The Federal Reserve announced on Wednesday, April 30, 2014, that it was going to reduce the amount of securities it purchased every month as a part of its third round of Quantitative Easing by another $10 billion. This means that over the next month the Fed will only buy $45 billion in securities.
This was the fourth month in a row that the Federal Reserve reduced that amount of securities it was purchasing.
Everyone expected longer-term interest rates to rise over the time period the Fed was “tapering” its purchases.
What has happened?
If we look at the yield on 10-year US Treasury bonds we find…that interest rates have fallen over the time period that the Federal Reserve has been tapering its purchases.
In January 2014, the yield on this maturity bond average 2.86 percent. In February it averaged 2.71 percent and in March the average was 2.72 percent.
For April, the average is going to be around 2.71 percent.
What is going on?
Well, let’s dissect the yield and see if we can learn anything from the “components” of the yield.
To do this we break apart the yield into two components…the “real” yield, as represented by the yield on the 10-year US Treasury Inflation Protected securities (TIPS)…and inflationary expectations.
The striking thing we see when we do this is that inflationary expectations over the period we are examining hardly changed! In January, inflationary expectations were 2.23 percent. In February, March, and April inflationary expectations were 2.16 percent.
In effect, inflationary expectations remained constant throughout the whole period under review!
Thus, the decline in the nominal yield on the 10-year Treasury security came solely through a decline in the “real” rate of interest.
This seems quite unusual. What does it mean?
Using this approach to the composition of the market interest rate, the next step is to use the assumption that investors relate the “real” rate of interest is to the expected “real” rate of growth of the economy.
Using this assumption, we can interpret the decline in the yield on the 10-year TIPS as an indication that bond investors adjusted their expectation for the future growth rate of the economy downward during the past four months.
This interpretation is not inconsistent with the fact that the statistics being released that relate to the economic growth of the United States have been relatively weak in the first quarter. The reasoning behind this feeling has been the weather. The monthly data that has been forthcoming has shown that there has been a real slowdown in business activity, the reason being the bad weather that has impacted a large portion of the country.
This fact has been captured in the first release of the figures for real Gross Domestic Product for the first quarter of 2014. The economy only grew at an annualized 0.1 percent from the fourth quarter of 2013 to the first quarter of 2014.
One can interpret the decline in the 10-year TIPS as the reaction of this information to the investment community. The conclusion of the market…future economic growth will not be as strong as it was originally thought.
Is this a reaction to the tapering that the Federal Reserve is going through?
My answer to this is no. For one, even with the slow down in Fed purchases, the total amount of securities the Fed will have purchased this year when it reaches zero purchases is over $400 billion. This is not a restrictive monetary policy. The amount of purchases the Fed will still do over the next few months is $125 billion. This is not a restrictive monetary policy.
In fact, I would argue that what the Federal Reserve is now doing is having very little impact on economic growth. The United States economy is going through a massive economic re-structuring resulting from the changes that have occurred in this economy over the past fifty years or so. This re-structuring takes time…and, it cannot be achieved by blunt fiscal and monetary policies. This is because the re-structuring requires changes in attitudes, in education and re-training, and in thinking.
So, even with all of the liquidity that the Federal Reserve has pumped into the economy, investors have not translated this into faster expected rates of economic growth or higher expected rates of inflation.
The Federal Reserve seems to be very comfortable with the way the early stages of tapering have worked out. I see nothing on the horizon to cause it to stop reducing its purchases.
Long-term interest rates will only rise as investors believe that economic growth is going to pick up or that inflation will begin to accelerate. Right now we seemed to be locked into a fairly benign environment.
About John Mason
John MasonJohn has been the President and CEO of two publicly traded financial institutions and an Executive Vice President and CFO of a third. He has also spent time as an economist in the Federal Reserve System and worked for a cabinet secretary in Washington, D. C. In addition John taught in the Finance Department at the Wharton School of the University of Pennsylvania for ten years. He now currently has a column on the blog Seeking Alpha and is ranked number 3 in terms of readers on the economy. From this column, two books have been published this past year from earlier blog posts. John is active in the shadow banking world, the venture capital space, and in angel investing. Other than that John works with start ups and early stage organizations, for profit and not-for-profit.
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