Econ 101 Question

[contentrenter]

I just read yet another article about how U.S. deficits threaten to drive up inflation, and how inflation makes bond yields higher. Can someone please explain to me, in liberal-arts-major terms, how these three phenomena are interrelated?

[davelj]

imagine our world had just two countries: the u.s. and china. the u.s.’s trade deficit grows because we are importing more than we are exporting. as we import (purchase) more chinese goods we must buy the chinese yuan (and sell u.s. dollars) to pay for them, thereby pushing up the value of the yuan versus the dollar (or, conversely pushing DOWN the value of the dollar versus the yuan – the same thing). thus over time imports will rise in price (inflation) as the dollar falls in value versus the yuan, all else being equal (which it never is, of course). bondholders want to be paid a premium to inflation to be induced to hold onto a bond as opposed to cash (bonds are more risky than cash). consequently, even if this premium remains steady, higher expected inflation will lead to higher overall bond yields.

one of the reasons that “headline inflation” numbers have remained tame (as opposed to “real inflation” numbers, which are much higher) even as our trade deficit has grown is that the foreigners we “owe” money to (china in the previous example) have been taking the money we pay to them and recycling it back into our economy via investments – more specifically, they’ve been buying a lot of our government debt. in order to buy this debt they have to sell their own currenty and buy dollars, a process that mitigates what would otherwise be a disaster for our currency and interest rates.

what our trading partners either don’t realize or don’t want to think about (the latter most likely – they’re not clueless) is that we’ve been printing money like mad over the last god-knows-how-many years and inflation is higher than the “headline” figures. consequently, these foreign debtholders are being paid back with dollars of diminished (and diminishing) value, but for now they’re looking the other way.

why? because their own economies are dependent on enormous exports to the u.s. (that is, they rely on america continuing to live beyond its means) and the moment this little game of chicken is over, everybody – including their economies – will lose. in fact, the music stopped a long time ago… but people are still dancing.

hope that helps.

[contentrenter]

That was actually very helpful. I think I get it, and it seems like it all comes down to that supply and demand thing that economists are always talking about: inflation due to trade deficits happens b/c we want somebody else’s stuff more than they want ours; bond yields go up b/c the bondsellers want the buyers’ cash more than the buyers (initially) want the bonds. Is that right?

[Anonymous]

The short answer is that interest rates are raised by the Fed during inflationary times to curtail consumption which lowers demand for things that are inflating. Lower demand then lowers the price of those things as prices are dropped to make them match where more people will buy them. That is about as simple as it can be explained.

[powayseller]

The Fed doesn’t set bond yields, and he asked how inflation, the deficit, and bond yields are related.

[davelj]

the first part is right, it all comes down to supply and demand. the rest of your post, however, is incorrect. unfortunately, i can’t explain it in any simpler terms than i already did without going into excruciating detail – there are books written on the interelationship between deficits, inflation and interest rates. at the risk of sounding didactic, if you really want to understand this stuff, i’d get a good grasp on econ 101 and 102 either by taking some classes or reading a few books. until you have the basics down, everything that flows from the basics won’t make much sense. just my two cents.

[davelj]

technically, the fed doesn’t set bond yields. however, for all intents and purposes it does set short-term interest rates through its open market operations. and every other interest rate in the world is, to one extent or another, priced off of short-term interest rates in the u.s. that’s why the fed “matters” to the extent it does. so, the obvious question as it pertains to the current yield curve is, “why haven’t long-term rates been rising as short-term rates have been increasing?” one should get paid a time premium, after all, to compensate for the risk associated with holding a longer term bond as opposed to short-term note. the answer is that bond market participants, in aggregate, are thinking, “i think the fed’s raising of short-term interest rates will slow the economy so much that they will end up lowering rates in the not-too-distant future. consequently, i’m going to stay put in my long-bond position because as rates begin to decline, my time premium will be restored. and, who knows, if things REALLY slow down, maybe my positions will actually increase in value and long-term yields will decline.” they may be right or they may turn out to be wrong. i don’t know. but, that’s what the market’s telling us.

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