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By Robert

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

(Click to enlarge)

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.

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.

Source: More on Real Interest Rates