QE and the “Crowding Out” of the Bond Market Vigilante

We’ve updated our chart of the sources of financing of the U.S. budget deficit from the Fed’s Flow of Funds data released on September 16th.   The chart illustrates how the Fed and foreign central banks have been indirectly fully funding the  massive U.S. budget deficit for the last three quarters.   It will be interesting to see the data for the quarter ending today as no doubt there will be less yellow with the end of Q2 on June 30 and more “flight to quality” blue (domestic) and red (rest of world).

Ronald McKinnon, professor of international finance at Stanford University, has an excellent piece in today’s Wall Street Journal about the damage the Fed’s zero interest rate policy (ZIRP) is doing to the U.S. and global economy.  One of his main points is the Fed and other central banks, who are not yield sensitive,  have been financing the U.S. budget deficit and crowding out the now extinct U.S. bond market vigilante.

As you know the Global Macro Monitor is not a fan of ZIRP and believes it one factor that ails the economy not what will cure it.  We take comfort to be the same company of such an intellectual heavyweight as Professor McKinnon.

The professor makes several excellent points in his piece,

Without the [bond market] vigilantes in 2011, the federal government faces no immediate market discipline for balancing its runaway fiscal deficits.

…the vigilantes have been crowded out by central banks the world over.  [see the yellow/red bars in the chart]

Central banks generally are not yield-sensitive.

True, in the last two months, this “bubble” of hot money into emerging markets and into primary commodities has suddenly burst with falls in their exchange rates and metal prices. But this bubble-like behavior can be traced to the Fed’s zero interest rates.

Beyond just undermining political discipline and creating bubbles, what further economic damage does the Fed’s policy of ultra-low interest rates portend for the American economy?

First, the counter-cyclical effect of reducing interest rates in recessions is dampened…

Second, financial intermediation within the banking system is disrupted…

Third, a prolonged period of very low interest rates will decapitalize defined-benefit pension funds—both private and public—throughout the country…

Perhaps Fed Chairman Ben Bernanke should think more about how the Fed’s near-zero interest rate policy has undermined fiscal discipline while corrupting the operation of the nation’s financial markets.


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