June 05, 2011
Life without QE2
Last November, the Federal Reserve announced a plan to purchase $75 billion each month in intermediate-term Treasury securities, a measure popularly described as a second round of quantitative easing, or QE2. June is the last month of this program, and it looks unlikely that the Fed will extend it, causing some observers to be concerned. My view is that QE2 had relatively modest effects, and such benefits as it provided should not evaporate with the end of the purchases.
One of the channels by which QE2 could have been expected to affect the economy is by changing the maturity structure of debt held by the public. The theory is that by taking a large enough volume of long-term debt off the market, the price of long-term bonds might rise, that is, long-term yields might fall. The Fed buys the bonds with newly created Federal Reserve deposits, which in the current environment function essentially like short-term Treasury bills. In the current situation, increasing the supply of these has no effect on short-term yields, so that the purchases on balance might be able to exert some economic stimulus.
The empirical evidence suggests that there is some potential for this to work, though massive purchases would be necessary to have modest effects on interest rates. The $75 billion purchased monthly by the Fed amounts to about 1% of marketable Treasury debt held by the public. Moreover, under QE2 the Fed has been purchasing intermediate-term rather than long-term debt, and the fact is that the average maturity of publicly held debt has actually been increasing rather than falling during QE2.
Moreover, as Jeff Miller notes, the end of QE2 doesn't mean the Fed is planning to sell its Treasuries, only that it's not going to continue to buy new ones.
The other reality to keep in mind is that the Fed simply doesn't have the ability to solve our current economic problems. The one thing the Fed can and should do is prevent deflation. I think the main success of QE2 was that it helped the Fed to signal convincingly that it had the ability and the will to prevent deflation. But the fact that the Fed is not buying more Treasury bonds should not change any of that.
There are plenty of things to worry about in the current situation. But the end of QE2 shouldn't be one of them.
Posted by James Hamilton at June 5, 2011 07:08 AMdigg this | reddit
75 billion may be 1% of total US debt, but 600 billion is a more significant chunk of the new 7-10 yr Treasuries; some estimate the Fed buying 70% of new debt. Furthermore, you note that the 10 yr rate has declined much more than the 30 yr.
The monetary base is 28% higher than it was a year ago; M1 is 14% higher. It seems reasonable to me to think that this has substantial effect on our economy, especially the deleterious effect of fooling market participants [& esp. slugbaits] about the abundance of savings.
More evidence of the degree of price distortion is the ongoing purchase of 10year Treasuries with a 3% when the understated CPI measures the loss in value of the $ of >3%. These purchasers then must pay tax on their 3% interest. It is hard to believe that any of these purchasers are normal investors. It is hard to imagine these are bought by anyone but central banks or banks getting their money from the Fed for nothing.
At any rate, I think you underestimate the effect. There will be a QE3, perhaps under some different stealth rubric.
Posted by: Bryce at June 5, 2011 08:28 AM
JDH I don't think your conclusions follow from your premises. Yes, there are plenty of things to worry about beyond the end of QE2, but that doesn't mean we shouldn't also be worried about not having a QE3 ready to step in. Yes, QE2 was not a whopping success...in fact, last summer I was one of those who supported it but did not expect it to have much impact. At the time I gave it "two cheers." But not having "much impact" is not quite the same thing as saying "no impact"; and beyond that QE2 as official policy also committed the Fed to ZIRP, which I think is needed. There are too many Fed Heads who want to start raising interest rates, and not following up with QE3 could be seen as a signal that those folks are winning the day. Finally, as you pointed out, the Fed misfired by not focusing enough on longer term securities. A better executed QE2 could have had somewhat better results. And given that it now looks like economic policies are going to spin out of control into ultra-bizarre Tea Partyland my concern is that QE3, small as it is, may be our last, best hope. Want proof? Listen to Austan Goolsbee's comments on today's This Week show. Here's a guy who is very smart and understands what needs to be done, but yet he was a blithering idiot on today's show. [Note: When the Chamber of Commerce economist said that all that was needed was for government to allow business to expand investment to meet demand I thought Paul Krugman was going to fall out of his chair. Krugman's expression was priceless.]
Bryce First off, I wasn't talking about "savings"; I was talking about "saving." "Savings" is a stock variable; "saving" is a flow variable. Second, the point of QE2 is to make private sector investment & consumption relatively attractive. There is price distortion, but that's because of the laws of arithmetic. You simply cannot have a negative nominal interest rate, which is what an undistorted Walras-style market clearing rate requires right now. So you do the next best thing, which is to push down long term rates.
Posted by: 2slugbaits at June 5, 2011 09:12 AM
I also think you underestimate the effect of taking Treasury's off the market (600b out of the 2011's estimated 1.48t deficit - 41%). This is especially true since QE2 created new IBDDs remunerated past the 1 year mark on the yield curve. I.e., IOeRs induced dis-intermediation among the mon-banks (e.g., MMMFs), decreasing the available supply of loan-funds.
Posted by: flow5 at June 5, 2011 09:55 AM
"The other reality to keep in mind is that the Fed simply doesn't have the ability to solve our current economic problems. The one thing the Fed can and should do is prevent deflation. I think the main success of QE2 was that it helped the Fed to signal convincingly that it had the ability and the will to prevent deflation."
Given that I completely agree with your explanation for the effectiveness of QE2 here, I'm surprised to hear you say the Fed can't solve (or reduce) our current economic problems.
If the Fed can convincingly signal it has the ability to create deflation, why can't it convincingly signal it has the ability to create more inflation? And given that expected inflation measured by the TIPS spread has fallen from 2.5% to 2.0% since Bernanke's press conference, pushing them back up again could be highly beneficial. It's also worth noting that prices are below their trend from 1990-2007, so even temporarily higher rates of inflation expectations (like 3%) can be easily justified.
Posted by: Cameron at June 5, 2011 10:53 AM
My own view is that the primary channels for the effect of QE2 should be observed in inflation expectations, asset prices and the exchange rate.
1) Inflation Expectations
US Dollar Two Year Zero Coupon Inflation Swap
2) Asset Price
3) Exchange Rate
Trade Weighted Major Dollar Index
Note that from the day before Bernanke announced the likelyhood of QE2 at Jackson Hole to approximately 8 months later (the term of actual implementation) 2 year inflation expectations increased by 1.8%, the S&P 500 rose 30.3% and the value of the dollar fell 11.0%. The first can be taken as a proxy for nominal growth expectations, the second implies that household wealth increased by about $5 trillion and the third resulted in US exports becoming more competitive.
Note also that all of these indicators have shown a retrenchment (20%-34%) since peaking in late April or early May.
Is there reason to believe QE2 has had an effect on real final sales of domestic product (a proxy for aggregate demand) and employment?
Looking at the household data one will note that the bottom occurred in December of 2009. In the 18 months since a total of 1.8 million jobs have been added. During that time there have been two major spurts in job creation (separated by a period of job loss).
A) During January 2010 through April 2010, counting the population correction factor, 1.49 million jobs were created. (Approximately 66,000 of the jobs were temporary census workers added in the month of April.)
B) During December 2010 through March 2011, counting the population correction factor 1.43 million jobs were added.
In each case the spurt in job creation followed an relatively strong quarter of real final sales of domestic product. During the entire recovery there have only been two quarters where the real growth rate in final sales of domestic product exceeded 1.1%: 1) the fourth quarter of 2009 (2.1%), and 2) the fourth quarter of 2010 (6.7%). Which leads me to real final sales of domestic product.
2) Real Final Sales of Domestic Product (real GDP less inventory change)
Estimates of the effect of the discretionary fiscal stimulus by Goldman-Sachs suggest that it added 0.5%, 2.3%, 1.9%, 1.8%, 1.6%, 0.5%, 0.0%, -0.5%, 0.0% to real growth in each quarter from 2009Q1 through 2011Q1 respectively. In the absence of the discretionary fiscal stimulus this suggests that real growth in final sales of domestic product would have been -4.4%, -2.1%, -1.5%, 0.3%, -0.5%, 0.4%, 1.7%, 7.2%, 0.6% in each quarter from 2009Q1 through 2011Q1 respectively.
Note that it is estimated that without the discretionary fiscal stimulus the real growth in final sales of domestic product would never have exceeded 0.4% prior to 2010Q3. The surge since then, particularily in 2010Q4 thus stands out.
I think this suggests that QE2 had a substantial though short lived effect on real final sales of domestic product and subsequently on employment. Given that the withdrawl of the discretionary fiscal stimulus is forecast to be a substantial and presistent drag on real growth for the remainder of this year, and that the benefit of QE2 appears to be mostly behind us, I am not sanguine about the prospects of the economy going foreward.
QE3 would be better than nothing. A more coherent way of implementing "unconventional" monetary policy, such as price level or nominal GDP level targeting would be better still.
Posted by: Mark A. Sadowski at June 5, 2011 11:13 AM
Deficits obviously generate a net increase in the demand for loan-funds; the larger the deficit, the greater the demand. That doesn’t necessarily mean interest rates will be higher. But if they are not higher, the only other conclusion is that QE2 keep interest rates lower than they would be in the absence of these purchases.
The repeal of REG Q on demand deposits will compound dis-intermediation in the non-banks (along with QE2), decreasing the available supply of loan-funds, & reducing the flow of savings into real investment, further exerting a depressing effect on the economy, job creation, etc. It will also force some smaller banks into bankruptcy.
Posted by: flow5 at June 5, 2011 12:13 PM
Crowding out doesn't start until private loan demand begins to compete with public sector borrowing. Considering loan-demand is stagnant QE2 has definitely kept rates down.
Posted by: flow5 at June 5, 2011 12:22 PM
Some wit once called a third marriage, the triumph of hope over experience. QE3 would deserve the same moniker.
Personally, I think the Fed should work on shrinking its balance sheet in a very quiet, non dramatic, but steady manner. I don't think heroics are called for at this time. And Ben Bernanke should renounce them.
Posted by: Walter Sobchak at June 5, 2011 06:42 PM
All QE is doing is tricking the treasury into taking on debt despite no positive NPV investments. Cut them off.
If banks want to lend money. they better learn to lend to people and business again.
Posted by: aaron at June 5, 2011 08:55 PM
While I agree QE2 has had a modelst effect, I disagree strenuously that the Fed "simply doesn't have the ability to solve our current economic problems."
Completely untrue. It may not have the *will* to buy enough treasuries to reflate the economy, but it certainly has the capacity. It could, for example, introduce a target for the 5 or 10 year treasury at 1% or 2% and buy/sell treasuries to effect this, as it does with Fed Funds. This would force people up the yield food chain and not only change the maturity profile but the credit/riskiness profile. Keeping mortgage costs low should be a key goal until the housing market heals. It would also, IMO, force a faster Yuan revaluation on China, boosting exports and trimming imports. It would force them to revalue faster because the stimulus would almost certainly be inflationary for their economy. Finally, (but not least) it would certainly be inflationary, which is a good thing as they are up against the 0 lower bound. Most Taylor rule models still call for negative real rates to the tune of 3-4% given UE of 9.1%
So its not that they can't. At *some* point they buy enough treasuries that it's reflationary. The velocity of money is not zero. Banks are holding historically massive reserves but still lending. The money multiplier is smaller but not zero!
They just don't have the political will to do it.
Posted by: dwb at June 6, 2011 04:44 AM
Or Life at the time of cholera
When looking at the BIS statistics,it is obvious that private debts are outgrowing domestic GDP.
How much of other countries QE is consumed and required when debts securities are issued in non domestic currencies,and debts issuances are up and growing?
International debt securities - all issuers By residence of issuer in USD billions
Countries Dec 2008 Dec 2009 Dec 2010 Mar 2011
United States5,270.9 6,027.7 6,600.1 6,729.5
United Kingdom 3,433.3 3,774.4 3,674.3 3,837.9
France 1,685.1 2,005.4 1,997.4 2,207.5
Greece 103.5 125.6 193.0 202.0
Japan 331.0 342.1 361.9 368.6
A quick look at the corporate issuers under the same chapter may not assuage the diagnostic,financials are the problems.
International debt securities - corporate issuers
If not convinced please look at the Domestic debt securities By sector and residence of issuer
Posted by: ppcm at June 6, 2011 05:04 AM
Prof JH says: "The one thing the Fed can and should do is prevent deflation. I think the main success of QE2 was that it helped the Fed to signal convincingly that it had the ability and the will to prevent deflation."
But aren't deflationary pressures reemerging?
Housing prices, commodities, stocks, gas, food are all drifting downward. Don't you think that wages will get caught in this same spiral if congress fails to provide more fiscal stimulus?
Posted by: Raskolnikov at June 6, 2011 05:41 AM
Another excellent post.
I do take issue with these comments in the post though:
The one thing the Fed can and should do is prevent deflation. I think the main success of QE2 was that it helped the Fed to signal convincingly that it had the ability and the will to prevent deflation.
If - as Bernanke and most financial pundits do - you define deflation as price decreases QE2 is a total failure as recent record home price declines show. If QE2 shows anything it is that the FED has run out of bullets and the last few were totally off the mark. The FED can neither prevent deflation nor stimulate the economy through increasing the money supply. All it has succeeded in doing is drive the dollar down against the euro, drive up the price of gold, and push the Chinese to divest themselves of 97% of their short-term Treasuries. If the FED continues on its QE path it will simply push more money into excess bank reserves.
Of course if you define inflation/deflation as a change in the purchasing power of money recent euro/dollar exchange rates and the price of gold definitely indicate inflation.
Posted by: Ricardo at June 6, 2011 05:58 AM
Only stock market will go down the drain, if that means something to economy. That was supposedly the wealth effect pushing citizens to spend more as their stock value grows. Now it will drop ( it there is no QE3) and citizens will spend less which is supposedly bad for economy.
On other hand, QE3 will continue inflation export and later import it back to the USA and Europe, and continue to set up fires at countries at the origin or near the oil supply chain origin. Coupled with speculation, it will give the final push to oil shock, which will stop both QE3 and stock market growth, and, push the USA into the recession by q1 2012.
Posted by: Ivars at June 6, 2011 01:14 PM
The Fed does not need to purchase any bonds to drive down long term treasury rates, if it wants to do that. It just needs to announce a target, and the market will go there.
Posted by: Max at June 6, 2011 02:21 PM
"The one thing the Fed can and should do is prevent deflation."
I echo the above comments. I like the analogy if the driver spinning his wheels on ice - the choice may be between deflation and disatrous inflation.
As for QE, I think the ony effects outside of support of unreasonable equity prices is dollar depreciation, and that mostly against currencies that it should not be depreciating against.
Posted by: don at June 6, 2011 03:34 PM
Must agree with Ivars. There is a huge difference between a correction and sustained deflation. A lot of us have been seeing deflation in the assets we hold and inflation in our consumables. This isn't because we are running low on supplies of consumables and inputs or that we are getting less efficient at production. Some people have just decided that that's where the most leverage is to make people pay. This should have been obvious to most people back in 2008. It was obvious to me.
Posted by: aaron at June 6, 2011 04:00 PM
Markets, like housing, aren't clearing probably because buyers don't believe houses have fallen enough. Rents are high because the market isn't clearing. The longer things drag out, the more things look like deflation and that it could be persistent.
The investment play right now is to buy real estate or real estate inventors. Short to long-term, companies that manage properties and buy properties to rent out, to take advantage of sticky rents and buying when the foreclosures market starts clearing. For the long term, buy home builders who are buying for the future.
Posted by: aaron at June 6, 2011 06:11 PM
Sorry for the broken link: http://seekingalpha.com/article/241088-homebuilders-perhaps-one-of-the-best-buys-of-the-decade
Posted by: aaron at June 6, 2011 07:09 PM
I believe that the main problem now is the high unemployment rate at over 9% that does not go down. This high unemployment rate is linked to a continuous property market slump. In order to revitalise this market and thus reduce significantly unemployment, one needs to target it with direct fiscal measures instead of indirect monetary measures. How to clear this backlog in the commercial and non-commercial real estate market to stabilise prices and reverse its continuous decline should be the main target for the government to tackle.
Posted by: The GD Bridge at June 8, 2011 01:45 AM