|“To Inifinity . . . and Beyond!”|
Let’s leave aside how asinine Bernanke’s view of the real economy really is, and instead focus on one brief exchange Bernanke had with a questioner at his press conference on Wednesday:
Question: Mr. Chairman, you've always argued that it’s the stock of assets that the Federal Reserve holds which affects long-term interest rates. How do you reconcile that with the very sharp rise in real interest rates that we've seen in recent weeks? And do you think the market is correctly interpreting what you think is most likely to be the future path of the Federal Reserve's stock of assets? Thank you.I can’t overstate how important—how revealing—this lone comment really was. The fact that Bernanke was “a little puzzled” by rising Treasury yields in the weeks before the Wednesday QE tapering announcement points to two things that are essential, if we want to understand what will happen to the markets and to the economy over the next 18 months:
Bernanke: We were a little puzzled by that. It was bigger than can be explained, I think, by changes in the ultimate stock of asset purchases within reasonable ranges, so I think we have to conclude that there are other factors at work, as well, including, again, some optimism about the economy, maybe some uncertainty arising. So I'm agreeing with you that it seems larger than can be explained by a changing view of monetary policy.
One, Bernanke does not realize that it is the amount of the monthly purchases of assets—and not the inventory of purchased assets that the Fed already has on its balance sheet—that determines the prices (and therefore yields) of those assets. And two, ending QE is tantamount to ending the price support for Treasury bonds—which means that yields will rise much much more, if the Fed exits QE. Since rising yields means rising interest rates, and the Fed explicitly does not want this until at least 2015, QE purchases will continue in order to prevent this rise in yields. They will continue, and if necessary (because of rising interest rates) they will increase.
Let me restate this in simple terms for the peanut gallery in the back: There will be no “tapering off” of Quantitative Easing—instead QE will continue indefinitely, and most likely in even greater quantity, even as yields rise and drive up interest rates in the economy.
My argument is simple.
Everyone looks at QE as the mechanism by which the Fed keeps interest rates low across the yield curve. The Fed buys bonds with newly-printed QE money, thereby keeping yields low and interest rates flat.
But the other, obvious way to look at QE is as a price support mechanism for Treasury bonds. Remember, bond yields move inversely to bond prices. Thus the more you pay for a bond, the lower the yield—which is what the Fed has been doing since it started QE back in 2008.
Everybody has been looking at bond yields and how they affect interest rates, when trying to make sense of the end of QE. But nobody has been looking at how QE supports the prices of Treasury bonds. That’s why Bernanke was “puzzled” that yields on Treasury bonds rose when the hints of tapering off began back in May. Since the Fed had not yet modified its QE position when it started dropping hints back in May, Bernanke fully expected yields to remain firmly in place. After all, nothing had happened, nothing had changed: The Fed was still buying $85 billion a month. Yields shouldn’t have moved—but they did, which was what puzzled Bernanke.
But if you look at the Treasury bond market from the point of view of price rather than yield, the reason yields have risen is obvious: Once the Fed announced it would be dialling back and eventually exiting the QE business, the market began to price in the exit of the biggest single buyer of Treasury bonds in the market. That is, holders of Treasuries began to sell them now, in anticipation of the exit of the biggest buyer in the market, i.e., the Federal Reserve.
So of course yields would rise before any actual official announcement of the possible end or “tapering” of QE. When the Fed–as the official super-buyer of the Treasury market by way of QE—hints and then outright announces that it is scaling back purchases of Treasuries, prices in that asset class will inevitably go down. Which means that yields go up.
Which means that interest rates go up—which is exactly what Bernanke and the Fed do not want.
Which is why Bernanke and the Fed are going to reconsider the end of QE, and then decide against it. And eventually, if yields continue to rise (that is, if bond prices continue to fall), Benny and the Fed will up the dosage on the QE. Whatever it takes to keep yields down and interest rates low.
The whole point of QE is to keep interest rates down across the yield curve. If exiting QE drives those interest rates up—which is what we got a taste of, with this “taper tantrum”—then the Fed will reconsider, the word “reconsider” here being used as a very polite euphemism for “180 degree reversal”.
Remember, Bernanke and the Fed are convinced that higher interest rates will kill any sustained recovery. Nothing will shake them from that idée fixe. Therefore they will do anything to prevent high interest rates—including walking back this talk of ending QE, and upping the dosage as need be to achieve their goal of sustained, consistent zero-percent interest.