So we pretty much called this.
On July 31 we wrote…
As the world’s big central banks are due to make announcements over the next couple of days, you’re likely to hear a lot of chatter about what they’re up to, and why. And a lot of that chatter will be nonsense.
(something) you often here is that the reason the Fed engages in actions like QE (which has mostly taken the form of buying government Treasuries) is to reduce public sector debt burdens.
The arguing goes: With governments issuing record levels of debt, they’ve now turned to their central banks for their funding and to reduce interest rates. The Fed happily complies and engages in ‘financial oppression’, lowering the rates on government debt to below where the market would otherwise set them.
Well, that myth came back this week.
In BusinessWeek’s profile of Ben Bernanke, we see this…
Ronald McKinnon, a Stanford University economist, says low rates can keep alive “zombie” banks and their borrowers when it would be better for the economy to flush bad debt out of the system. The Fed is also shielding Congress from the consequences of the federal government’s fiscal irresponsibility, McKinnon says. Ordinarily the bond market vigilantes, alarmed by the prospect of uncontrolled deficits, would have pushed up America’s borrowing costs, says McKinnon, but they’ve been neutralized by the Fed’s commitment to keep long-term rates low at all costs. Foreign central banks, including China’s, have kept the dollar from collapsing by soaking up dollars that go abroad for higher yields, he says. In a forthcoming paper, McKinnon says zero interest rates are more “mutilating” than “stimulating.”
You can read our original post to see why this is nonsense on stilts, but here’s the brief version.
The Fed is not looking at public debt levels when it decides to engage in QE and so forth. It looks at employment and prices.
Furthermore, each time the Fed did to QE, interest rates went up, not down. Got that, rates went up!!
This chart from Doug Short shows what happened to the 10-year during QE1 and QE2.
Look at the green line during QE1 and QE2.
Photo: Doug Short
The flipside of this is that if the Fed said it was no longer going to try to help the economy, you know that investors would rush out of risk assets and buy Treasuries.
Furthermore, there is no history whatsoever of there being a connection between the size of the debt and the interest rates the US pays to borrow. We’ve written about this extensively.
Now in Europe it is different. The ECB can play a role in depressing yields for the US but there’s nothing to the notion that McKinnon is pushing here.