The Bond Market Won’t Allow an End to QE Any Time Soon

A couple of days ago I linked to this article which suggested that were Hayek alive today he might well counsel to proceed with caution in its use of unconventional policies, e.g. QE. The gist of the piece was that economists, indeed all social scientists, tend to certitude based on quantitative models which are anything but certain. In other words, a model of employment and aggregate demand while engaging, is in no way infallibly descriptive of what actually will transpire under differing sets of circumstances in the same way that, say, Einstein’s theory of relativity is.

Humility is probably not going to cause the Fed to question what they have wrought, let alone incent them to begin withdrawing QE. That appears to be solely up to the vagaries of the economy, particularly the health of the labor market, and the Fed thinks that it is far from robust. Greg Mankiw in a New York Times essay doesn’t disagree that by some measures the market for jobs is still quite weak – relatively high unemployment, a declining labor force participation rate, abnormally high number of long-term unemployed – but also points to data which tell a different tale.

Another clue to what’s happening in the labor market is the vacancy rate. Although less widely followed than unemployment figures, this rate is its mirror image. To compile the unemployment rate, the Bureau of Labor Statistics surveys households to find workers without jobs. To compile the vacancy rate, the bureau surveys employers to identify jobs without workers. In short, the vacancy rate measures the percentage of available jobs that are currently unfilled.

Not surprisingly, the vacancy rate is highly cyclical. In recessions, when customers are hard to find, businesses post fewer new jobs. In addition, because the number of job seekers expands, the posted openings are filled quickly. As a result, the vacancy rate falls. Conversely, when the economy recovers, businesses start posting new openings, and jobs are harder to fill, so the vacancy rate rises.

The recent recession is a case in point. Seven years ago, the vacancy rate was a bit over 3 percent. It fell to a low of 1.6 percent in July 2009, a month after the official trough of the recession. The most recent reading puts it at 2.8 percent. So according to this measure of labor-market tightness, the economy is almost back to normal.

Data on wage inflation also suggest that the labor market has firmed up. Over the past year, average hourly earnings of production and nonsupervisory employees grew 2.2 percent, compared with 1.3 percent in the previous 12 months. Accelerating wage growth is not the sign of a deeply depressed labor market.

The point he makes is that the data present conflicting pictures of the labor market and that this particular recession has tended to break historical molds. To put it less charitably the past is not prologue. He concludes by suggesting that Ms. Yellen might need to be adaptive if the signals she’s watching turn out to be wrong.

So here we have one economist suggesting humility and another that the Fed might be reacting to the wrong signals. Then we have Felix Salmon coming forth with a good post which lays out a scenario for the Fed being trapped in QE.  He posts a couple of intriguing charts which show a marked change in both the demand for bonds and the mix of buyers of those bonds. Essentially, since 2008 buyers, save for pension funds, have exited the market having been replaced by foreign official and G4 central banks. The supply of bonds now comes preponderantly from government entities, though the amount raised is decreasing. He concludes:

…Instead, step back and look at the big picture, which is pretty simple: as a stylized fact, the bond market is dominated on both sides by the official sector. Private participants might sit in the middle as market-makers, or try to borrow money here or there, but overall what you’re looking at, when you look at the bond market, is government issuing debt and governments buying it.

The good news is that this large transfer of money from the official sector’s left hand to its right hand is slowing down, but that’s going to take a while. In any case, there doesn’t seem to be any conceivable way that the private sector could possibly be able to fund the still-substantial government deficits which have been bequeathed to us by the financial crisis. As a result, I suspect that QE is likely going to be around for a while, just as a matter of mathematical necessity. The world’s national deficits can’t get funded any other way.

So Brough and Mankiw might well make excellent points but the inexorable logic of the math, at least at this point in time, would seem to dictate QE for an indeterminate time. It’s certainly possible that the demand side for government bonds could expand to include previous market participants, but that seems unlikely given the current regulatory environment as well as the near certainty of loss of principal given the low current coupons. For the time being most of the buyers are going to be those who intend to hold to maturity. It also seems unlikely that interest rates will rise enough in the near future to compensate for this problem given the bias of the Fed and other central banks towards the idea that economies are still sick and in need of support, as well as a political and economic imperative to keep rates low in order to lessen the strain on government budgets. Felix is right, the structure of the mark dictates the continuation of robust QE.

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