I’ve been getting questions about what happens when the Fed wraps up QE2 — related especially to Bill Gross’s public view that interest rates will shoot up. This is related to the question of the extent to which QE2 has kept interest rates low. So a quick exposition of my theoretical position, which also happens to be more or less standard economics.
So: I basically think of asset prices in a Tobin-type stock equilibrium framework (pdf). People make portfolio choices, allocating their wealth among bonds, stocks, etc.. Asset prices – including the famous “q” – rise and fall to match these portfolio choices to the actual asset supplies.
On this view asset purchases matter because over time they change the stocks of assets available : by buying long term federal debt, the Fed takes some of that debt off the market, and hence drives up the price of what’s left, reducing interest rates. The flow – the rate of purchases – matters only to the extent that it affects expected returns.