There are a couple different schools of thought out there regarding what the Fed can do to foster stronger economic growth. I'll offer a brief explanation of each.
1. Raise long term inflation expectations, so that real rates fall and people, corporations, etc... spend and invest more. Just think of this in context of the Fisher equation where i = ir + pe. "i" is the nominal interest rate, "ir" is the real rate, and "pe" is expected inflation. If you can find a way to credibly raise pe, leaving i constant, then ir falls. Simple!
2. Lower nominal rates through a process known as "quantitative easing," which literally amounts to traditional monetary policy conducted on non-traditional parts of the yield curve. In this process the Federal reserve conducts open market operations to buy treasury bills, in turn providing liquidity to the market, and lowering interest rates. This is also very simple.
The Federal Reserve has committed, barely, but still committed to both of these policies. Ben Bernanke recently announced a 2% inflation target and a $600 billion asset purchase program. (Fine, the Fed isn't actually "targeting" inflation, just admitting that we're currently below the mandate). Together these policies aim to raise inflation expectations and bring down long term interest rates. Still seems simple, but here's the issue... what happens if together, these policies actually take hold and "work?"
To help better understand, lets do a little exercise. For our purposes here we'll say expected inflation is 1.5% with a 10-year nominal yield of 2.5%, (this isn't far off from conditions we saw in mid October). Under these assumptions, controlling for inflation, the yield investors require to hold US debt is exactly 1%. Now what happens when the Fed sets an inflation target, and investors actually believe it? If expected inflation moves toward 2%, investors will require a higher nominal yield to hold US debt. If the required real rate of return remains constant, and a credible inflation target of 2% is set, nominal yields will go to 3%, up from 2.5%. But recall the Fisher equation, if nominal rates and expected inflation go up, real rates stay the same. So to counteract this the Fed is attempting to hold down nominal rates by purchasing $600 billion in US T-bills. The prevailing thought seems to be, "hold nominal rates constant through 'supplying' the market with a temporary increase in demand for US debt." The problem with the Fed's logic here lies in the word "temporary." Most investors don't expect the Fed to continue QE into perpetuity, and as such should expect asset purchases to stop at some point, causing future nominal rates to rise. But if you foresee higher future nominal rates, (because of an inflation target and the looming end of QE), there is nothing to keep nominal rates from rising right now.
The Federal reserve is attempting to lower mid to long term interest rates while simultaneously trying to raise inflation expectations. Whenever one policy grabs a foothold, the other will counteract it.
This is what I've found to be simple, raising inflation expectations will not lead to lower real yields because higher inflation expectations will be accompanied by higher nominal yields. Why do so many economists seem to think investors will take the same 2.5% on a 10-year treasury if inflation expectations go from 1% to 3 or 4%. I don't see why this would have any affect on real yields, only that changes in the nominal yield will "crowd out" if you will, any noticeable changes in the real yield.
So what is really going on here? Well, we've seen rates on the far end of the yield curve rise in the last month. I don't think its because investors fear a US debt default, I think its because they believe in the Fed's inflation target. And this could be a good thing, it will make our outstanding debt cheaper, devalue the dollar, and hmm... Now that I mention it, maybe that was the Fed's intention all along. Simple.
