Noted for December 22, 2012
Liveblogging World War II: December 23, 1942

Back When I Feared the Bond-Market Vigilantes: Maundering Old-Timer Reminiscence Weblogging

Maya and the Vigilantes  NYTimes com 1

I think Paul Krugman gets one partially wrong today…

Paul writes, correctly:

Maya and the Vigilantes: Maya MacGuineas… is the queen of the deficit scolds, having run the Committee for a Responsible Federal Budget, perhaps the most prominent of the many Pete Peterson-backed organizations trying to scare us about the deficit…. As Scheiber points out… her efforts actually make the situation worse. Her stock in trade is denouncing partisanship… but she (like pretty much all the deficit scolds) actually empowers hyperpartisanship by always condemning both sides equally… making excuses for hardliners in the GOP…. [R]emember that CRFB was one of the three deficit-scold organizations that gave Paul Ryan an award for fiscal responsibility. As I’ve pointed out many times, Ryan’s “plan” was essentially a scam: all the alleged deficit reduction came from revenue allegedly generated by closing loopholes, which he refused to specify, and from huge cuts in discretionary spending, which he refused to specify. What he really offered was huge tax cuts for the rich, only partly offset by savage cuts in aid to the poor. But CRFB, in pursuit of the image of even-handedness, chose to pretend that Ryan was a Serious, Honest Conservative, thereby removing any penalty for being, in fact, deeply unserious and dishonest….

I agree. I applaud. Maya MacGuineas spends time giving fire-chief hats to budget arsonists. And this is profoundly unhelpful.

But then I think Paul falls into a degree of heresy and error:

[Sarah] Kliff… emphasizing in particular how MacGuineas was “fascinated” by the supposed attack of the bond vigilantes in the early 1990s – a period when there was, indeed, a sharp rise in long-term interest rates. This prompts Matt Yglesias to ask a very good question… how sure are we that there really were any vigilantes back then?…

[O]ne way to tell what’s driving interest rates over any given period is to look at what was happening to other asset prices…. If rates have risen because investors fear default and fiscal chaos, stock prices should plunge. Did this happen during the supposed vigilante attack of the 1990s?

Well, no.

What really happened in 1994? The economy was starting to recover (it was actually adding 300,000 jobs a month for a while), and investors expected the Fed to tighten a lot. Clearly, they overreacted. But the events don’t bear the “signature” of an attack driven by debt fears.

Let me make two comments.

FRED Graph  St Louis Fed 3

First, what was going on in 1994--and what those of us working in the Treasury and watching the Federal Reserve and the financial markets thought was going on--was not an attack of bond-market vigilantes terrified of rising debt and the prospect of explicit default or implicit default through rapid inflation. The Federal Reserve had undertaken a long easing from 1990 through the mid-1992 unemployment rate peak. But then, as unemployment started to decline, the Federal Reserve held off on tightening: it was expecting the passage of the deficit-reducing Clinton 1993 Reconciliation Bill--OBRA 19930--and believed that the spending cuts and tax increases in that were sufficient. In early 1994, however, the Federal Reserve concluded that it was time for monetary tightening, and began to gradually raise short-term safe interest rates by selling off some of its bonds for cash.

We in the Treasury--and the staff at the Federal Reserve--had expected the reaction of the long-term bond market to this Fed tightening cycle to be modest. Between 1990 and 1994 the Federal Reserve had reduced short-term interest rates by 5%, and as it had done so long-term rates had fallen by 3%. We attributed 1.75% of that long-term interest rate reduction to the reduced current and expected future federal deficits as a result of Clinton's OBRA 1993 and the earlier Foley-Mitchell-Bush OBRA 1990, leaving 1.25% to be the reaction of the long-term bond market to lower short-term interest rates. Thus as the Federal Reserve raised short-term safe interest rates from 3% to 6%, we expected a quarter of that to show up as a rise in long-term rates--we expected to see them go from 6% to 6.75%.

Instead, in 1994 long-term bond rates rose from 6% to 8%.

In the end we attributed the excess rise in long-term bond rates in 1994 to two factors:

  1. As interest rates rose, the duration of Mortgage Backed Securities lengthened--people weren't refinancing their houses any more. MBS thus became much longer duration securities--there was a much greater supply of long-term bonds in the market--and by supply and demand that pushed the prices of such bonds down until investment banks could figure out how to tap more risk-bearing capacity to hold those bonds.
  2. Nobody was sure that the Federal Reserve was going to stop raising short-term safe interest rates when they hit 6%. In the late 1980s, after all, they had not stopped until short-term interest rates hit 8%. Without effective forward guidance from the Federal Reserve, the bond market was pricing in a larger tightening than seemed likely to us.

FRED Graph  St Louis Fed 5

We were, I think, completely correct. By mid-1995 it was clear that the Federal Reserve had reached the end of its tightening cycle and more money had flowed into the long-term bond market to hold attractively-priced MBS, and the long bond rate fell back into the trading range we had anticipated--and then fell some more.

So: 1994 was an interesting lesson on the importance of clear Federal Reserve forward guidance in avoiding excess bond-market volatility and on the consequences of endogenous duration for the short-term pricing of complex securities, but it was not an example of bond-market vigilantes fearing higher deficits and default or inflation riding over the horizon. The federal deficit was under control and rapidly shrinking in 1994 as the combination of the business-cycle recovery and Clinton's OBRA 1993 worked even better than we had anticipated.

Second, there had been an attack--or, rather, not an attack but rather bond-market vigilantes visible on the horizon and gunshots in the air--earlier.

Throughout 1992 there was a 4%-point gap between the 3-Month Treasury rate and the 10-Year Treasury rate. Those of us in the Clinton-administration-to-be read this as market expectations that the uncontrolled federal budget deficit would lead people to expect higher inflation and the Federal Reserve would then feel itself forced to raise short-term interest rates far and fast in order to hit the economy on the head with a brick and keep those expectations of higher inflation from coming true. The result would be a low-investment and perhaps a jobless recovery. The right policy, we thought--and I think the evidence is pretty clear that we were 100% right--was to aggressively move to reduce the budget deficit in 1993 even thought the recovery was weak in order to eliminate any market expectations that high deficits would lead to higher inflation, and--more importantly--to eliminate any belief on the part of the Federal Reserve that it need to raise rates rapidly and far to create a low-investment jobless recovery in order to guard against any possibility of a renewed inflationary spiral.

That was not an attack but a horizon-sighting of bond-market vigilantes--or perhaps only the market thinking the Federal Reserve thought it was about to get a horizon-sighting of bond market vigilantes.

I think we were right then to fear and take steps to ward off the bond-market vigilantes--or perhaps only right to fear and take steps to ward off any Federal Reserve decision that it needed to fear and take steps to deal with bond-market vigilantes. In any event, our policies were right.

But that was then, with a 4%-point gap between 10-Yr and 3-Mo Treasury yields.

Today we only have a 1.6%-point gap between 10-Yr and 3-Mo Treasury yields.

1.6% < 4%