Stop Judging Success By Movements In Long-Term Interest Rates

By now, I’m sure that everyone has had time to digest Bernanke’s Jackson Hole speech. The speech contained a lot of historical information, so, if anything, it serves as a useful review of U.S. monetary policy over the past 5 years.

Grep Ip speculates that the speech may have paved the way for further action at the FOMC’s upcoming September 13th meeting. Perhaps. But that’s not what I want to discuss in this post. Rather, I want to talk about whether the Fed has even diagnosed the current slump correctly – because there’s evidence in Bernanke’s speech suggesting otherwise.

Bernanke spoke at length about how effective the Fed’s two Quantitative Easing (QE) programs have been. Evidently, the barometer for success is by how much the Fed’s QE programs have lowered longer-term interest rates. Here’s Bernanke:

“How effective are balance sheet policies? After nearly four years of experience with large-scale asset purchases, a substantial body of empirical work on their effects has emerged. Generally, this research finds that the Federal Reserve’s large-scale purchases have significantly lowered long-term Treasury yields. For example, studies have found that the $1.7 trillion in purchases of Treasury and agency securities under the first LSAP program reduced the yield on 10-year Treasury securities by between 40 and 110 basis points. The $600 billion in Treasury purchases under the second LSAP program has been credited with lowering 10-year yields by an additional 15 to 45 basis points.12 Three studies considering the cumulative influence of all the Federal Reserve’s asset purchases, including those made under the MEP, found total effects between 80 and 120 basis points on the 10-year Treasury yield. These effects are economically meaningful.”

Bernanke also spoke about the effectiveness of the Fed’s forward communication guidance, which has consisted mostly of setting an explicit target date for when the Fed hopes to start raising short-term interest rates. And again, Bernanke seems to imply that a successful communication strategy involves a reduction in long-term interest rates:

“Clear communication is always important in central banking, but it can be especially important when economic conditions call for further policy stimulus but the policy rate is already at its effective lower bound. In particular, forward guidance that lowers private-sector expectations regarding future short-term rates should cause longer-term interest rates to decline, leading to more accommodative financial conditions.”

All of this begs a simple question: Is the economy even being held back by long-term interest rates that are too high?

I don’t think so. In my mind, the problem has always been that people are not spending enough money. Consumers are not spending enough money, because many of them remain debt-strapped. Businesses are not spending enough money, because consumers are not spending enough money – the correlation between consumer spending and business investment is extremely tight. And the government is not spending enough money, because the bankers and MBAs have hijacked the conversation on budget policy in Washington.

In the current environment, it’s unclear how lower long-term interest rates get people to spend more money. Sure, mortgage rates have plummeted, but many homeowners still can’t qualify for refinancing, because the values of their homes are too far underwater. And as the New York Fed notes, while households have taken on more debt in the form of credit card loans and student loans in recent quarters, the deleveraging process is still being swamped by an overall reduction in mortgage debt.

In other words, the effects of the recent balance-sheet recession are still lingering. And the Fed bragging about lowering long-term interest rates in the aftermath of a balance-sheet recession is a lot like a quarterback bragging about a field goal when his team really needed a touchdown to win the game.

The important thing to remember, after all, is that the Fed could have easily scored a touchdown by letting inflation overshoot. A higher rate of inflation would have sped up the household deleveraging process, since most debt contracts are negotiated in nominal terms. And the sooner households deleverage, the sooner consumers start to spend more money, leading to stronger business investment spending. Also, to the extent that a higher targeted rate of inflation weakened the value of the dollar, that would have been an incredibly welcome development, considering that the countries that have historically recovered from financial crises quickly have done so by exporting their way back – a trend that is apparently repeating itself in the developed world.

So I wish Bernanke would stop judging success by movements in long-term interest rates. The problem has always been a demand gap, which lower long-term interest rates have done little to fill.

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