Lesson 23 The Hidden Bond Market

The market approach was very popular when I learned macroeconomics. A macro model was composed of several markets – for goods and services, labor, money, and financial markets (bonds and stocks). By studying those markets we would learn about changes in things such as output, unemployment, wages, prices, and interest rates.

While each market could be studied separately in isolation, the trick of macro was to study them as an interconnected system of markets. What fun. We learned that something that first disturbed one of the markets, for example, the goods & services market, could subsequently affect outcomes in the other markets. Not everything was obvious by looking at one market. You had to study the whole system. 

Think of the US economy as being composed of a bunch of lily pads. A frog lands on one of those pads and impacts that one pad. But then the change in that one pad may affect the whole pond and all the other pads. The impact of those pads then reverberates around until that dang frog leaves the pond. That’s the way we think about macro. Something might disturb the labor market but before all is done, all the markets will have been impacted and therefore that one initial change might affect output, employment, wages, price, interest rates and more.

Isn’t macro fun? Lily pads! Frogs!

An economist named Leon Walras (pronounced vall rah) was diddling around with macro systems of markets and decided that one could focus on all the markets except one. You would always know the results for the “dropped” market because it was totally determined by looking at all the other markets. It became traditional to “drop” the bond market via Walras’ Law. That does NOT mean there is no bond market. It does not mean that the bond market is unimportant. It means only that one can learn all one needs to learn about all the markets without directly addressing the bond market.

The bond market is, therefore, hidden in macro models. It is lurking in the background but generally not in direct view. (Many of us learned something called the IS-LM model in macro. The IS curve represented goods & services and the LM curve was the money market. The bond market was "dropped" and we just looked at goods, services, and money.)

Aside from silly macro modeling, why would a normal human care about any of this? The answer is that sometimes the hidden bond market is forgotten, yet sometimes the bond market is very important. Today, this is especially important given all the focus on the Fed and its impacts on interest rates. 

People mistakenly think the interest rate is determined in the money market and is very much impacted by the Fed’s policy decisions. That belief oversimplifies the truth. The interest rate is the rate of return on a bond or other similar credit instruments. Changes in the supply and demand for bonds, therefore, have fundamental impacts on interest rates. To forget the bond market is to leave out critical factors impacting interest rates.

Today, we are concerned that Fed policy is going to raise interest rates. Our eyes are peeled for Fed policy meetings and the resulting impacts of their decisions on interest rates. But wait, there is much more to it. The Fed might influence interest rates, but much depends on the other factors in asset markets. For example, because the government is going to have large deficits in coming years, the Treasury is going to sell a bunch of government bonds to finance those deficits. Call that a large increase in the supply of bonds. Without a corresponding increase in the demand for bonds, that launch of new bond sales puts upward pressure on interest rates. One could argue that the Fed need do very little to raise interest rates since the Treasury is going to do a nice job of lifting them anyway.

Think about other borrowing in the economy. Firms will need to borrow more to permanently raise the amount they spend on plant, equipment, and innovation. Students will likely borrow more, too. There seems to be no end to how much we want to borrow for new cars. In a strong economy, all of that borrowing combined with the Treasury’s borrowing could be putting strong pressure on rates to rise. What if the Fed pushes rates even higher?

What I am suggesting is that ignoring the “dropped” bond market could result in interest rates rising too much too soon. If rates rise too much, this could trigger the next recession. Interest rates are returning to more normal higher levels due to the usual impacts of a growing economy that is reliant on debt. The Fed seems overly worried about inflation these days and is very willing to push rates upward. But they should also be worried about the bond market’s impact on interest rates and instead be focused on not letting interest rates rise too much.

The Fed is always somewhere between a rock and a hard place. The Fed finally decided that interest rates were too low. Sadly, it might be true that the real worry is that rates may be already rising too much. Why is the Fed always a day late and a dollar short?