More on Real Interest Rates
In comments Mark Sadowski noted that short term real interest rates have fallen a lot since Ben Bernanke began announcing QE2. In earlier posts, I had considered only the 7 year constant maturity and the 5 year constant maturity series. I think that medium term real interest rates matter most for investment and that real interest rates have a negligible effect on consumption, government consumption, and net exports (except via exchange rates). I am also interested in the fact.
So I generated an absurdly crowded Fred Graph
The red, blue, green are real interest rates measured with TIPS prices — the red line is the real interest rate paid over the next year and 15 days, blue average over the next 2 years and 9 months and green average over the next 3 years and three months. The grey line is the 5 year real interest rate calculated by the Fed by interpolating yields on TIPS maturing at different times. The orange line is CPI inflation in the preceding year and the purple line is CPI minus food and energy (core) inflation in the preceding year.
I discuss the graph after the jump
They grey line is the one I’ve blogged about before. It shows no change over the period from first mention of QE2 (August 2010) until now. The red line in contrast dropped sharply corresponding to an increase in expected inflation on the order of 2%. This is Mark Sadowski’s poing (he cited a paper which interpolates a lot and I prefer to look at relatively raw data).
The blue and green lines show an drop of 1% on average. Along with the 1 year rate, this roughly corresponds to an increase in inflation expected for March 2012 through January 2014 of about half a percent (the nominal 3 year rate went up 0.2%). The difference in the 5 year nominal minus TIPS increased about ‘.5%, which suggests roughly no change in inflation expected after January 2014.
TIPS are indexed to the CPI not core inflation. As everyone knows, CPI and core inflation diverged in late 2010. I don’t live in the USA, so perhaps I can be forgiven for trying to put the change in the price of gasoline on the same graph (all of the interest rates looked like horizontal lines). I used increase in the past year, a very smoothed lagged measure, to fit inflation on the same graph as the TIPS rates.
Notably CPI inflation increased a lot over 2010 (the one year moving average increased 1%) and core inflation increased much less. Just from that, I’d guess CPI inflation will be high for a while then decrease. In other words, I tend to guess that the sharp change in the price of TIPS maturing in one year was mostly caused by the increase in the price of petroleum and partly by the increase in the price of food.
Of course, now that I have written here (and all over the web) that QE2 did nothing, I would be inclined to make such an interpretation. It is also possible that investors assume that the Fed will decide that 7% unemployment is low enough and reverse QE2 in the near future (the president of the St Louis Fed already discussed the possibility of not completing the scheduled purchases of 7 year notes).
Just to try to psychanalise the graphs more, there was clearly a TIPS price response in August 2010. Then it vanished in November (buy on the rumor sell on the news). My reading is that investors discovered that demand for 7 year notes is extremely interest elastic so QE2 itself didn’t affect prices. It is also possible that the November announcement was for much less quantitative easing than expected. And, since I have decided that developments since the peaks in very late 2010 are not due to QE2, I can’t complain if commenters note that I object rather fiercely when people suggest that the little up tick in very late 2010 was not related to QE2.
“It is also possible that investors assume that the Fed will decide that 7% unemployment is low enough”
In the late 1980s the bond market went crazy when unemployment dropped below 7%. I don’t know if that means that the Fed thought that 7% was low enough. I guess the bond trader thought that the Fed thought that. But that was then. Now, maybe 7.5% will be “low enough”. 🙁
“In comments Mark Sadowski noted that short term real interest rates have fallen a lot since Ben Bernanke began announcing QE2.”
Actually that’s not what I said at all. I said that inflation expectations had risen a lot since Bernanke’s Jackson Hole speech on 8/27/10. This may have led to a decline in short term real interest rates but in my opinion that was somehat beside the point as real interest rates are not the prime determinant of investment. The prime determinant of investment is the rate of return which is surely quite low in the face of persistently low capacity utilization rates.
But not only have inflation expectations increased dramatically since QE2 was announced, there has also been a sharp increase in the value of equities. And we have also seen signs of life in the real economy (household employment and domestic purchases) for the first time since the supposed “recovery” began nearly two years ago. And, it’s important to note, this is all taking place as the discretionary fiscal stimulus (ARRA) is being rapidly unwound and hence is acting as a net drag on the economy.
And yet some still claim QE2 is having absolutely no effect. The real test will be when QE2 ceases in June.
P.S. Robert distrusts interpolation. Fortunately there are other market based measures of 2-year inflation expectations:
http://www.bloomberg.com/apps/quote?ticker=USSWIT2:IND#chart
The two year inflation zero coupon swap rose from 0.92% on 8/26/2010 to 2.61% on 3/31/2011. Since the implosion of inflation expectations in late 2008 the highest it had closed prior to QE2 was 1.74% on 4/30/2010. In fact this is the highest level that 2-year inflation expectations has been since 8/4/2008.
But remember, QE2 is having absolutely no effect.