Echo

The Fed's success in the Treasury market depends on stable inflation expectations

Monday, June 1, 2009

Yield curves are steepening in those countries (i.e., the US and UK) with active quantitative easing policies (see chart to left). Two issues have emerged regarding the effect of rising fiscal deficits and printing money on the long-end of the curve: (1) supply of debt issuance is growing, and markets require a higher term premium for the notes, and (2) inflation expectations are rising - inflation expectations may be rising for several reasons, QE policies, rising government debts or simply an improved economic outlook - driving up expected short term rates.

Regarding US monetary policy and the recent steepening of the yield curve, I was struck by Naked Capitalism's claim that the Fed is targeting tighter spreads and trying to raise inflation expectations. That doesn't make sense: research shows that in order to target tighter spreads (via a low Treasury yields), inflation expectations must remain stable, i.e., stay within a prescribed band.

Since the Fed announced its Treasury purchase program, inflation expectations have risen but remain below the 2%-2.5% historical mark. According to a 1991 NBER paper by Barry Eichengreen and Peter M. Garber, the necessary condition for a successful interest-rate target is stable inflation expectations. The paper presents a nice case study of the 1945-1951 pre Treasury-Federal Reserve Accord, where the Federal Reserve explicitly targeted U.S. Treasury bond yields below a ceiling of 2.5%.

A return to near 2% market inflation expectations could be called stable (see chart above). And as long as inflation expectations do not blow through the roof, the Eichengreen and Garber paper suggests that the Fed can successfully maintain low term rates low for a period in spite of debt accumulation. The 1945-1951 period likewise suggests that the Fed's interest rate policy is unsustainable. However, though, inflation expectations will eventually grow, and market participants (foreign and domestic buyers alike) will be unwilling to participate in the market at low rates.

Hopefully that time is not here, and that inflation expectations remain stable. Because if they do not, the Treasury purchase program would be deemed one of the Fed's biggest policy failures to date. To date, inflation expectations remain low relative to historical standards (see above chart); and therefore, the Treasury purchase program has a good chance of success. But eventually, inflation expectations will likely become unmoored; and at that point, the Fed will have a problem.

There are alternate explanations for the recent uptick in inflation expectations alongside those of new Treasury supply: take oil, for example, which has been on the rise for months now, hitting $65/barrel on economic optimism. I agree with Paul Krugman, who argues that deflation is still the bigger threat.

Rebecca Wilder

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