed). In economic jargon it would mean we currently have perfectly elastic demand for short term treasury bonds.
Short term rates are directly set by The Fed. (Notice I said "rates" not "bonds". In the jargon "Bonds" have terms of over a year. Bonds are not controlled directly by The Fed - only very short-term rates (typically just a few days).)
Long-term rates (i.e. Bond yields) are set by the market in which the The Fed is a major participant but not big enough to completely control the market. This was greatly expanded under the 3 quantitative easing programs but the last of these ended almost a year ago.
Also keep in mind that the US bond market is huge - around 40 trillion dollars - with treasuries only about 1/3 of the total. Even after all the extraordinary intervention by The Fed they hold around 10% of that total. China holds less than The Fed and much of that is not is US dollar bonds.
Are basic bonds beyond the grasp of this forum? High yields are low prices for the bond holders. So when people sell bonds, the price drops, which causes the yield to rise.
ams6110 is fully correct here and is stating simple facts of the bond market.
Because it's clear the person he's responding to understood that relationship. If he'd bothered to read all four sentences, it's clear he meant he wasn't sure why yields would rise if the Fed would react by buying bonds.
Perhaps it's getting downvoted because it's irrelevant to JamesBarney's point. The Fed (normally) sets (very) short-term rates; the market sets longer rates. But the Fed also can to some degree set longer rates by QE. And, in fact, the Fed can print more money than China can sell dollar-denominated bonds, and therefore the Fed can win the battle - if they want to badly enough.
Printing more dollars to buy bonds would counteract China's sale of bonds. I fail to see any way in which that is not clear.
> Rising long-term yields signal future inflation.
In this case, they would signal no such thing. They would signal sales by China's Central Bank. That is not related in any way to future inflation expectations.
I'm not sure how this causes yields to rise. The short term interest rate is determined by the FED. If China sells off enough treasuries that the interest rate on them jumps to 1.0% then the FED will probably just buy more treasuries until the interest rate hits the zero lower bound again at 0% interest. This would stimulate the economy.