THE FED POLICY IS WORKING / THE WALL STREET JOURNAL OP EDITORIAL ( VERY HIGHLY RECOMMENDED READING )

OPINION

DECEMBER 14, 2010.

The Fed's Policy Is Working


The rise of long-term Treasury interest rates is evidence that investors are bullish on growth..

By JEREMY J. SIEGEL

The recent surge in long-term Treasury yields has led many to say that the Fed's second round of quantitative easing is a failure. The critics predict that QE2 may end up hurting rather than helping the economic recovery, as higher rates nip in the bud any rebound in the housing market and dampen capital spending. But the rise in long-term Treasury rates does not signal that the Fed's policy has backfired. It is a sign that the Fed's policy is succeeding.


Long-term Treasury rates are influenced positively by economic growth—which encourages consumers to borrow in anticipation of higher incomes and causes firms to seek funds to expand capacity—and by inflationary expectations. Long-term Treasury rates are affected negatively by risk aversion: Seeking a safe haven, investors pile into Treasury bonds, running up their prices and lowering their yields.


The Fed's QE2 program has raised expectations of growth and inflation, sending long-term Treasury rates up. It has also lowered risk aversion, which implies rising long-term rates. The evidence for a decline in risk aversion among investors is the shrinkage in the spreads between Treasury and other fixed-income securities, the strong performance of the stock market, and the decline in VIX, the indicator of future stock-market volatility. This means that expectations of accelerating economic growth—and a reduction in the fear of a double-dip recession—are the driving forces behind the rise in rates.


Those who look only at interest rates to judge whether monetary policy is too loose or too tight are making a mistake that monetary economists have long warned against. As a colleague of Milton Friedman at the University of Chicago in the 1970s, I remember him stressing that the extremely low interest rates of the early 1930s were not indicative of an easy monetary policy. They were instead the result of the Fed's drastically tight policy, which did not provide enough reserves to failing banks and drove the economy into the Great Depression.


Similarly, the double-digit interest rates that we witnessed in the 1970s were not indicative of the Fed's brave stance against inflation but of a far-too-easy policy that inflated the money supply and heightened inflationary expectations.


I admit that expectations of economic growth recently have been boosted by President Obama's agreement with congressional Republicans to extend the Bush tax cuts. But long-term Treasury rates were rising even before Mr. Obama announced his policy switch. The combined impact of the tax cuts and the Fed's QE2 policy will continue to stimulate the economy and send long-term interest rates higher. For this reason, it is likely that the Fed will not complete all of its purchases by the middle of next year. It may instead begin the process of draining reserves and raising short-term rates much earlier than most forecasters now anticipate. But monetary tightening will only begin if the pace of the economic recovery accelerates significantly next year, which I believe is increasingly likely.


We should not look only at interest rates to judge whether monetary policy is working. Indeed, in the present situation, if long-term rates were not rising, it would be a sign that the economy is in serious trouble—a sign that investors are worried about deflation and a decline in economic activity.


Mr. Siegel is a professor of finance at the University of Pennsylvania's Wharton School.

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