An alternative explanation

Paul Krugman cites a firewall-protected WSJ article offering another explanation for the recent rise in Treasury rates: the attack on QE by Republicans has raised questions in financial markets as to whether the Fed will actually go through with the plan. This is plausible, but it's very difficult to distinguish this possibility from the others.

Here's a way to think about the effect of QE on long-term interest rates. Long-term interest rates should be equal to the average of the expected future rates on short-term securities plus a term premium reflecting the degree to which long-term securities are imperfect substitutes for short-terms. The expected future short term rates, in turn, can be decomposed into expected future real rates plus expected future inflation.

QE has a direct effect on the term premium: think of a two-part process whereby the Fed first trades short-term securities for long-term securities, thus increasing demand for longs at the expense of shorts and driving up the price of longs relative to shorts, reducing the term premium. Then the Fed conducts conventional open market operations (purchases of shorts) to keep the interest rate at zero.

QE can affect expected future real interest rates by altering markets' beliefs about the health of the economy. A stronger economy means higher real rates, weaker economy means lower real rates.

QE can affect inflation expectations. Higher expected inflation means higher nominal rates, lower expected inflation means lower nominal rates.

Perhaps we can distinguish between the possibilities by looking at the spread between the 30-year and 10-year Treasury yields. The Fed's purchases under QE2 will be confined to securities with a maturity under 10 years. Let's see, if QE is effective we should see yields on 10-year securities fall relative to those of 30-year securities, so the 30-year - 10-year spread should rise. If QE is not expected to hold we should see this spread fall. Expectations of an improving economy and inflation should affect the 10-year and 30-year identically, so there should be no change in the spread.

Roll the tape:



Hmm, the spread rises following the Fed announcement of another round of QE (though this only makes sense if the $600 billion purchases the Fed announced was bigger than expected; I don't think it was). Then it starts falling a couple of days before the letter from Republicans and conservative economists criticizing the policy (but a few days after Sarah Palin's tweet). So if you fudge dates a little you can get support for the WSJ/Krugman view (how often do you see those two names together behind one view?!). But if you look at where the spread is now versus where the spread was before the QE announcement, and you remember that both 10-year and 30-year rates have risen since Nov. 5, it seems like support for the "economy is strengthening" view.

And then we learn that GDP grew at a 2.5% rate in the third quarter rather than the 2.0% increase initially reported. The increase in the estimate reflects better numbers for consumption spending, inventory investment and imports. So some more foundation for the economy-is-strengthening view.