What is likely to happen when the Fed's QE2 program is finished next month? Here are two competing theories and possible scenarios (for related discussion see today's WSJ article on the subject):
Weaker growth, lower Treasury yields. QE2 was a successful program, providing needed stimulus to the economy and vanquishing deflation fears. That is why 10-yr Treasury yields started rising as soon as the program started in early November. The end of QE2 therefore will hurt the economy by withdrawing needed stimulus; a weaker economy, in turn, will increase the demand for safe-haven Treasuries, driving yields lower. This explains the recent decline in 10-yr Treasury yields, since the market is already pricing in the expectation of a weaker economy, disregarding stronger economy news such as the greater-than-expected increase in April jobs.
Stronger growth, higher Treasury yields. QE2 never provided direct stimulus to the economy, since it never resulted in any meaningful addition to the amount of money in the economy. And since the end of QE2 will not result in the withdrawal of any of the bank reserve injections, nor shrink the Fed's balance sheet, it should have no direct effect on the economy. QE2 was indirectly helpful, however, since it effectively vanquished deflation fears and this helped boost investor confidence. That helps explain why equities started rising shortly after the idea of QE2 was first floated in late August, and the subsequent rise in Treasury yields was the market's natural reaction to news that the economy was indeed improving. To the extent that QE2 increased the market's uncertainty about the outlook for inflation and weakened the dollar, however, it was a drag on the recovery, which has been modest by historical standards. Treasury yields are relatively low today because the market is ignoring signs of strength (e.g., faster jobs growth) and worrying instead about possible threats to growth in the future, some of which likely have been exacerbated by QE2 (e.g., higher oil prices, weaker dollar).
My sympathies lie with the second scenario, because I don't believe that Washington has the ability to create or fine-tune growth through standard Keynesian measures. Fiscal "stimulus" which relies on more government spending and transfer payments can never create growth, since it destroys incentives and makes the economy less efficient, and stimulative monetary policy can only create inflation (i.e., you can't print your way to prosperity).
The above chart is my way of interpreting the significance of different levels of 10-yr Treasury yields. I've never believed that Fed purchases of Treasuries were artificially suppressing yields. Instead, yields are driven mainly by inflation and growth fundamentals. Growth expectations feed into inflation expectations, since both the market and the Fed believe in the Phillips Curve theory of inflation, which holds that very weak growth is potentially deflationary, while very strong growth in potentially inflationary. Today's yields are symptomatic of a market that expects very weak growth.
This next chart shows a decent correlation between 10-yr Treasury yields and the year over year change in the core CPI. With core and headline inflation rates now trending upwards (the 6-mo. annualized change in the core CPI is 1.4%, and the headline CPI is 4.7%), we have likely seen the lows in Treasury yields. Yields are only as low as they are today because the market is very concerned that the economy is at risk from a cessation of QE2, from high oil prices, from a renewed bout of housing weakness, and from the fiscal austerity measures that will be necessary to deal with our out-of-control federal budget.
The market is ignoring signs of rising inflation and rising prices because it believes that they will eventually be trumped by very weak growth. This assumption, however, is likely to be put to the test by the end of this year, since I believe that we will see the economy tending to grow a bit faster and inflation tending to increase.
Meanwhile, the end of QE2 won't change the Fed's balance sheet, but it will mean we no longer have to worry about the Fed compounding any inflationary errors that it may have been making with QE2. And if the Fed ends QE2 because it is worried about the dollar and rising inflation and not overly concerned about the economy's supposed weakness, then that should bolster confidence and strengthen the dollar, and that in turn should be an impetus to growth. Likewise, if Congress manages to put in place policies that lead to a reduction in the size of our bloated government, that is likely to boost confidence and increase economic efficiency over time, thus leading to stronger growth.
In short, instead of worrying about the end of monetary "stimulus" and fiscal "stimulus," we should be cheering. Misguided stimulus is bad; ending it is therefore good. The economy is struggling under the weight of too much "stimulus," and it needs a break.