[rt]

Hi Dr Herbener,
The Fed is currently buying $85 billions worth of assets (MBS and treasuries). However the newly created money does not fully enter the system and ends up in excess reserves.

My question is: Which interest rates would rise if the Fed stopped buying MBS and Treasuries?
Only the yields on these assets or interest rates throughout the economy? And why? Thank you!

[jmherbener]

Like all exchange ratios in the market, interest rates are determined by demand and supply. So, to anticipate what would happen, one must conjecture about both sides of the market.

If the Fed quit buying MBS, their prices would fall and yields would increase. Private demand would likely fall because investors would attach a more realistic risk premium to them without the Fed’s support. There would be little incentive to arbitrage funds to other investments and so there interest rates would not be significantly affected.

If the Fed quit buying Treasuries, their prices would fall and yields would increase. Given that private investors did not reassess the credit worthiness of the securities, the difference in interest rates would generate arbitrage opportunities and therefore, change interest rates on other securities. Whether the effect would be large or small depends on the relative size of the Fed’s intervention. The average daily volume of trade in U.S. Treasuries in 2012 was $519 billion.

Of course, the above comments assume that banks do not change their credit creation as their reserves change.

[rt]

Thank you!
Could you explain what you mean by: “Given that private investors did not reassess the credit worthiness of the securities, the difference in interest rates would generate arbitrage opportunities and therefore, change interest rates on other securities.”
So the interest rates in the loanable funds market would more or less stay the same?

[jmherbener]

For example, suppose investors view the credit worthiness of 10-year Treasury Securities and 10-year AAA Corporate Bonds the same and the interest rate on both is 2 percent. If the Fed cuts back its purchases of Treasuries their prices will fall and yields increase, say to 3 percent. Investors gain by shifting funds out of Corporate Bonds and into Treasuries. Their arbitrage activity will move the Corporate Bond rate up and the Treasury rate down until they are the same again, but at a higher level than the original 2 percent.

[rt]

Thanks!
Are all interest rates in the economy somewhat brought to the same level through arbitrage?

And what would be the effect on interest rates with regards to the fact that the growth of the money supply would be slowed down?
Thank you!

[jmherbener]

Arbitrage brings all interest returns together as far as possible given differences among different types of investments, including uncertainty and maturity.

Monetary inflation through credit expansion has a two-fold effect on interest rates. The credit expansion increases the supply of credit which pushes interest rates lower. The monetary inflation reduces the purchasing power of money which pushes interest rates higher. These basic effects of monetary inflation and credit expansion on interest rates is complicated by changes in demand for credit and demand for money. For example, monetary inflation during the 1970s generated double-digit price inflation, in part, because money demand was falling while monetary inflation of similar magnitude recently has generated little price inflation, in part, because money demand has been rising.

[rt]

Okay so we cannot predict at this point how high interest rates would be if the Fed quit purchasing MBS and Treasuries… Well thanks again for your help!

[jmherbener]

Armed with economic theory, each of us can make a prediction about how high interest rates will go when the Fed stops QE3 by using our judgment as to the likely impact of the different causal factors. Since our judgments differ, we will make different quantitative predictions even if we accept the same theory of cause and effect.

Given that interest rates have nearly doubled since Bernanke hinted that the Fed might begin tapering QE3 by the end of the year, it seems that the effect will be large. But the reason, I think, is not because by tapering QE3 that monetary inflation through credit expansion will slow down. Instead, I think, the effect has been on the demand side in changing investor expectations. Because investors have now adjusted their investments to accommodate their changed expectations, when the Fed actually tapers QE3 there will be less effect at that time than there would have been had Bernanke not made his announcement.

[Author]

Posts