Adam Tooze has a post discussing the bond vigilante theory:

The phrase “bond vigilante” is normally attributed to Ed Yardeni a Wall Street economist who coined it in the 1980s to describe the role of bond markets in disciplining governments.

“Bond Investors Are The Economy’s Bond Vigilantes”, Yardeni once declared. “So if the fiscal and monetary authorities won’t regulate the economy, the bond investors will. The economy will be run by vigilantes in the credit markets.” As Yardeni later spelled out: “By vigilantes, I mean investors who watch over policies to determine whether they are good or bad for bond investors … If the government enacts policies that seem likely to reignite inflation”, Yardeni elaborated, “the vigilantes can step in to restore law and order to the markets and the economy.”

This is an example of reasoning from a price change. If bond traders fear that government policies are likely to lead to higher inflation, this may result in higher interest rates (via the Fisher effect). But higher interest rates due to the Fisher effect are not a contractionary policy. In order to prevent inflation from occurring, the government must stop engaging in inflationary policies. Bond vigilantes won’t solve the problem.

Tooze discusses the 1994 bear market for bonds, an example often cited by proponents of the bond vigilante theory:

Furthermore, 1994 was not a spontaneous bond market attack. It too was triggered by the Fed.

In the summer of 1993 Alan Greenspan had become worried about the acceleration of inflation. Even though the Clinton administration in August 1993 had forced through the fiscal consolidation plan that would return the US Federal government to surplus, Greenspan wanted to add further dampening pressure. He was convinced that allowing for inflation expectations real interests rates had fallen to zero.

Tooze is appropriately skeptical of the bond vigilante theory but is also reasoning from a price change. Tooze assumes the rate increase was caused by the Fed, presumably a contractionary monetary policy by the Fed. I see no evidence for this claim.

Here it will be helpful to revisit an analogy I often use. A bus drives from Denver to Salt Lake City. What determines the path of the bus? Is the path determined by the way the driver adjusts the steering wheel, or by the layout of the highway (combined with an assumption that the driver prefers to avoid going off the road?)In this analogy, the bus driver is the Fed and the road is the natural rate of interest under a 2% inflation target.

Here language fails us. It’s not clear what people mean when they ask what “determines” the path of the bus. The driver or the road?

Tooze provides this helpful graph of short-term interest rates:

Why did interest rates rise during 1994? One could argue that the increase was caused by the Fed’s decision to raise its short-term rate target. Or one could argue that the Fed raised its target rate because the natural rate of interest rose as the economy strengthened in the mid-1990s, and they had to raise rates to keep inflation close to 2%. I find the latter explanation more useful.

If someone asked me to explain why I drove though Green River on my way from Denver to Salt Lake City, I would not explain this fact by referring to how I turned the steering wheel left and right at various times, I’d refer to the layout of I-70. I’d assume the listener understood that I tried to stay on the road.

But that view is not always adequate. If I plunged off the road and fell into a deep canyon, I would not explain that fact by pointing to the map, I’d point to my incompetence as a driver. If I wanted to explain why the US end up with 13% inflation in 1980, I would not assume that actual short-term interest rates always followed the path of the natural rate of interest, rather I’d assume they were mistakenly held below the natural rate during the late 1970s.

The 1990s were a successful period for monetary policy, and thus it’s enough to point to the map—movements in the natural rate of interest. We can infer from stable 2% inflation that the actual interest rate stayed pretty close to the natural interest rate during the 1990s.

HT: Matt Yglesias