Yichuan Wang: Keep financial and monetary decisions separate

Yichuan Wang has an excellent new post discussing parallels between the QE of 1932 (and tapering of 1932) with the QE of today.  Here’s the conclusion:

To get back on track, the Fed must commit to keeping rates low until the price (or nominal GDP) level is back to trend. On the other hand, if the Fed were to raise interest rates now, this would collapse expected inflation, lowering the Wicksellian curve and knocking the economy into a low output, low interest rates environment. So even if you think the low rates environment is causing financial distortions, the only way to get higher rates in the future and to solve the apparent financial distortions of low interest rates is, ironically, to promise to keeping short rates low now.

The financial stability view gets off track because it ignores general equilibrium effects. In partial equilibrium analysis, when there’s an excess stock of something, such as bank reserves, the natural response is to cut supply. But this is misleading analogy for bank reserves, because an excess supply of bank reserves actually represents an excess demand for money. Therefore the proper response is to maintain lower rates and not prematurely tighten.

Therefore the real bills/financial stability doctrine fails for three reasons. First, it identifies excess reserves as the result of reduced borrowing that the Fed cannot control, whereas the excess reserves actually are symptoms of an excess demand for money that easier monetary policy can address. Second, this misdiagnosis means we are left thinking the Fed is powerless, whereas the Fed can pin down the price level through forward guidance. Third, it ignores the general equilibrium relationship between money and goods. By prematurely raising rates, this actually depresses interest rates in the long run and worsens the excess demand for money. Bottom line? Worrying too much about financial stability concerns can exacerbate the business cycle and actually prolong a period of low rates. Instead, the Fed should keep its eyes on the real economic prize, and keep financial decisions separate from its monetary ones.

Evan Soltas has a follow-up to his study of the relationship between stock prices and bond yields, which suggested that in recent weeks the rise in long term bond yields has been caused by expectations of tighter money.  In his new post he shows that most bond dealers believe the spike in long term bond yields is due to expectations of tighter money.  He seems to have the strongest arguments of anyone I’ve seen in the blogosphere, and he is undoubtedly at least partly correct.  And yet I have a few nagging doubts:

1.  Since May 1 the stock market has risen strongly, and 5 year TIPS spreads have stayed at about 2% (after dipping lower in the interim.)

2.  Tighter money should reduce TIPS spreads and stock prices.

How can these facts be reconciled?  Consider the following:

1. Expectations of tighter money have had a dramatic impact on markets on certain days, such as the period from June 18 to June 21, when 5 year yields spiked from 1.07% to 1.42% and 5 years TIPS spiked even more, from -0.77% to -0.24%.  That means TIPS spreads fell from 1.84% to 1.66%.  Stocks also fell sharply over that three day stretch.   So why are TIPS spreads back close to 2%, as they were in early May?  And why are stocks far above the levels of early May?

Perhaps yields have been affected by two factors:

1.  Expectations of tightening have boosted yields during certain highly visible periods, and this depressed stocks and TIPS spreads.  This is what the dealers noticed.

2.  Expectations of faster growth have been gradually raising stock prices, TIPS spreads, and bond yields on the other days, the days when there is no hawkish news out of the Fed.

Perhaps those who follow the markets more closely than I do can tell me if these two hypotheses can explain most of the stylized facts.

PS.  I’m still quite puzzled by all this, as I don’t see much evidence of faster growth.  The next 12 months of macro data will tell us a lot about what has been going on over the past few months in the markets.



33 Responses to “Yichuan Wang: Keep financial and monetary decisions separate”

  1. Gravatar of Geoff Geoff
    17. July 2013 at 15:17

    Stop the presses! I don’t believe it! After years of reading these posts, Soltas or Wang have finally mentioned the effects of non-market inflation on economic calculation…

    Oh wait, no they didn’t.

    My bad.

  2. Gravatar of Wawawa Wawawa
    17. July 2013 at 15:25

    On the faster growth front, I believe that I’ve recently read the folks at Macro Advisors are calling for slowed growth? I can’t find a link however.

    Also note that even someone whose “reading comprehension skills are below first grade levels” could read the writing on the wall with regards to yields.

  3. Gravatar of rbl rbl
    17. July 2013 at 15:50

    Prof. Sumner, is it possible that the Fed has shown itself to be fairly responsive to the stock market, witness the “clarification” after the taper talk tanked the market, and as such the stock market isn’t as concerned about fiscal contraction? If the Fed will only pursue tighter money to the extent that it won’t kneecap stocks, it would make sense for the bond markets to be more concerned.

  4. Gravatar of Cameron Cameron
    17. July 2013 at 15:57

    Perhaps markets think the Fed will rely less on QE in the future and more on forward guidance and economic projections? Bernanke also stressed that the stock and not the change in the monetary base is a better judge of monetary stance. That should put downward pressure on the demand for long term treasuries without the Fed having actually tightened policy. After ending QE, the next tightening move may well be an anti-twist.

    I’m skeptical of the bond dealer survey. To them tight money probably=high rates.

  5. Gravatar of ssumner ssumner
    17. July 2013 at 16:13

    Wawawa, I see your reading comprehension has not improved, at least if you think this post supports your argument.

    rbl, Yes, that’s possible.

    Cameron, But I’m puzzled as to why the markets think the Fed will raise rates next year. Neither Bernanke nor I think that’s likely.

  6. Gravatar of jknarr jknarr
    17. July 2013 at 16:34

    Consider that Japanese and US 10 year Treasury bonds are very highly correlated. US yields happened to catch up to Japanese levels — and the rise in inflation-indexed yields was global. (There is no relationship between inflation-indexed bond yields and real GDP.)

    One lesson from the BoJ is that bondholder constituencies can force the resumption of tight money, slow growth, and low yields. Floating-FX central banks worry mostly about relative easing versus other central banks, not the absolute quantity of easing. A tighter Japan means less easing scope for other CBs.

    You may simply be short equity / long breakevens, which would be a perfectly reasonable trade.

  7. Gravatar of Wawawa Wawawa
    17. July 2013 at 16:38

    ssumner, your hubris is embarrassing with these petty comments about the reading comprehension of someone you’ve never met very Krugman-esque of you. Still, I’m disappointed (thought not surprised) by the assumptions that you make. Where did I ever allude to your comments as support for my argument? Maybe it is your reading comprehension that is lacking?

  8. Gravatar of Cameron Cameron
    17. July 2013 at 17:02



    Markets don’t seem to think the Fed will raise rates next year, at least anymore. Expected fed funds rates did rise in along with the sharp increases in treasury rates in mid June and early July though, supporting the tightening theory.

    This is certainly a mess.

  9. Gravatar of Jeff B. Jeff B.
    17. July 2013 at 17:13

    Hate to be a “dufus” but why would tighter money result in reduced TIPS spreads?

  10. Gravatar of jknarr jknarr
    17. July 2013 at 17:27

    Scott, P.S.,

    I’m also puzzled about these real bill critiques: real bill purchases free up capital at the banks, and likely stabilized prices (no panic selling) in the secondary market for bills. World War one was largely funded by the Fed buying bills from banks, and banks turning around and buying war debt with the cash.

    Bank lending in the first place is the procyclical factor, not necessarily the real bill policy. The Fed could have chosen to buy in the early 1930s, but instead actually tightened up purchasing standards in the early 1930s and bought much less, as bill purchases fell off a cliff. This decision was entirely unrelated to the policy of real bill assets.

    Excess speculation (stretching for yield) would appear to me to be the symptom of tight money and reduced cash flows in the real economy, and where low interest rates are symptom, not causes.

    re real bills: Warburton via Timberlake, the Fed “virtually stopped rediscounting or otherwise acquiring “eligible” paper. This was not due to any lack of eligible paper. . . . Nor was this virtual stoppage . . . due to any forces outside the Federal Reserve System. It was due to “direct pressure” [from the Fed Board] so strong as to amount to virtual prohibition of rediscounting for banks which were making loans for security speculation, and a hard-boiled attitude towards banks in special need of rediscounts because of deposit withdrawals. . . . Federal Reserve authorities had discouraged discounting almost to the point of prohibition.”

  11. Gravatar of Steve Steve
    17. July 2013 at 17:45

    I second Cameron’s argument.

    Also, I think the stock market is recognizing that inflation has fallen and can’t get up. Therefore a zombie inflation targeting policy regime can’t become an active impediment to recovery as it was in 2007-08 and again in 2010-11. They can tighten a little, but ultimately zombie inflation targeting is more friend than foe for the next few years.

  12. Gravatar of Evan Soltas Evan Soltas
    17. July 2013 at 18:33

    Scott — Maybe it’s strange for me to put it this way, but I agree with your doubts. More clearly, I would have said with very high confidence that the major cause of the rise in Treasury yields was a change in future monetary policy. I think the last week forces me to revise down that confidence, even if it is still high. My sense is that the Fed has clarified one thing, and the market’s mind has changed on another: (1) the Fed will be conditional, and markets feared at first it wouldn’t, and conditionality improves the median forecast by containing downside risks, (2) the market may have reassessed the sensitivity of NGDP growth to interest rate changes (or monetary policy changes) in the relevant range. I find (1) and (2) a much more persuasive story of why rates could stay high and equity prices could revive than anything else out there.

  13. Gravatar of Evan Soltas Evan Soltas
    17. July 2013 at 18:37

    Also, I’m still openminded on these questions. I don’t see myself as advocating for a particular point of view. I just saw a lot of writers who I respect getting way too cavalier last month about the changes in expected future interest rates. I’m excited for monetary policy to normalize — but, like you, I don’t see the super strong evidence (as much as I’d like to!) that the economy is suddenly stronger.

  14. Gravatar of kebko kebko
    17. July 2013 at 19:04

    Evan’s comment is basically what I’ve been saying.

    Someone posted the primary dealer surveys here recently:

    The funny thing is that the primary dealers moved their expected date of tapering up significantly from April until after the June Fed statements, and attributed some the rising rates to that effect.

    But, what is interesting is that their answers on the expected date of the first Fed Funds rate increase and short term rate levels after that were basically unchanged. Their answers on the range of expected sizes of the Fed balance sheet at the end of 2014 were basically unchanged, except that the mode was much higher and the possibilities of the Fed still having a much larger balance sheet were lower.

    So, they claimed that the taper was key, but their actual future expectations suggest that the main change in their expectations was more confidence in the Fed’s ability to wind down the size of their balance sheet.

    Interestingly, in both April & June, they report an expected forward rate in 2017 of around 3%. The rates in the futures market actually went from about 1.5% in April, to 2.25% in May, up to…..3% in June. I’m going to take this as evidence of the theory I presented here previously that futures rates were previously being pushed below pure expectations rates by uncertainty about future Fed balance sheet management.

    I will add that there has been a significant negative correlation between bonds and equity, due to the bearish effect of the low inflation policy. A negative correlation would be expected to lead to a more leveraged position in both assets. This relationship broke down in May & June, so temporarily falling prices in both assets could be the result of deleveraging, per modern portfolio theory.

  15. Gravatar of maynardGkeynes maynardGkeynes
    17. July 2013 at 19:46

    I think the commenters are over-thinking this. The stock market has become a virtual carry trade, and the only question is how soon the music is going stop. Bernanke has clearly signaled “not anytime soon, so keep dancing.” Why Bernanke or anyone would care whether it is going to be knee-capped or not is beyond me.

  16. Gravatar of ssumner ssumner
    17. July 2013 at 19:55

    Wawawa, My mistake, it’s your writing skills that are awful. I have no idea what your first comment to this post means, if it doesn’t mean what I assumed.

    Cameron, Are the futures telling a different story from the yield curve? Doesn’t the yield curve suggest rate increases in 2014?

    Jeff, It reduces inflation expectations.

    Steve, I find that plausible, but translate that into NGDP growth expectations May 1 and today. Which is higher?

    Evan, Good points. I probably shouldn’t have implied you were dogmatic on this point. I see your posts as being empirical, in a good way.

    Regarding point two, wouldn’t it have been great to be able to watch a real time NGDP futures markets as the ten year went from 1.6% to 2.6%?

    jknarr and everyone, We’ve seen a sizable rise in yields, even over the 2 to 5 year range. Are you saying that doesn’t show up in fed funds futures? If so, is that difference normal or unusual? (I don’t follow these markets as closely as I should.)

  17. Gravatar of kebko kebko
    17. July 2013 at 20:37

    Bond yields show up in Eurodollar futures (Fed Funds futures don’t go far enough past 2014/15 to tell us much). What doesn’t necessarily match with futures rates is survey responses and stated expectations.

    You believe in EMH, but you don’t know if bond yields and futures prices match up?

  18. Gravatar of Ricardo Ricardo
    17. July 2013 at 20:53

    I typically like to go back and find who was correct with their call and review their reasoning. So…

    – Goldman Sachs had it right back in Feb 2013, saying yields would be higher w/o QE:

    “Goldman Sachs says those yields would be 100 to 125 basis points higher if the Federal Reserve hadn’t enacted its unconventional monetary policy measures to boost the economy”

    – Some insight on their reasoning may be found at the link below, apparently this link is the full Goldman note from May.

    Some useful stuff here:


    “the US bond market returned to being more responsive to incoming economic information…”

    “We ascribe this movement to a shift in the Fed’s reaction function. In the second half of 2012, the Fed’s forward guidance on the future path of the policy rate was linked to a specific calendar date. The introduction of ‘macroeconomic thresholds’ in the Fed’s policy guidance last December led investors to focus again on data developments.” eg: the continued improvement in the employment situation.

  19. Gravatar of Cameron Cameron
    17. July 2013 at 21:13


    The two year yield rose from ~0.25 to ~0.5 after the June Fed meeting, but has since fallen to .3. 10 and 30 year yields are only slightly below the June post-Fed meeting June high.

    So the fed funds futures and the yield curve are telling the same story, that a fed funds rate increase before late 2014 was expected just after the June meeting, but isn’t anymore. Longer term yields haven’t declined much during the same period. Stock prices are up 6% since the initial reaction to the meeting.


    So I’d revise my assessment and say the rise in yields leading up to the June meeting were clearly signaling tighter money, but Bernanke’s successful backtracking has managed to ease policy without lowering long term yields much. For that I’ll go back to my original guess, QE3 to end soon but a rate increase still far off.

  20. Gravatar of 123 123
    18. July 2013 at 01:26

    Various interest rate markets indicate that the monetary tightening was partially reversed.

  21. Gravatar of Saturos Saturos
    18. July 2013 at 03:34

    Robert Shiller on bubbles: http://www.project-syndicate.org/commentary/the-never-ending-struggle-with-speculative-bubbles-by-robert-j–shiller (HT @Noahpinion)

  22. Gravatar of Saturos Saturos
    18. July 2013 at 04:39

    The time has come, Scott, to ask: Have you or have you not ever engaged in “punching hippies”? http://noahpinionblog.blogspot.jp/2013/07/how-normal-people-see-macroeconomics.html

  23. Gravatar of ssumner ssumner
    18. July 2013 at 06:40

    Ricardo, So GS thinks the cause is both tapering and the continued improvement in the employment situation? I can buy that.

    Cameron, Actually the two year peaked at 0.43%, but I buy your general observation, it looks like more than a “liquidity effect” at work here.

    You may be right that the 10 year still factors in the end of tapering, but Bernanke’s been able to convince the 2 year market that the end of tapering will be followed by an extended period before fed funds rates rise.

    It’s odd because tighter money is supposed to flatten the yield curve. I understand the zero bound issue, but even so the movements in the 2, 5 and 10 look more like faster growth than tightening, when viewed in combination.

    Perhaps the market segmentation view of the yield curve has more power than I’d assumed, which would fit in with kebko’s comment about me being too dependent on the EMH.

    Saturos, I know one hippie I’d like to punch! (Just kidding Noah.) I’ll do a post on that.

  24. Gravatar of ssumner ssumner
    18. July 2013 at 06:45

    123, I agree.

  25. Gravatar of ssumner ssumner
    18. July 2013 at 06:48

    123. But note that 10 year yields are still much higher than late last year. Perhaps the sequester did less damage than the markets expected, I really don’t have a firm opinion on this.

  26. Gravatar of 123 123
    18. July 2013 at 07:12

    Scott, sequester has done no medium term damage.

    Eurodollar futures two years ahead still show some damage from tapering.

  27. Gravatar of RyGuy Sanchez RyGuy Sanchez
    18. July 2013 at 08:18


    Small caps are outperforming large cap stocks as treasury yields have risen, suggesting that, money is slightly tighter (since large cap companies have more credit access), but growth is also higher(since equities are reaching new highs). Still the best explanation i have heard is from andy harless’s multiple equilibrium post. Combine that thought with Yang’s on the unimportantance of the recent QE and that is where I currently sit.

  28. Gravatar of kebko kebko
    18. July 2013 at 11:14

    I have a knack for miscommunicating my ideas to you, I think.

    I don’t think you are overdependent on the EMH, necessarily. I depend on EMH to the extent that I know that forward rates and bond rates are equivalent without even having to look.
    The interesting stuff is figuring out the narrative about what the current prices are telling us, which of course is an impossible task.

  29. Gravatar of Tim Condon Tim Condon
    18. July 2013 at 17:44

    I am expanding on comments I made on a David Glasner post “Who sets the real rate of interest?.” Since QE3 the important re-pricing is in real rates. Swings in breakeven inflation rates can be “interesting” as we saw in late May-June. But they’re less “interesting” than before QE3 because QE3 supports inflation expectations; the recent fall in breakeven inflation rates was not as steep as those that preceded QEs 1 & 2 and Op Twist.

    The episodes of steeply falling inflation expectations those earlier episodes of unconventional easing were associated with steep declines in real rates; both markets repriced for a US-as-Japan scenario. QEs 1 & 2 and Op Twist reversed the declines in inflation expectations. The puzzle is the hysteresis in real rates. I attribute it to go-stop monetary policy; the pre-QE3 unconventional easings were seen as transitory interruptions on the path to a US-as-Japan scenario.

    QE3 ended go-stop (even if it didn’t eliminate discretion) and real rates are normalizing, not signalling faster growth. You’ve written that the Great Recession probably slowed potential RGDP growth and I agree. So why are stocks rallying? They’re repricing for better monetary policy. Once the repricing has finished they’ll return to moving with discounted profits.

  30. Gravatar of Johannes Fritz Johannes Fritz
    19. July 2013 at 03:31

    Evan Soltas’ update on the correlation prompted me to produce a scatter plot of T-Bills vs. SP 500 for 2013.


    If one sticks to the two-dimensional logic (change in same direction = economic outlook driven; opposite direction = expectations of Fed policy), markets seem a whole lot more confused since May 22.

    Up to that point, markets only revised expectations towards looser monetary policy and along the economic oultook dimesion.

    Now, the don’t seem to know what to think.

    I also looked at the TIPS as you suggested, but don’t see any change in pattern whatsoever since May 22.

  31. Gravatar of ssumner ssumner
    19. July 2013 at 05:46

    123, That supports my point, I said the sequester did less damage than expected. “None” is less than expected.’

    I agree with your second point, except of course we can’t be certain it is from tapering. (I agree it likely is partly tapering)

    RyGuy, So small caps are more tied to growth? That sounds reasonable.

    kebko, Good point.

    Tim, What do you mean by “hysteresis” in real rates?

    Thanks Johannes, That’s why I always say “never reason from an interest rate change.”

  32. Gravatar of Tim Condon Tim Condon
    20. July 2013 at 03:37

    Scott: I mean that real rates failed to quickly reverse the re-pricing for a US-as-Japan scenario after QEs 1 & 2 and op twist (in contrast to expected inflation). Real rates went down and stayed down.

  33. Gravatar of Some links on bubbles and monetary policy | TVHE Some links on bubbles and monetary policy | TVHE
    23. July 2013 at 12:01

    […] This also feeds into the discussion about keeping financial and monetary policy separate (via Scott Sumner): […]

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