Did the Federal Reserve's Stimulus Plan Fail, Already?

With the recovery slowing over the summer, the Federal Reserve announced that it would inject a fresh bit of stimulus into the economy. Dubbed QE2 -- or quantitative easing, part two -- the plan was to buy Treasury bonds from banks in exchange for newly minted money. Ben Bernanke and other advocates of the plan hoped it would lower medium and long term interest rates, making it easier for banks to lend cash, easier for businesses to get credit, and easier for families to buy homes.

But now that QE2 is underway, interest rates are going up, not down. The yield on 10-year and 5-year U.S. government notes both jumped a full percentage point in December, making it more expensive for government to borrow. Does that mean that the Federal Reserve plan failed and made investors afraid of our debt?

Not so fast. There are at least two broad forces that make interest rates rise. One is high risk: If investors think the U.S. might default on its debt, they'll demand a "risk premium" that will look like higher interest rates. (If you want to know what risk premium looks like, look at borrowing rates for Greece and Ireland.) Two is higher inflation expectations: If investors think the economy will grow dramatically in the next ten years, they'll demand higher interest rates on non-inflation protected bonds to ensure that higher prices don't erode the value of their investment in a decade.

It's possible that investors are nervous and recoiling from the combination of $600 billion of monetary stimulus from QE2 and $850 billion in fiscal stimulus from the Obama tax cut deal, because they think the United States has officially fallen off its rocker and crawled toward the brink of default. But it's also possible that interest rates are climbing because investors think this powerful one-two punch dramatically improves our recovery outlook.

In the weeks before QE2 was announced, bond yields for 5- and 10-year Treasuries fell dramatically as the market "priced in" the impact of quantitative easing. But in the last few weeks, those interest rates have jumped. The Federal Reserve's proceeded as planned. What changed?

At least two things: the data and the District. Economic indicators like consumer spending and business investment followed their sluggish summer with a strong autumn, raising expectations for the recovery. Meanwhile in Washington, DC, a stand-off over the Bush tax cuts ended with a surprising deal that not only extended current rates but also added additional stimulus for the unemployed, for businesses looking to buy new equipment, and for middle class workers. New York investment banks immediately raised their growth expectations for next year by half a percentage point, and bond yields have steadily climbed.

Let me try to anticipate your next question: Derek, it's really nice that investors think the economy is going to grow faster next year. But if the Federal Reserve wanted interest rates to fall, should we cheer higher interest rates, even if they represent good news? Good question! I don't know. On the one hand, if the bullishness is correct, it means more jobs, more sales. On the other hand, the bullishness is somewhat self-defeating as higher interest rates might dampen the fiscal or monetary stimulus.

The most important point to make here is that if the yield bump has nothing to do with QE2, then quantitative easing might actually be keeping interest rates lower than they would otherwise be. It's difficult to separate the effects of monetary policy, fiscal policy, animal spirits, international investment appetite and domestic economic data, so I won't play with counterfactuals. I'll only point out that it's too early to evaluate the success of QE2 or even to know that Ben Bernanke's latest scheme is responsible for the interest rate spike of the last few weeks.