January 23, 2011
The Fed's new policy tools
We had to throw out our textbook descriptions of how monetary policy is implemented after the fall of 2008, as the Fed turned from its traditional tools to active use of large-scale asset purchases. A number of studies have now been conducted of the potential efficacy of these new policy tools. I surveyed some of the new studies last October. Today I'd like to discuss three new papers that have come out since then.
Let me begin with a little background. Prior to the fall of 2008, the focus of monetary policy was to choose a target for the fed funds rate, which is the interest rate banks charge each other for overnight loans of Federal Reserve deposits. In normal times, this rate was extremely sensitive to the quantity of those deposits created by the Fed, enabling the Fed to achieve its target for the fed funds rate with relatively modest additions or withdrawals of reserves. But by the end of 2008, the Fed had driven the fed funds rate essentially to zero and began paying interest on reserves. Since then, banks have been content to hold an arbitrarily large amount of excess reserves, and the overnight rate has been as low as it could go. In other words, the traditional tools of monetary policy have become completely irrelevant in the current setting.
The Fed has therefore been trying to find other ways to stimulate the economy by buying longer term assets. Hess Chung and colleagues expressed the idea this way:
A primary objective of large-scale asset purchases is to put additional downward pressure on longer-term yields at a time when short-term interest rates have already fallen to their effective lower bound. Because of spillover effects on other financial markets, such a reduction in longer-term yields should lead to more accommodative financial conditions overall, thereby helping to stimulate real activity and to check undesirable disinflationary pressures through a variety of channels, including reduced borrowing costs, higher stock valuations, and a lower foreign exchange value of the dollar. In many ways, this transmission mechanism is similar to the standard one involved in conventional monetary policy, which primarily operates through the influence on long-term yields of changes to the current and expected future path of the federal funds rate.
Although the transmission mechanism may be similar to conventional monetary policy, the implementation is quite different. To make a significant change in the supply of Federal Reserve deposits, in normal times the Fed only needed to buy or sell a few billion dollars worth of T-bills. But to make a significant change in the market's available supply of long-term Treasury securities, the purchase needs to be in the hundreds of billions of dollars, and even then, there are debates as to whether there would be any noticeable effects. Hence the interest in empirical studies of exactly what the effect of such operations appears to be.
Eric Swanson of the Federal Reserve Bank of San Francisco has a new analysis of Operation Twist, which was an effort by the Kennedy Administration in 1961 to change relative yields by having the Treasury preferentially issue less long-term debt and the Federal Reserve preferentially buy more long-term debt. Although the magnitudes seem small by current standards, Swanson argues that they amounted to 4.5% of U.S. Treasury-guaranteed debt at the time, which is actually bigger in percentage terms than the magnitudes associated with QE2. Swanson found that there were unusually large declines in long-term yields on the days of significant Operation Twist announcements, and that the size of the effect is similar to what would have been predicted to happen based on other empirical studies of the potential effects of such operations.
Federal Reserve economists Diana Hancock and Wayne Passmore have a new study that focuses on the Fed's purchases of mortgage-backed securities since 2008. They regard the risk premium on MBS to have been unnaturally low during the housing boom, but shot way up as the market for new MBS broke down in the fall of 2008. The spread was brought quickly back down by the Fed's announced intention to purchase large quantities of MBS.
Hancock and Passmore attribute these effects not so much to the Fed's absorbing the stock of outstanding MBS, but instead to creating a functioning market for newly issued MBS.
A third study by John Williams of the Federal Reserve Bank of San Francisco and Federal Reserve Board economists Hess Chung, Jean-Philippe Laforte, and David Reifschneider has recently been updated to include an assessment of the effects of the Fed's large-scale asset purchases. As initially envisioned, the Fed was going to allow its holdings of MBS to shrink gradually as a result of prepayment and repayment of the underlying mortgages, implying a future time path for Fed holdings such as that represented by the black line below. Last August, the Fed announced that it would instead replace maturing MBS with longer-term Treasuries in order to prevent its holdings from contracting, consistent with a path such as the blue line in the figure below. Then in November the Fed announced QE2, in which it intends to buy an additional $600 billion in longer-term Treasuries, consistent with a future path such as that indicated in red below.
Chung and coauthors then used rough estimates derived by Gagnon and colleagues of the effects these actions could have on longer-term interest rates, and fed those effects into the FRB/US model (a large-scale model the Fed sometimes uses to describe the economy) to find predicted implications for a variety of variables of interest. The figure below summarizes the results of their calculations. For example, the upper-left panel shows that the initial MBS purchases resulted in a 10-year Treasury yield that was almost 50 basis points lower than it would have been in the absence of such purchases. The panel also shows that when those purchases were augmented by the August reinvestment and the November QE2, the combined effect would be a yield almost 60 basis points lower than it would have been otherwise. The authors also conclude that real GDP in 2012 would be 1% lower without phases 2 and 3 and almost 3% lower if the Fed had done nothing (upper right panel). The authors estimate that there would be 3 million fewer people employed on private payrolls next year if the Fed had not acted, and that inflation would have been 1% lower, that is, the policy helped avoid deflation.
It should be emphasized that these calculations are the result of putting together a series of multipliers, no one of which we know with any precision. The numbers are better interpreted as effects that one could plausibly claim rather than magnitudes we can be at all sure about. Still, they are consistent with the policy recommendation that it was better for the Fed to give this a try rather than stand by and do nothing.
It should also be emphasized that the authors study the effects only of the Fed's actions in isolation. My assessment is that the actions by the Treasury more than 100% offset the effects on security supplies of the Fed's QE2.
But even if one is unconvinced that the Fed was able through these actions to provide the significant benefits claimed in the above analysis, there is another channel discussed by Chung and coauthors which may have been one of the most important ways in which QE2 was beneficial:
Finally, the Federal Reserve's asset purchase program could potentially have stimulated real activity by changing public perceptions about the likely longer stance of monetary policy, conventional and unconventional; for example, it may have led market participants to expect that the FOMC would respond more aggressively to high unemployment and undesirably low inflation than was previously thought. In a similar vein, initiation of the program may have diminished public perceptions of the likelihood of extreme tail events, such as deflation, potentially lowering risk premiums and increasing household and business confidence, thereby raising agents' willingness to spend.
Whatever else you may say, QE2 did seem to have an effect on public perceptions. And that has always been one of the most important elements of the conduct of conventional monetary policy as well.
Posted by James Hamilton at January 23, 2011 06:49 AMdigg this | reddit
The Fed created a better apportioning of risk in and around the Washington DC/New York region. Out here in California, as in Illinois and Texas, risk is rising.
Posted by: Matt Young at January 23, 2011 08:50 AM
Wow. You and Menzie have been putting out some pretty impressive product in the last few weeks.
Posted by: Steven Kopits at January 23, 2011 09:12 AM
I’m afraid that I think these excel sheets in the sky have become so esoteric as to be meaningless. The idea that 900 billion in QE2 creates 3,000,000 jobs is ridiculous. Not because I don’t believe they did it but because it cost $300,000 per job. I'm sorry ... all that is … is a clear example of malinvestment by the government.
Posted by: ArkansasAngie at January 23, 2011 09:24 AM
"In normal times, this rate was extremely sensitive to the quantity of those deposits created by the Fed, enabling the Fed to achieve its target for the fed funds rate with relatively modest additions or withdrawals of reserves"
I completely disagree. In fact, that has never been the case. The crux of the cause of our monetary mis-management esp. since 1965, has been the assumption that the money supply could be controlled via interest rates. I.e, in reality, Keynes's liquidity preference curve is a false doctrine.
QE2 was a disaster. Long-term interest rates rose along with, for example, the Reuters Jefferies/CRB weekly futures commodity price index. I.e., the poor got poorer.
As Bernanke said in 2002: "The most striking episode of BOND-PRICE PEGGING occurred during the years before the Federal Reserve-Treasury Accord of 1951. Prior to that agreement (which freed the Fed from its responsibility to fix yields on government debt), the Fed maintained a ceiling of 2-1/2 percent on long-term Treasury bonds for nearly a decade......Interestin... though, the Fed enforced the 2-1/2 percent ceiling on long-term bond yields for nearly a decade WITHOUT EVER HOLDING A SUBSTANTIAL SHARE OF LONG-MATURITY BONDS OUTSTANDING"
But today, the FED has now become (as a direct result of QE2), the largest holder of U.S. government debt.
Just like (the inflation-unemployment trade-off curve shifting to the right, and at an accelerated rate), so is the FED's ability to influence (suppress), long-term interest rates thru debt monetization.
Posted by: flow5 at January 23, 2011 09:55 AM
Qe2 definitely bought time and put stock market prices on artificial life support at least few months beyond the day they should have peaked.
So, also "wealth" effect was created. On other hand, high stock prices have enticed individuals to spend cash to prop up money velocity while banks are not doing it, not lending. So in essence, QE2 is strapping the individuals from their savings which they might regret later when the euphoria wears out, while banks are making profit being only the mediators in this process and propping up the stock prices.But not propping up lending, or are they?
Posted by: Ivars at January 23, 2011 10:55 AM
As usual, the FRB economic modeling extolling the benefits of its MBS purchases is limited to a very limited time horizon of ten years. What is not considered, is the drag on future economic performance by the debts accrued by current expansionist policy. What would the real US GDP and employment be, if $50 Trillion of credit didn't have to be serviced?
Posted by: MarkS at January 23, 2011 11:07 AM
"The authors estimate that there would be 3 million fewer people employed on private payrolls next year if the Fed had not acted, and that inflation would have been only 1% higher, that is, the policy helped avoid deflation."
You meant to say inflation would have been one percent lower, I presume.
"such a reduction in longer-term yields should [help] to stimulate real activity and to check undesirable disinflationary pressures through ... reduced borrowing costs, higher stock valuations, and a lower foreign exchange value of the dollar."
I would say under current conditions, that the effect on the foreign exchange value of the dollar is the dominant effect at work right now, with a side effect of maintaining overvalued asset prices, which latter I see more as delaying adjustment rather than facilitating solid 'recovery.' Moreover, I think the effect on exchange rates will prove to be nonsalutory by the end of the day, as it puts untoward pressures on the few actors who play by the floating exchange rate rules. I think this is short-sighted. Better to focus efforts on proscribing foreign currency mercantilism in Asia.
"But to make a significant change in the market's available supply of long-term Treasury securities, the purchase needs to be in the hundreds of billions of dollars, and even then, there are debates as to whether there would be any noticeable effects. Hence the interest in empirical studies of exactly what the effect of such operations appears to be."
Well, there appears to have been a noticeable effect on the value of the dollar, even preceding the actual implementation. Furthermore, this is exactly as I would have expected - what more natural relief for the pressure on local returns than to engage in foreign asset purchases, the latter supplying a very large pool of fairly close substitutes.
As far as looking to 'operation twist' for comparison, that would seem to me to be a natural nonstarter, as loan demand was under very different circumstances then (or indeed, under any situations post-GD1.
The conjecture of Chung et al. seems to me the most reasonable cause for hope that the policy may do more than merely beggar our neighbors who still follow floating exchange rate policies, but even there, the result depends on business response to lower borrowing costs, which is a very weak reed under current circumstances in my view.
Posted by: Anonymous at January 23, 2011 11:38 AM
Anonymous at January 23, 2011 11:38 AM: Thanks, error fixed now.
Posted by: JDH at January 23, 2011 12:06 PM
I don't understand why we haven't seen something like this.
The way to go is an Interest Moratorium and principal tax deduction for people who are current and make their full scheduled payments on mortgages that originated during the bubble (ie., the scheduled interest is applied to principal for some period). This does not need to be a forced policy, it can be done with incentives.
It's nearly costless.
Government, loses some tax revenue in the short run due to lower bank profits.
Banks, cash flows improve as people have greater incentive to make their payments. Balance sheets improve and less taxes are paid (lower profits during moratorium). Reduced foreclosures and short-sales. House values are less likely to fall.
Banks, lose some profit if people are able to refinance at lower rates sooner. Banks also lose at the end of the mortgage, as it is payed off earlier; these losses are very small and very far in the future. Banks can also lose at sale the amount above principal, up to the amount of scheduled interest during the moratorium, that the home sells for.
Homeowners, balance sheets improve. Uncertainty diminishes.
Homeowners, insolvent homeowners are given false hope and make payments they shouldn't.
For the Fed, value returns to some toxic assets, since many of the instruments were created under the assumption of prepayment of principal and non-payment of interest (the operating model was that people moved frequently and bought houses to invest in and sell).
What is really amazing is that banks haven't taken it upon themselve to do this. I guess banks think that the difference between bubble rates and current rates is greater than the cost of the foreclosures and short-sales they'll see. They really should be doing this on their own. All it might take is for the goverment to offer to make interest payments applied to principal tax deductible.
Having payed too much for a house, and paying too high an interest rate on top of that, is a real burden and a psychological one too. It's eating up a lot of cash that could be out doing something and creating uncertainty.
Posted by: aaron at January 23, 2011 12:52 PM
QE2 was not the remedy for job growth. It was a prescription for supporting the Treasury Market (the FED's informal mandate).
But to put more money into consumer's pockets, to support the housing market, & to increase real gDp, the FED needed to reverse the flow of funds being impounded within the commercial banking system and channel a proporationally larger volume of savings into the Shadow Banking system (the non-banks).
The non-banks previously comprised upwards of 82% of the lending market. But non-bank lending has dryed up. The short-fall can't be replaced with Reserve & commercial bank financing without producing intolerable levels of consumer and producer inflation.
Unfortunately economists don't understand money & central banking. Otherwise you would hear that we should get the member banks out of the savings business. What would this do? It would make the member banks more profitable, it would lower long-term interest rates, it would stimulate spending and increase production.
But we are being lead in exactly the opposite direction of the only true cure. Bernanke has now given us IORs.
Economists should realize that IORs absorb savings, and that savings held by the commercial banks are actually lost to investment. And that the commercial banking system has caused disintermediation (where the Shadow Banking System shrinks in size, but the size of the CBs remains the same).
Unfortunately for our economy, more and more lending and investment is being financed thru the Commercial & the Reserve Banks, where savings cannot be matched with investment. The correct paradigm is 1966.
Posted by: flow5 at January 23, 2011 07:46 PM
Not that I think it merits any credit, but 'anonymous' at 11:38 was me.
Posted by: don at January 23, 2011 08:00 PM
It is interesting to read "Have we underestimated the likelihood severity of the Zero lower bond events" in conjunction with:
"Lesson learned? Comparing the Federal reserve s responses to the crisis of 1929 - 1933 and 2007-2009" David C Wheelock Federal reserve Bank of Saint louis.
The later supplying many answers to the former.
H Chung, J Philippe Laforte,D Reifschneider,J.WIlliams
"The current episode of the long period stay in ZLB is much longer than those typically generated by the simulation analysis of Reifschneider and Williams 2000"
According to the table 1 supplied by D Wheelock
CPI declined from 19929 to 1933 by 27.17 %
H Chung , J Philippe Laforte,D Reifschneider,J.WIlliams
"Securities holding by the Fed has lowered the unemployment by 11/2 %"
Unemployment (1929-1933) 25.36%
Table 6 D Wheelock
The banks excess reserves to GDP were much higher at the end of 1936 in relative value to GDP than present. Shall we expect more Qe s ?
Posted by: ppcm at January 24, 2011 05:29 AM
"... it may have led market participants to expect that the FOMC would respond more aggressively to high unemployment and undesirably low inflation..."
This makes sense to me -- this mechanism struck me as the best way of explaining the behaviour of interest-rate markets in December. See here:
Posted by: John Butters at January 24, 2011 05:46 AM
If you get a chance, could you give us a first order estimation of the implications of an oil shock for GDP and employment? Some thoughts on implications for the financial system would be welcome as well.
Posted by: Steven Kopits at January 24, 2011 06:28 AM
You call it "deflation," a 25 year old looking to buy his first house calls it, "asset prices reflecting actual demand pricing." Guess what language you use depends on how much skin you have in the game.
Posted by: Some Kid at January 24, 2011 07:45 AM
"A primary objective of large-scale asset purchases is to put additional downward pressure on longer-term yields at a time when short-term interest rates have already fallen to their effective lower bound."
This puts far too much emphasis on the interest rate channel of the monetary transmission mechanism, and it is disturbing that this came from within the Fed.
It's questionable that QE2 is having this effect or even that that was its intent. Less than 30% of the asset purchases have been 10 year or longer term T-Bonds. Furthermore, since Bernanke's Jackson Hole speech in late August the average yield on a 10 year T-Bond has soared from 2.5% to 3.4%.
So it's useful to consider the other channels of monetary transmission.
1) Asset prices
Since late August equity prices have increased by 20%.
2) Exchange rate
Since late August the dollar has fallen by 5%.
So far excess reserves have changed little despite QE2.
4) Inflation expectations
Since late August the USGGBE10 (a measure of long run inflation expectations) has risen from 1.5% to 2.2%.
It would appear that the biggest impact has been through the the asset price and the inflation expectations channels. The increase in equity prices has probably added about $2 trillion to business and household balance sheets. The increase in inflation expectations is helpful because it suggests higher expected nominal expenditures and lower expected real interest rates.
It's too early to state whether credit is more free although so far it's a good sign that this hasn't simply padded excess reserves. And the impact through the exchange rate channel likely has been negligible.
In short, if the goal of QE2 was to flatten the yield curve (doubtful) then it's been a complete flop. But, in my opinion, the interest rate channel is the least important one of all.
Posted by: Mark A. Sadowski at January 24, 2011 09:42 AM
None of these experts seem to be able to point to any evidence that QE2 actually did anything. What do we actually know?
1) QE2 did not reduce rates. It did not induce borrowing or reduce the cost of credit. Mortgage rates are higher by almost 1% since the program started and the cost of credit is higher across the board. While many academics prefer to make the argument that inflation expectations have risen, the truth is that a home owner has almost no perception of broad inflation changes.
2) QE2 did not result in increased borrowing. This is not shocking given the rise in interest rates. Totals loans have FALLEN since QE2 began so the entire interest rate mechanism has been a big fat failure. http://research.stlouisfed.org/fred2/series/LOANS
3) The US Dollar did not decline. Therefore, the argument that it might induce an export based boom is bunk.
4) QE2 altered perceptions and generated a wealth effect. This might be true to some extent, however, one must wonder whether it even matters. Nominal wealth creation via a stock market increase is not real wealth. Real wealth is not created by rising paper prices. It is created when the more goods and services are produced. This outlook is backed by Robert Shiller who has thoroughly debunked the equity market wealth effect.
5) If QE2 has done anything it has caused investors to bid up equity prices and diverge price from reality. It has also caused an increase in commodity prices due to fears over reckless Fed policy. This has crunched corporate margins. If Shiller is right and there is no equity market wealth effect then it's likely that Bernanke's psychological impact is only hurting the economy via the commodity channels.
It's clear to me that QE2 has been a big fat flop. The evidence above confirms this.
Posted by: MarkS at January 24, 2011 02:52 PM
For your information: 1966 revisited. These posts document the "savings-investment" process and the proper public savings policy between financial intermediaries & commercial banks.
Leland J. Pritchard
Dr. Pritchard earned his masters degree in Statistics and in 1932 began his PhD in Economics at the University of Chicago where he was elected Phi Beta Kappa. Before coming to the University of Kansas in 1942 he taught political economy courses at Syracuse University Maxwell School of Public Administration. He served with the Federal Emergency Relief Administration, The Works Projects Administration, and The War Labor Board. Professor Pritchard served both as Dean of the School of Business and from 1955 to 1962 as the Chairman of the Economics Department. In 1962-1963, he was a Fulbright Lecturer in Ankara, Turkey. He was President (1963-1964) of the Midwest Economics Association. His extensive research and publication record display a broad knowledge of both Finance and Economic Statistics. His Money and Banking Text (1958, 1964) was widely used and is perhaps the most literate of all recent American texts in economics.
Posted by: flow5 at January 24, 2011 04:53 PM
I think that QE2 has been a success... at least for the short term, and that might just be good enough. The Fed has been playing poker and in order to win they have to convince people they are willing and committed to creating inflation no matter what. There are just enough people paranoid about inflation to give them the advantage and the ability to move the markets and expectations in their desired direction. However..... do they really have the cards in their hand to win if they get called? What if deflation gets the upper hand again (due to another crisis, commodities price collapse, i.e.) and calls the Fed's hand and the public sees that they are truly out of ammo? Watch out.
Posted by: Doc at the Radar Station at January 24, 2011 04:54 PM
Doc and his "playing poker" reminds me of Samuel Clemens:
Posted by: calmo at January 26, 2011 04:12 PM