Why Fed Tapering caused a rise in bond yields

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Readers Question Why did bond yields in the USA rise at news of the Fed Tapering back in August?

The Federal Reserve has been engaged in a policy of quantitative easing. This involves:

  • Creating money electronically
  • Using this created money to buy assets, such as government bonds.

The aim of quantitative easing is to stimulate economic activity – increase economic growth and avoid inflationary pressure. QE aims to stimulate economic growth through increasing the money supply and reducing interest rates in the economy.

With the Federal Reserve buying bonds, other investors are also keener to buy bonds. The Fed is pushing up the price of bonds so whilst this is occurring other investors may be encouraged to also buy bonds and benefit from the rising prices.

Fed Tapering

Fed Tapering means that the Federal Reserve will begin to stop buying bonds, and no longer continue to create money and buy bonds. This tapering could also be seen as a preliminary to reversing quantitative easing and selling the bonds that have been accumulated.

A decision that the Fed would be beginning to end quantitative easing, will encourage investors to start selling bonds.

If the Fed stops buying bonds, the price is likely to stop rising; and if quantitative easing is reversed,  bond prices could fall. This expectation of falling bond prices will encourage investors to sell. Markets are always trying to anticipate future movements. Therefore, even a weak signal that bond purchases may start to be tapered was seen as a signal that now would be a good time to sell bonds and move into something else.

As bond prices fell, the yield started to rise (the inverse relationship again)

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UK House prices to rise?

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The UK housing market always provides something to write about. Just when you thought house prices were already too expensive. It looks like the government’s second phase of ‘right to buy’ could push up prices even more.

The scheme  allows buyers to purchase a property under £600,000 with just a 5% deposit. The government have brought forward the scheme. In anticipation traffic to Zoopla, a popular property search website, immediately jumped 17% compared to a week earlier. Whilst demand is rising, the number of properties listed has fallen 14% compared to last year.

Return of Gazumping

The fear is that the surge in demand for limited houses could see a return of the phenomena of ‘gazumping’ This occurs when you’ve nearly bought the house, but someone comes in at the last minute to bid a higher offer. It is a particular weakness of the UK housing market. You are most vulnerable to gazumping when price rises are very high. It can take a long time to complete the paperwork – solicitors, surveyance e.t.c. During this time of getting documents ready, if housing is in a short supply, some may be tempted to offer a higher bid.

Should we help people to buy a house?

From a personal perspective, I was grateful to get a little help from parents to buy a house in 2005. With a deposit, I was able to  get a mortgage that was many times income (I dare not admit how much) It is better than renting for the rest of my life. I can definitely understand the personal aspiration to buy a house rather than rent.

But, from a macro-economic perspective there does seem something very short sighted about a scheme that helps to increase the availability of credit to buy already over-priced houses. The scheme will do little to help improve the availability of supply, it will only increase demand and push prices higher. It may not cause a boom in house prices. At the moment, the economy is still weak. But, it will continue to artificially inflate house prices, and that is damaging for the economy in the long-run. Why should we subsidise home-ownership? Does home ownership have positive externalities for the rest of the economy? No, in fact the reverse.

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Are there different types of government borrowing?

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Readers Question: National debt is now extremely high. However aren’t there different kinds of debt e.g that which funds current spending, that which funds investment in infrastructure and emergency (bank bail out etc) Surely it’s the first we should really be worried about and less concerned with borrowing that makes the economy more efficient such as infrastructure

1. ‘National debt is now extremely high.’

UK national debt

But, is national debt extremely high? In one sense, a public sector debt of £1,193.4 billion  is very high. But, if we compare national debt as a % of GDP (which is most meaningful comparison) over the past 100 years, it is significantly lower than between the 1920s and the 1970s. The increase in national debt we have seen in the past few years, is partly a reflection of the recession and rise in cyclical borrowing. In a recession GDP falls, but tax revenue also falls and government spending increases. If the private sector cut back on spending in a recession, it is helpful to the economy for government borrowing to rise temporarily.

debt-interest-payments-percent-gdo

If you look at the cost of servicing national debt (interest payments as % of GDP) it is also relatively low. The cost of debt interest payments as a % of GDP was significantly higher in the 1980s.

2. aren’t there different kinds of debt

Not really. When selling bonds, the government doesn’t distinguish between the use of the government borrowing. However, we can split debt up into

  • Structural deficit – the level of borrowing that would occur if the economy was operating at full capacity (i.e. ignoring borrowing as a result of the recession)
  • Cyclical deficit – the level of borrowing that has occurred as a result of the economic downturn.

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Resale price maintenance (RPM)

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Resale price Maintenance RPM used to be a common practise for manufacturers to set a minimum price for retailers to sell their goods. In the UK, the use of RPM was quite common in the post-war period from clothes to books, records, clothes and electronic goods. It ensured a minimum price of resale and avoided price competition. However, in recent years it has rapidly disappeared from the UK economy.

corner-shop

This post was inspired by Robert Peston’s BBC documentary – Robert Peston goes shopping because it reminded my how common RPM used to be.

The logic of resale price maintenance is that:

  • It helps retailers to be more profitable. Manufacturers may like this as they feel that if they keep retailers profitable, then retailers are more able to keep selling their goods.
  • It prevents damaging price wars with retailers under-cutting each other in a race to the bottom.
  • Provides support for smaller retailers, who cannot buy in bulk, to remain profitable. For example, small bookshops benefited from a RPM for books because they can’t  benefit from purchase economies of scale. Since the removal of RPM on books, many smaller independent retailers have gone out of business, losing out to large scale distributors like Amazon.com
  • It enables manufacturers to reward shops who promote their product through advertising. It also enables manufacturers to invest more in future products. For example, since the end of RPM in books and music, the industry claims it has lost some types of investment in music production and in the promotion of authors.
  • RPM can also reward firms who provide a high quality of personal service. For example, without RPM, consumers can take the free advice of knowledgeable sales assistants and then go and buy online from a cheaper provider. In effect the online retailer who doesn’t offer any service is free riding on the ‘bricks and mortar’ shops who can offer a personal service.
  • Consumers don’t have to waste time searching around for the best deal. They know the price will be the same where-ever they buy it.

Criticisms of RPM

  • It artificially inflates prices, leading to a decline in consumer surplus and gives consumers less discretionary income to spend on other goods. It is allocatively inefficient as the price is likely to be above marginal cost.

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What happens if the US defaults on debt payments?

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A debt default means the US is unable to pay back US bond holders the full value of their bonds. If investors lost money from US Treasuries, it would cause widespread financial panic, leading to a fall in bank lending, rising bond yields, a fall in the value of the dollar and the possibility of a global recession.

There are some things I became reluctant to write on because you can’t believe the situation is so needlessly bad.

Essentially, the Republican dominated congress is attempting to block health care reform by restricting funds to finance it. The President can claim a democratic mandate for health care reform; legislation has been passed and the Supreme Court has ruled it constitutional. By European standards the health care reform is a very modest attempt to extend coverage to the uninsured and try and patch up one of the most inefficient and inequitable health care systems in the world.  (see: US v UK health care)

But, for whatever reason, Republicans are blocking the money going to health care, leading to a government shut down. This involves 800,000 federal employees being put on unpaid leave. The fear is that this battle on health care will be a preliminary battle on the debt ceiling.

If congress refuses to allow the debt ceiling to rise, the US may not be able to increase its borrowing. It will be faced with a stark choice.

  • Cut public spending immediately by 20% (up to 4% of GDP)
  • or face risk not being able to meet debt payments.

In the worst case scenario, the US might find itself unable to meet its debt obligations because Congress is not allowing the Federal Reserve  to increase the level of debt. This could mean that holders of US bonds may not have their bonds honoured. If this really did occur, it would cause a widespread panic in the global financial system.

Some believe that it will never come to this as there will be ways to constiutionally wriggle out of the debt ceiling. But, even fears over liquidity shortages could have serious consequences.

 

What would happen if the US defaulted on debt payments?

  1. Higher long term bond yields. Any liquidity crisis would cause panic, and other investors would look to offload their US securities. This would increase bond yields and increase the cost of US debt interest payments. The Eurozone has showed how fears over liquidity can be contagious. Even the fear of liquidity shortages can be sufficient to push up long-term bond yields  above what they should be. If the US even, temporarily, defaulted, the US is likely to face higher bond yields for a considerable time. This would increase the cost of federal debt interest payments.
  2. Devaluation in the dollar. If US bonds are seen as risky, foreign investors are very likely to move their funds elsewhere. This would lead to a fall in the value of the dollar as foreign investors sold dollar assets and moved it elsewhere. The devaluation in the dollar would make imports into the US more expensive. The US, a big driver of the world economy, would reduce its demand for foreign exporters. This would hurt economies who rely on strength of US economy. A devaluation in the dollar would also effect other economies who peg their currency to the dollar. They would see a fall in their standards of living and could see inflation.
  3. Recession. If the US were defaulting, there would be some attempts to panic cut federal spending. The US recovery is fragile and a significant fall in government spending is likely to tip the economy back into recession. Also, the panic and loss of confidence surrounding any potential default would also reduce business investment and consumer confidence. The economic effect of an unprecedented default and cut in aggregate demand could precipitate a deep recession. Another recession would be very damaging for the US and world economy. Unemployment would rise. Ironically, it would also make it harder to deal with debt to GDP ratio as tax revenues would fall.

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Impact of global economy on UK inflation

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Readers Question: I am currently researching the impact of the global economy on inflation in the UK. I have come across economic policy uncertainty but am unsure what effect policy uncertainty in the EU and USA will have on the UK.

cpi-inflation

UK inflation is primarily due to domestic factors. For example, if you look at the inflation of the early 1990s, it was due to an economic boom and rapid growth in aggregate demand. This level of inflation wasn’t experienced by our main international competitors.

In 2011, the UK experienced higher rates of inflation than the Eurozone and the US. The reason inflation was higher in the UK than the Eurozone was due to factors such as:

  • Impact of devaluation causing imported inflation.
  • Rise in taxes. CPIY (a measure of inflation excluding taxes) was much lower than the headline CPI rate
  • Rise in commodity prices having a greater impact in the UK.

Global factors affecting UK inflation

There are still global factors affecting UK inflation. Firstly, the price of commodities, such as oil, metals, food will affect UK inflation. The rise in oil prices in 2008 and later in 2011/12 was a factor in causing UK inflation.

Global trends in inflation. Since the 1970s, inflation in advanced industrial countries has fallen. This global trend towards lower inflation has helped the UK also experience lower inflation. Lower inflation across the globe is due to several factors, such as:

  • Rising productivity and cheap manufactured goods from China / Asia.
  • Improved technology and working practices which have helped reduce costs.
  • Perhaps inflation targeting. e.g. Monetary policy geared towards keeping inflation low.
  • Decreased inflation expectations making it easier to keep inflation low.

The UK has definitely benefited from these global inflationary trends. But, at the same time, domestic factors have been influential in affecting UK inflation. Currently, Eurozone inflation has fallen to 1.1% but UK inflation is higher at 2.7%

What will be the effect of policy uncertainty in the USA  on the UK?

There is significant policy uncertainty in the US, with the government shut down. A prolonged debate about US government spending could risk precipitating a downturn in the US economy and an end to the US economies reasonable recovery. This would be highly damaging to the global economy. If the US economy falters, it will definitely have a negative impact on economic growth elsewhere in the world. There is also the risk of adversely affecting confidence in countries like UK and Europe.

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Global warming and tax cuts on petrol

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The other day, I had a quick glance at the newspaper headlines, whilst in a service station.

  1. UN Report on global warming states global warming is a real threat to the future of the planet. To contain these changes will require “substantial and sustained reductions of greenhouse gas emissions”.
  2. Chancellor announces yet more freezes on fuel duty.

It seemed a paradox to have both headlines on the same day. At the very least, we could enable a small increase in tax on fossil fuels causing the problem.

sea-morecambe-bay
Rising sea levels will be more damaging that a few pence on the price of petrol

Costs of global warming

In the summary of the UN document on global warming.

  • The report states that for a doubling of CO2 in the atmosphere, the increase in the global temperature is forecast is to be 1.5C to 4.5C.
  • The scientists say that sea level rise will proceed at a faster rate than we have experienced over the past 40 years. Waters are expected to rise, the document says, by between 26cm (at the low end) and 82cm (at the high end), depending on the greenhouse emissions path this century. (BBC link)

Political benefits of tax cuts

The chancellor has announced more freezes on fuel duty because it believes it will be politically popular. He is probably guessing that concern over the cost of petrol is greater than concern over the future of the planet.

Tragedy of the Commons

This situation could be classed as a classic example of the tragedy of the commons. People pursuing their self-interest but ignoring the common shared resources – leads to a loss in economic welfare. The problem is that with many individuals maximising their short-term welfare, there is a high cost to the future sustainability of the common resource.

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