Instead of talking about something which would play to my core strengths (say, energy economics, financial regulation, complex derivatives, risk management) I'm going to take the opportunity to demonstrate my ignorance of macroeconomics in general and monetary policy in particular.
Now, the obvious impetus for this post is QE2. The Ben Bernank has decided to run the printing presses and buy Treasuries out to 10 years maturity to drive their yields down. This has created much wailing and gnashing of teeth amongst some inflation hawks.
In some respects, I understand how quantitative easing works a hell of a lot better than I understand how "regular" monetary policy works. In normal open-market operations the Fed messes with the extreme short end of the yield curve. They can fiddle with that as much as they want, but the long end of the curve barely moves. Why doesn't it move? Well, because fixed income traders aren't (complete) idiots. They know that the Fed is going to be there to take the punch bowl away as soon people start having too much fun. If Fed manipulation is expected to work in the short-to-medium term then forward rates are barely affected by the Fed's signaling. Only if Fed actions are expected to fail (necessitating low short rates for an extended period of time) will their actions have an actual effect on the interest rates businesses in the real economy care about. It's nice to be able to borrow cheaply for the next 3 months, but it's pretty hard to build factories, houses and other stuff on that sort of timescale. So there's some kind of black magic going on with normal monetary policy I don't understand. Maybe nobody understands it, or maybe I'm just obtuse. With QE, on the other hand, the Fed just steps in and miracles the yield curve into whatever shape it wants. Abra-damn-cadabra. That's the kind of power you wield when you have access to an unlimited supply of money.
Why does a change in the yield curve for government obligations have any effect on the "real economy"? Well, I know of a few different transmission mechanisms:
1) Cheaper borrowing: the most straightforward story. Holding credit risk (and the mumbo-jumbo that goes into the swap spread) constant, a change in gov't bond yields leads to an equal change in the borrowing costs for businesses. This encourages expansion, the creation of new businesses etc. An alternative means of looking at this is that the present value of future cashflows are discounted at lower rates, meaning that investment becomes more attractive (ceteris parebus). Basically, the Fed makes holding Treasuries less attractive relative to other investments. Money flows into investment and consumption. Inflation goes back up to "normal" levels. More stuff is bought and built. Everybody's happy.
2) Tobin's "q". Entry of the Fed's new money into the capital markets causes bond prices to go up. The extra money they dumped into treasuries has to go somewhere, and one of the places it goes is the stock market. Equity prices also go up. All of a sudden, companies can finance more investment by issuing new equity than they could have previously.
3) Wealth effects. A stock market and bond market where investors earn paper profits causes them to feel richer. What do they do? Spend more money, of course.
4) The Plausibly Deniable Mechanism: exchange rates. It doesn't work in the long term, but in the short term an unexpected shock in nominal interest rates causes people to dump their dollars, causing the price of USD-denominated goods to drop outside the USD zone and non-USD denominated goods to rise inside the USD zone. This causes an increase in demand in the USD zone. Why do people dump their dollars? Well, usually what I hear is some mealy-mouthed explanation about inflation expectations. The mechanism seems to be a lot clearer to me when you say two little words: "carry trade". You know the story about the Japanese housewife? She's the one who trades her Yen in for some Aussie dollars, puts those in an Aussie bank and earns 5% more than her Yen would have earned in a Japanese bank. (Side note: what's the risk here? Well, this isn't an arbitrage, because the JPY/AUD forward curve slopes upward at 5%. The danger is that JPY will actually appreciate along its forward curve, screwing all of those Japanese housewives). If the interest rate in dollars drops, people sell their dollars and buy AUD or any other currency with higher interest rates. Of course, Uncle Ben would never do anything this underhanded to the USA's nice trading partners, would he?
To summarize: QE is pretty straightforward, and in my opinion is probably desirable at the current moment in time (inflation is very low, output growth is mediocre, employment is weak). It's the regular open market operations of the Fed that are mysterious (to me, at least)...
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