Krugman Vs. Feldstein on Interest Rates and the Fed
Paul Krugman has been taken shots at Martin Feldstein over this article (Link). Feldstein made the case that the Fed is keeping interest rates artificially low - and sooner or later this will cause a problem. The issue is whether the Fed is creating a new bubble. Feldstein says, "Yes". Krugman says "N0". A few lines from PK on this topic:
I really don’t understand how Marty Feldstein can look at these facts and conclude that the only way to explain low interest rates is to imagine that the Fed is imposing massive market distortions.
(Feldstein) then grabs hold of an answer to his imagined puzzle — it must be the quantitative easing! — that assigns vastly more importance to Fed bond purchases than I think can be justified by any evidence I see.
The notion that rates are low only because the Fed is holding them down by “gobbling” up debt is clearly refuted by international evidence, clearly refuted by the behavior of rates over time, and logically flawed.
This is a very important debate. Either Krugman is right, or Feldstein is. IMHO Krugman is ignoring the laws of supply and demand, and also the laws of gravity. The Fed's ZIRP policy anchors the short end of the curve at 2% below the rate of inflation. The long end of the curve is a function of the base cost of money, adjusted for supply from Treasury of new paper, and the demand that the Fed is creating with $85b a month of POMO.
If Feldstein can't convince Krugman, I doubt my thoughts will either. But I'll try.
Krugman provided a chart in this post (Link) that he maintains proves his point - QE has little consequence on the shape and level of the yield curve. PK's comments and the chart:
You can see a couple of pauses in the Fed’s expansion of its holdings — and no relationship at all to rates.
A different way to track the relationship between the Fed's balance sheet and interest rates comes from the folks at BMO Capital. Read the full report here. The author, Dimitri Delis, looks at the Fed's POMO buys (QE) under a different light than PK. BMO measures the Fed's purchases based on the 10-year equivalent duration (If the Fed buys 3 year bonds it has less "consequence" than an equal $ amount of 30-year bonds) and looks at real interest rates as opposed to PK's nominal. Delis concludes that the relationship between QE and real interests rates line up nearly perfectly (.94 correlation).
Krugman compared apples to oranges to make his point. BMO's look of the same data, makes an apples to apples comparison, and comes to a different conclusion.
So Mr. K, whatdaya think of those apples?
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