Data Suggests Fed Stimulus is Working

Bloomberg reports:

Government bonds are falling the most in a year as the gap between yields on longer-term Treasuries show that the Federal Reserve’s second round of quantitative easing may be its last.

The difference between 10- and 30-year yields shrank to 1.05 percentage points, or 105 basis points, on Dec. 15 from a record 1.60 points on Nov. 10, the fastest contraction since the 1980s, according to data compiled by Bloomberg. The shift in the so-called yield curve is taking place as Bank of America Merrill Lynch index data show U.S. bonds due in 10 years or more lost 4.64 percent this month, trimming 2010’s gain to 8.37 percent.

Flattening usually foreshadows the end of Fed interest-rate cuts aimed at stimulating growth. U.S. reports this month showed rising retail sales, higher consumer confidence and a jump in industrial production after the central bank expanded itsbalance sheet to an unprecedented $2.39 trillion, pumping money into the financial system. It’s adding $600 billion more purchasing Treasuries through so-called quantitative easing to keep the economy from deflating.

“A peak in the yield spread between 10s and 30s signals the end of an easing cycle,” said Steven Wieting, managing director of economic and market analysis at Citigroup Inc. “It’s part of a recovery and improved growth expectations. If the outlook is for a stronger recovery, then QE would be limited and they may not expand beyond it.”

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Mankiw on Fed Stimulus: “Modestly Good”

Greg Mankiw writes:

Several people have asked my opinion of the Federal Reserve’s new round of quantitative easing.? In particular, some have noted that I did not sign the?open?letter by conservative economists critical of recent Fed actions.

My?view is that QE2 is a modestly good idea.? I say it is a “good idea” because, like Ben Bernanke, I am more worried at the moment about Japanese-style deflation and stagnation than I am about excessive inflation.??By lowering long-term real interest?rates below where they otherwise would be,?QE2 should help expand aggregate demand.? I include the modifier “modestly” because I don’t expect these actions to have a very large effect.

Moreover, I do see some potential downsides.? In particular, the Fed is making its portfolio riskier.? By borrowing short and?investing long, the Fed is in some ways becoming the hedge fund of last resort.? If future events require higher interest rates,?the?Fed?will end up making losses on?its portfolio.? And even if doesn’t recognize these losses (by not marking to market), it could end up paying more interest on newly expanded reserves than it is?earning on its newly acquired portfolio of long bonds.??Such a cash-flow deficit could potentially undermine the?Fed’s political independence?(which is already not very popular in some circles).? Yet if the Fed tries to avoid these losses by failing to raise rates when needed, inflation could indeed become a problem down the road.? I trust the team at the Fed enough to?think they will avoid that mistake.

So, in?the end, I judge QE2 to be a small?but risky step in the right direction.

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