Fed’s Kohn on Lessons from Buying Government Bonds….in Britain
Preface:
Recently Dr Jarrell, now a fellow author of this Blog as well as her own, debated the meaning of inflation. That essay, in three parts, may be found in the list of Essays on the right hand side of this Blog. This Post is an extract from a recent Post that Dr Jarrell presented on her own site and is presented here with the hope that, following the essay on inflation, this Post is more widely accessible to you, the reader. Paul Handover.
By Jon Hilsenrath of the Wall Street Journal
JACKSON HOLE, Wyo. — Federal Reserve officials have made it clear that they have mixed feelings about their effort to bring down long-term interest rates by buying long-term Treasury bonds. It hasn’t been clear if the program was achieving its intended goal of bringing down long-term interest rates.
If all goes according to plan, the $300 billion effort will run its course in October. All along, Fed officialshave worried than the program would spook investors into thinking they were “monetizing the debt” – which is econospeak for facilitating big, inflationary budget deficits by buying government debt with money the Fed simply prints. Such a perception in the market could make the program backfire and push long-term rates higher instead of lower.
With that background in mind, it’s worth noting a comment that Fed Vice Chairman Donald Kohn made from the audience this weekend at the central bank’s Jackson Hole meetings. He was struck, he noted, that interest rates on British gilts fell earlier this month after the Bank of England re-upped its plans to buy government bonds. The program in the U.K., in other words, seemed to be having its intended effect, evidence supporting its usefulness. “The markets must perceive that there is an effect there,” he noted during a panel discussion on monetary policy.
The Fed has said it doesn’t intend to expand or extend its bond-purchase program. But what if the economy underperforms? And what if evidence mounts that this program, or others like it such as the U.K.’s, actually did have their intended effect? Maybe it won’t be dead after all. The Fed can be expected to keep its options open on the question.
Wonderful article and comments! There seems to be some confusion on the facts surrounding the relationship between the Fed’s actions, the demand for and supply of U.S. bonds, and the interest rate.
First, the Fed buys U.S. treasuries all the time, and they are only part of the world demand for U.S. instruments. Their plan to buy an additional $300billion in Treasuries within a relatively short window did represent a notable increase 
relative to their usual purchases, and was intended to raise the price which lowers the yield or equilibrium interest rate on those bonds, assuming these purchases continue to represent a net increase in world demand for U.S. bonds (which requires a fairly stable supply), and assuming inflation expectations remain flat.
There’s the rub: IF the Fed creates money (deposits, reserves) when it purchases these bonds, inflationary pressures do enter the picture. And increased inflation means higher interest rates. Inflation does require a sustained increase in the supply of money relative to underlying productivity of the economy.
If money supply simply “keeps up” with productivity, we’d have zero inflation. If there is insufficient money (or liquidity or credit), deflation kicks in — which I believe is the real concern of the Fed under Bernake. There is ample evidence that Bernake is fairly cavalier about inflation, and perhaps overly confident about his ability to counteract inflationary pressures in fairly short order without much volatility in the markets. It’s deflation he wants to avoid at almost all costs.
I wonder if anyone can help me find any reference in the press of the Fed Res bulletins or minutes that clearly state that the Fed is going to create deposits in order to fund their purchase of the $300billion in Treasuries?
I’ve looked and cannot find it. It’s important because this is what links the Fed’s purchase of bonds to any concerns about inflation — a source of a great deal of the confusion on this topic.
To the extent the Fed uses anything else, like some of the AIG and Maiden Lane assets that they’ve recently purchased (a result of Paulson and Geithner’s borderline-constitutional blurring of the roles of the Treasury and the Fed), to buy some or all of these bonds, the money supply doesn’t increase and inflation worries abate.
By Sherry Jarrell
Learning from Dogs 