Over at Mike Norman Economics, Mike Norman poses the question, "Would rates be higher if the Fed hadn't done QE?" Before I get to his answer, let me acknowledge that this question has crossed my mind a number of times over the past couple years. The answer I have settled on is that rates would be lower and let me explain why. There is a broad misconception about what QE (effectively open-market-operations) really means on an operational basis. I've tried to explain this many times but Mike offers a succinct explanation:
In so doing the Fed changes the composition and duration of the financial assets held by the public. It's not stimulus, it doesn't enable gov't spending and it's not money printing. These are asset swaps, that's it, pure and simple.
QE reduces the default risk and shortens the duration of financial assets held by the private sector (i.e. public). Assuming risk preferences do not change significantly during this process, the private sector will likely counter QE by shifting other assets to higher risk and longer duration securities. The result is a smaller tradable supply of Treasuries and decreasing demand. Since a significant portion of QE has and continues to involve purchasing Agency-MBS instead of Treasuries, my intuition is that the demand effect trumps the change in supply. Without QE, the demand and supply of Treasuries would therefore be higher, with the larger demand effect pushing up prices and lowering rates.
A significant portion of Mike's argument is worth highlighting (my emphasis):
when the government spends it adds to the level of bank reserves in the system and this accumulation of reserves causes the Fed to engage in monetary operations on a fairly regular basis (like, daily) to maintain reserves at a level that is consistent with whatever target interest rate they have decided upon. If the Fed were to allow reserves to build and build and build as a normal consequence of ongoing gov't spending, then the overnight lending rate (Fed Funds) would quickly fall to zero and all other rates out along the term structure would follow suit.
So the fact of the matter is the Fed has to work quite hard to KEEP RATES FROM FALLING TO ZERO ON THEIR OWN if the banking system were just left alone without its intervention. Those who say the Fed is keeping rates "artificially low" have got it backward. On the contrary, high rates or rising rates for a currency issuing nation are artificial.
The first statement in bold is often overlooked or misunderstood but critical to understanding monetary operations and its impacts. Clarifying Mike's point, since taxation actually decreases the level of reserves, government spending in excess of revenues causes reserves to build. Scott Fullwiler addresses this issue in a fantastic paper on Interest Rates and Fiscal Sustainability:
When a deficit is incurred, in order for the Fed's interest rate target to be achieved either the Fed or the Treasury must sell bonds in order to drain the net addition to reserve balances a deficit would create. If no bonds were sold, the deficit would generate a system-wide undesired excess reserve balance position for banks. (p. 17)
Based on this analysis, the conclusion is pretty clear:
The notion that rates would have been higher if the Fed had not done QE is false.
Fullwiler - "The main shortcoming of the money multiplier paradigm"
Bubbles and Busts: Why QE2 Failed, Part 1
Modern Money Regimes Redefine Fiscal Sustainability
Fed's Treasury Purchases Now About Asset Prices, Not Interest Rates
"Interest-On-Reserves Regime" Will Rule Monetary Policy For The Foreseeable Future