Why buy long-term Treasuries?

1. The U.S. Treasury issues bills/bonds when it needs to borrow money.

2. Buying a bond is lending money. Banks, insurance companies, and other financial intermediaries buy bonds with reserves. They also make other types of loans. (Banks only keep a fraction of all reserves (deposits) on hand to meet the liquidity demands of their depositors. They loan out most reserves in order to earn a profit on the interest rate spread - pay one rate of interest to depositors and charge another, higher, rate to borrowers).

3. Bond prices and interest rates move in opposite directions. Why?
Because buying a bond is lending money. An increase in the demand for bonds will, like an increase in the demand for apples, put upward pressure on the price of bonds and send interest rates lower. Or, look at it this way. Someone buys a $100 bond and the interest rate is 10% so that at the end of one year the bond can be redeemed for $100 plus $10 in interest. Then, right after buying the bond, interest rates fall to 3%. Now the holder of that bond can sell the $100 bond for something more than $100... because current interest rates are only 3%.

4. Treasury Bond/Bill maturities vary. One month, three month, 6 month, one year...

5. Monetary stimulus: The Fed, the central bank, typically buys and sells short-term bonds when conducting monetary policy. When the Fed buys bills (short term bonds) it creates the money to do so. Roughly, it credits the bondholder (bank) by increasing the reserves that the bank has at the regional Fed (member banks have accounts at the Fed. The Fed is the bankers' bank, the lender of last resort). The bank, the seller of the bond, now has cash, excess reserves that it is free to lend to a borrower in the private sector. When the Fed demands bonds it sends the price of bonds higher and interest rates lower. It is increasing liquidity, creating money.

6. Liquidity trap: When interest rates are very low as they are now (short term rates are as low as they can go), then it might be that conventional monetary policy does not stimulate increased lending and borrowing. If the Fed buys short-term bonds that pay less than 1% per year then the bank has merely substituted one low yield asset, a Treasury Bill, for another - cash reserves. Lenders, in a time of uncertainty and credit risk, are reluctant to lend - liquidity is trapped. Banks might choose to hold excess reserves instead of making more loans. Monetary stimulus doesn't stimulate.

7. Fed has more bullets: The Fed can also buy agency debt - bonds issued by the likes of Fannie Mae and Freddie Mac (google TALF). Again the Fed can create money to buy bonds (lend to GSE's). The Fed can, and will, buy longer term Treasury bonds. Again, this sends the price of those bonds up and longer term interest rates down. This should increase liquidity that can then be used to loan to riskier borrowers (everyone is riskier than the U.S. government).

Notes:

Bernanke is a great scholar of the Great Depression. Milton Friedman's great contribution was his assertion that the Great Depression was primarily a monetary phenomenon. The Fed, according to Friedman, failed at the onset of the downturn to act as the lender of last resort. They allowed banks that were otherwise solvent to fail via bank runs. They should have added liquidity. The money supply contracted. Interest rates rose. The recession quickly deepened.

As the money supply fell prices fell - deflation. Big problem, two actually. With falling prices it becomes rational, for banks and people, to horde money. Banks don't lend; holding money has a positive return. People don't spend; better to wait for prices to fall further. Second problem - the real value of debt increases. Suppose you owe $10,000. As prices and wages fall the real value of your debt increases.

I think the Fed has a very healthy fear of deflation and buying long-term Treasuries - increasing the money supply substantially - is inflationary. Mortgage interest rates should fall. Re-finance activity should increase.

I refinanced about six weeks ago and went from 6.25% on a 30 year note to 4.75%. This will save me nearly $200 per month. Multiply this by many households and you're talking about a real stimulus. Falling housing prices are a real problem. People lose equity and consumption falls. If housing prices increase nominally, not in real terms (they increase at the rate of prices and wages generally) then that should help to stabilize the economy.

Active fiscal and monetary policy are short-term remedies. Long-run growth is not achieved via tinkering with the money supply and by engaging in massive deficit spending. Indeed there are costs associated - inflation and paying down the debt. Long run growth, for any country, is achieved via improvements in techology, improvements in human capital (health and education), stable prices (good monetary policy), fiscal discipline, respect for property rights, and through free and fair markets.

I think Bernanke will be seen as a great Fed chairman in years to come. We'll see. Obama? Depends on one's perspective. If GDP is growing and unemployment is down two years from now he'll cruise to re-election. Supporters will claim his fiscal stimulus worked while others will say that it didn't hinder recovery a great deal.

On Keynesian economics: According to a recent Amer. Economic Association survey of PhD economists, 90% believe that fiscal policy can be used to stimulate an economy in recession. 85% believe, as did Keynes, that the budget should be balanced over the course of the business cycle. That is to say that deficit spending should be employed at the onset of a downturn but the debt should be re-paid when growth returns. In other words, fiscal policy should be used to smooth the business cycle.