Good News from Bond Markets: Is QE Already Working?

The Fed’s decision to start printing money has generated no shortage of debate. On one hand, devaluing the US dollar to try to inflate asset prices in hopes of kick-starting spending, investment and job creation seems like a cheap trick that’s bound to go badly — after all, as critics point out, it seems to encourage the US to just keep on racking up larger and larger debts. On the other hand, the Federal Government seems unable or unwilling to produce stimulus packages large enough to do the job, leaving it to the Fed to figure out how to lower unemployment. Many argued that QE2 might not work, since handing cash to banks might not result in expanded credit. Banks aren’t stupid: if economic conditions mean that lending out more will only result in more bad debts, they’ll sit on their cash or use it to buy more bonds and sell those to the Fed for a profit. Or they’ll lend it to their own traders and other hedge funds so it can be invested in higher-yielding bonds or stocks or other securities at home or overseas.Some have argued that the goal of QE2 is to lower interest rates and therefore borrowing costs. This is only partially true. While the goal of quantitative easing is to pump cheap cash into the economy, the goal is not to push down long-term interest rates for homeowners to refinance. That might make sense: the promise that the Fed will buy $600 billion in Treasury bonds would drive up the price and drive the corresponding yields lower. In fact, the opposite is happening. Remember that inflation is the enemy of bonds, since it reduces the real value of repayments in the future. More importantly, inflation generally coincides with higher interest rates, which make existing bonds with lower rates less attractive as assets, particularly since they can end up yielding negative real returns. So the prospect of the Fed pumping cash into the economy and creating inflation should tend to push prices for longer-term bonds lower and yields higher.

In fact, this is what has been happening since Fed Chairman Ben Bernanke first suggested that he might launch a new program of bond purchases back in late August at Jackson Hole, Wyoming. Since then, yields on short-term Treasuries have dropped, while yields on longer-term Treasuries have climbed. The result is what is known as a steepening yield curve, which because it suggests rising inflation in the future, also implies accelerating economic growth. Here is the result in charts (with thanks to

Here’s the yield curve the day before Beranke’s Jackson Hole speech:

And here it is today:

The difference in yields is small, but the overall effect is a steeper curve.

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