July 13, 2011
Evaluating quantitative easing using event studies
Event studies are one method that has been used to try to assess the potential effects on markets of nonstandard monetary policy measures such as QE2. The Federal Reserve Bank of St. Louis recently hosted a conference whose objective was to evaluate evidence on the effects of these policies. Here I relate remarks I made at the conference on some of the challenges from trying to use event studies to answer this question.
Event studies look at a narrow window of time around which a significant policy initiative was announced to see how markets responded at the time. The hope is that, over the short period studied, the policy announcement itself is the most important news item to which markets were responding.
For example, a paper by Joseph Gagnon, Matthew Raskin, Julie Remache and Brian Sack presented at the conference identified 8 key days on which major details of the Fed's initial large-scale asset purchase (sometimes referred to as "QE1") were communicated to the public. These included:
- Nov 25, 2008: LSAP announced
- Dec 1, 2008: Bernanke in a speech described LSAP as involving "substantial quantities"
- Dec 16, 2008: FOMC said it "stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant"
The graph below shows the yield on 10-year U.S. Treasury securities during November and December of 2008, with the particular days mentioned above marked by vertical bars. This yield fell 170 basis points over these two months. Most of us would agree that the primary cause of this decline was not QE1, but instead news of a rapidly weakening economy, which would have been a reason for falling yields even if the Fed had done nothing. The problem plaguing any effort to measure the effects of the policy is the fact that QE1 was itself also a response to that same news. How much of the decline in yields was due to news of a weakening economy, and how much was due to LSAP?
The idea behind the event-study methodology is to focus on the particular 3 days highlighted above, the hope being that the primary news on these days was the actions of the Fed rather than the deteriorating economy. It turns out that 61 basis points, or more than a third of the total decline over these two months, occurred on these 3 days alone. That observation suggests that the Fed's actions may have had a significant effect of their own.
But it's also interesting to look at the behavior of other variables over this period, such as the graph of nominal oil prices below. These also were coming down dramatically at the time, falling 30% over the same two months, and again presumably in response to incoming news of a worsening economy. And it turns out that 16% of this decline again occurred on the same 3 days highlighted above.
Now, one could tell a story for why the oil price might in fact have been responding to the LSAP announcements on those particular days. For example, traders could have figured, "gosh, the Fed wouldn't do this unless they were really scared about what's happening to the economy. Things must be even worse than I thought!" But, to the extent this was the case, such a story may also be part of an effect incorrectly attributed to LSAP on yields themselves. Another plausible interpretation is that there was in fact some other bad news about the economy arriving at the same time as the LSAP announcements.
This is just another illustration of the principle that correlation does not establish causality. Notwithstanding, correlations are not irrelevant. If LSAP did have an effect on yields, one should see a correlation like that in the top diagram. On the other hand, if LSAP also had an effect, as some claim, of raising commodity prices, one would not expect to see a correlation like that in the lower diagram, and thus the second correlation is harder to reconcile with that hypothesis. The observed evidence is what you'd expect to see if you believed that LSAP lowered yields, and not what you'd expect to see if you believed that LSAP raised commodity prices. Correlations are in my opinion always worth looking at, even though they're always subject to a variety of interpretations.
Fortunately, there are a number of other candidate event-days besides the ones I listed above. Papers by Gagnon, et. al., Krishnamurthy and Vissing-Jorgensen, Jonathan Wright, and others have used a number of other key announcement dates associated with QE1 and QE2. Joyce et. al. looked at LSAP announcements in the U.K., while Eric Swanson examined the effects of "Operation Twist" in 1961. Yet other studies, including Greenwood and Vayanos, D'Amico and King, and my own research with Cynthia Wu, documented longer time-series relations between the term structure of interest rates and the supplies of bonds of different maturities. Any one of these investigations, taken by itself, is perhaps not completely convincing. But the overall conclusion from looking at this question using a broad range of different data sets and methodologies is that large-scale asset purchases do seem to have a modest potential to influence the economy.
Posted by James Hamilton at July 13, 2011 06:15 AMdigg this | reddit
Why the debate? It has been shown by Phelps and Friedman that short term Phillis Curve effects are real. The emphasis of course is short term, and and resulting illusion must be paid for.
Where are the studies to see if Phillips Curve analysis could be expanded beyond just employment, inflation analysis? I suspect as postulated by Friedman, a good case could be made of diminishing effect of QEII for the economy compared to QEI due to less surprise, as well as a showing that any QEIII would be even less.
Regardless if a study is made or valid, if Professor Chinn would publicly have a Morgenthau moment, then maybe all this would be worth it.
"No, gentlemen, we have tried spending money. We are spending more than we have ever spent before and it does not work...And an enormous debt to boot! We are just sitting here and fiddling and I am just wearing myself out and getting sick."
May 9, 1939
Posted by: Ed Hanson at July 13, 2011 06:48 AM
many private economists focus not on november, but on august (Bernanke's Jackson Hole speech) where he laid the groundwork for keeping the balance sheet constant and perhaps further QE. By November, many would argue, it was not a question of IF, but of HOW MUCH.
Posted by: dwb at July 13, 2011 07:32 AM
Ed Hanson: My topic here was whether monetary policy could still do anything even when the short-term interest rate is driven to zero.
dwb: QE1 (which graphs above refer to) would be November 2008. QE2 (evidence of whose effects I discussed most recently here) would be November 2010.
Posted by: JDH at July 13, 2011 07:41 AM
Looks like the pro QE3 crowd is going to get its way;
If QE1 and 2 did not work, why does anyone think QE3 will? What does it take for QE's to turn into W-2's; to paraphrase Dr. Gramm? Or, are my expectations to high? Is the economy so far pasted screwed that the light from screwed will take a million years to reach us? Do we have to keep engaging in poor choices just because it is the only option? The country reminds me of the scene in Pilgrim's Progress where the people in cages cannot repent and get out. They had gone so long in their bad behavior that there is no turning around, no opportunity for repentance. Are we so addicted to debt and spending that our destiny is already written. We have been "weighed in the balances and found wanting?"
Posted by: David Penwell at July 13, 2011 08:00 AM
For these event studies, it might be better to consider intraday values for the prices and yields being tracked - I suspect the daily closing prices aren't detailed enough to capture the reaction to the events as they occurred to capture a cause-effect relationship.
The greater detail might help resolve the question of causality - based on what we've observed elsewhere, if the reaction to the announcements begins within 2-4 minutes after they were made (assuming the markets weren't expecting the news - it would be nearly instantaneous if they were), then you'll know the announcements, rather than other factors, affected the direction of the markets.
Posted by: Ironman at July 13, 2011 08:02 AM
In any event, the QE's don't seem to have caused much harm, so far. So if they might have been (or were) modestly helpful, and not particularly harmful, then it may have been worth doing.
But it's tough to push on a string...
Posted by: Steven Kopits at July 13, 2011 08:04 AM
They were no compelling reasons to introduce a Fed led ZLB should the target be a zero tangential interest rates. Before the actual Fed chairman, the trend was built without apparent bottlenecks,the ECB and Fed primary dealers were coupling retention of primary issues,interest swaps and bonds futures.
The banks balance sheets were exhibiting an active liabilities assets management coupled with growing assets,the rating agencies never earmarked their profits,the auditors and comissaires aux comptes never qualified their accounts,BIS never cast a warning,the central banks never made any claims.
The new found puritanism required the Fed and CB to take their official shares of the Banks obesity and to help them to square their IRS and futures position.
Then what? IS LM has been lifted to gather with trust and confidence,the debts have been swiped out,the prices are in equilibrium, the risks have been removed,the savings have been uplifted,the macro accounts have a face lift.
All answers are available with Fred,ECB statistical warehouse,IMF statistics (please spend time on private savings when perusing this gallery of achievements by country)
I read the exhibits as supplied summary and papers they narrow the tropism ZLB works,worked in the US international and in the UK.
Causes are not touched upon,causations are sugestive.
Posted by: ppcm at July 13, 2011 08:18 AM
If the Fed really wanted to spur the economy, they should stop lending money only to banks. Open up shop and start giving loans to small businesses who can't get loans at the moment. Currently banks are borrowing money from the Fed a zero interest and buying treasuries and profiting the margin. Why take a risk on a small business which may default when you can put that money into secure treasuries and make predictable earnings. If the Fed went into competition with the Banks then the banks would want to start lending.
QE1 and QE2 and possibly QE3 now will not spur job growth unless that money gets into the hands of those who can hire people.
Posted by: Fed Zepplin at July 13, 2011 08:59 AM
QE1, QE2, QE3... watch closely now. Follow the shells and pick which QE the economic recovery is under....
Posted by: Bruce Hall at July 13, 2011 09:38 AM
Instead of pushing on a string, as Steven puts it, the Fed could pull very hard by announcing an inflation target of four or five percent for the next ten years and then do whatever necessary to reach that target. This would lower real interest rates much more effectively than quantitative easing and also help repair household balance sheets. After all, this is at its core a balance sheet recession.
Instead we have a timid Fed that is aiming for a miserly 2 percent inflation and achieving 1.5. Bernanke has become the feckless banker for which he chided the Japanese.
Posted by: Joseph at July 13, 2011 09:39 AM
Event studies are have critical flows.
First, markets are rarely completely surprised by an announcement. To the extent policies are discounted in advance, event study windows are too narrow to capture this reaction.
Second, markets discount both the probability that a policy announcement will occur; and the probability that once it will occur, it will have the expected effect. Event studies do not capture this "conditional probability" aspect of a market's reaction to policy.
Given the above flaws, why do economists cite event studies as proof of anything?
Posted by: David Pearson at July 13, 2011 09:46 AM
Professor you responded (and thank you)
"My topic here was whether monetary policy could still do anything even when the short-term interest rate is driven to zero."
That was my point. The Fed can do something. QEIII is doing something. But everything the Fed has done so far is at best temporary and those temporary results of its action are diminishing as the market exhibits less surprise. The fact is monetary policy outside long term currency stability isn't just overrated, it is down right bad thinking. The problem with today's economy is the the country has reached its tax capacity and exceeded its regulation capacity. It is a fiscal problem.
The reason you have seen little harm (as you hint)so far, is because the bill will be paid in the future. Either real interest rates will rise, above historical average, because of inflation expectations if the Fed is lax at withdrawing excess money, or the same will happen due to higher demand for credit if the Fed does withdraw.
The best the Fed can do now is to return to predictable slow steady monetary growth. And to inform the fiscal side of government that interest rates will be allowed to rise if the market demands higher return on government securities. Only reduced deficit can moderate where the inevitable will be.
Posted by: Ed Hanson at July 13, 2011 11:55 AM
I'm not sure QE has been no harm. If the treasury wasn't borrowing so much, I'd agree.
I think they've shifted lending to the treasury and away from the private sector. While the banks may not have lent to the private sector even without QE, they've likely been funding very bad investments (ie. government spending).
My econ 101 is a bit rusty, when calculating GDP, is borrowed money subtracted out of government spending? Shouldn't it be?
Posted by: aaron at July 13, 2011 12:12 PM
No harm from QE2? The Fed funds ~70% of all new gov't debt, on the order of $1 TRILLION of false savings created out of thin air, & no harm?
Fooling market participants about the abundance/scarcity of savings on this order is not trivial harm. Decisions have been & are being made based on these artificially depressed 10yr rates as to the viability of & sustainable demand for all kinds of projects. They are being made with bad information. With distorted relative prices.
Are retired people or insurance companies who are absolutely dependent on safe deployment of their savings with a reasonable return not harmed by 2.9% 10 Treas. [that is guaranteed to lose you money] rate?
Vast numbers of investors who have been pushed out the risk curve to get any return will probably live to regret it.
What about the moral hazard encouraged upon the Federal govt to borrow like drunken Keynesians, falsely secure that it isn't very expensive, since true market interest rates can be pushed off into the future? The 10 year eventually assuming a positive real interest rate of ~5-5.5% would wipe out all the savings of a Simpson-Bowles or a Ryan plan!
I'm sure I'm just scratching the surface of harm.
Posted by: Bryce at July 13, 2011 02:57 PM
Sorry, I just don't understand this opposition to QE2 or a possible QE3. Yes, I suppose there are some risks associated with quantitative easing, but unless the Fed is taken over by complete Tea Party lunatics (or perhaps Charles Plosser), I am pretty sure that the Fed has the resources and intelligence to manage an unwinding of QE2/3 in a fairly orderly fashion. The bigger risk is that the Fed will unwind things too soon. And compared to the downside risk of the Fed doing nothing, this just seems like a no brainer. I don't expect QE3 to accomplish a lot, but a little is still better than nothing.
aaron Yes, your econ 101 is a bit rusty. Borrowed money is not subtracted out of GDP. GDP is a measure of the amount of final goods and services produced domestically in one year. In a simple flow diagram gross domestic income (GDI) should equal gross domestic product (GDP). One is dual to the other. Setting aside govt spending and net exports, GDI income is either consumed or saved. If saved, then there has to be a borrower. Note, our problem today is that S is greater than I, so there is leakage...think of stuffing money in the mattress as a leak in the GDI flow model. Because people want to save more than people want to invest, income must shrink to bring the two into equilibrium. That's called a recession. If we want to increase GDP, then we need more borrowing, not less.
Posted by: 2slugbaits at July 13, 2011 03:28 PM
I'm with David Pearson; the event studies method is deeply flawed. Newspaper reporting on "event-driven" market price changes is routinely ridiculed (for good reason) by market participants, and the extension of that into economic analysis seems deeply flawed. I don't think you can turn lead into gold just by statistically aggregating the lead and hoping that the gold sifts out in the balance!
Are the immediate market effects of policy announcements driven by the technical policy content of the announcements, or by what the announcements reveal about the state of mind of the policymakers?
Given that the market is made up of individual human beings who often need time to digest the implications of events, does a single-day event analysis even make sense?
Over the last two days we saw the release of Fed minutes hinting at QE3, then we had Bernanke's Humphrey-Hawkins more explicitly hinting at QE3. The immediate stock market reaction (within moments) was a sudden rise... and a bond market selloff... but in both cases followed by a longer reversal. So is QE3 good or bad for the economy? Or is the market unhappy that the economy seems to have gotten so bad that the Fed already needs to mention QE3 less than a month after QE2 ended? Or is the market actually tensed up over something else altogether (debt ceiling debate and implied change in fiscal policy? Greek/Irish/Portuguese/Italian/Spanish crises flaring up?) and just twitching in response to whatever stimulus is presented by the media? There's no way to tell with any degree of certainty.
Personally I think that too many are too focused on market perceptions, on perceived "stocks of assets" rather than real cash flows. The real economy, where the vast majority of global GDP is generated (and other forms of genuine wealth which may not be measured by GDP), depends on the daily choices of billions of people who live, thrive or suffer, and then die... That is a few layers deeper down than Wall Street. Does making waves on Wall Street actually tell anyone anything about what's going on at the bottom of the ocean?
Looking at the U.S., it seems that we need to return to a "value" mindset rather than a "capital gains" or "price growth" mindset: Is the overall population of the United States better off with expensive housing (and tons of debt used to purchase it), or with cheap housing (and less debt)? Are they better off with savings vehicles paying high interest yields or low yields? Are they better off investing in stocks that have high prices, but low dividend yields and reduced prospects for future capital returns -- or with stocks ?)
Are the financial elites (who control the banks which own the Federal Reserve) better off living amongst a financially healthy, hard-working population eager to get to a bright future, or a financially ill population struggling just to survive and with grave doubts about the future?
Posted by: Wisdom Seeker at July 13, 2011 03:48 PM
WS, three years say they want high prices and low-no yield in the long run, and a drepressed, un-motivated population.
Posted by: aaron at July 13, 2011 04:53 PM
"If the Fed really wanted to spur the economy, they should stop lending money only to banks. Open up shop and start giving loans to small businesses who can't get loans at the moment. Currently banks are borrowing money from the Fed a zero interest and buying treasuries and profiting the margin. Why take a risk on a small business which may default when you can put that money into secure treasuries and make predictable earnings. If the Fed went into competition with the Banks then the banks would want to start lending.
QE1 and QE2 and possibly QE3 now will not spur job growth unless that money gets into the hands of those who can hire people."
Sorry...but this is the same flawed logic that the the FED / monetarists use. Our economy HAS run on credit for 25 years now...but that paradigm is unsustainable.
Businesses NEVER use credit to just hire people. They use credit when the proven rate of growth in sales and revenues is greater than their ability to expand their business activity with assets in hand! In other words...it is arbitrage between the COST OF BORROWED MONEY vs. RETURN ON THAT MONEY!!
If you can get a loan at 6%, and by investing in equipment and personnel...you can make 15% on that...you borrow the money! Right now...businesses are losing customers. There is NO GROWTH!
Our family business, with total revenues is the range of $1.2M, and about 10 employees...has seen revenue fall every quarter for 2+ years no. Please explain WHY we would borrow money just because it is there. There is no where to make a return, greater than the cost of money.
Frankly...if loans were made available to us...we would do the same things the banks are doing...invest in no risk assets....if there is such a thing.
Posted by: BTW at July 13, 2011 06:08 PM
Consider, if you dare, US income and wealth concentration in the context of central bank debt-money reserve expansion and US gov't deficit spending since '08 of equivalent to nearly 50% of private GDP.
The top 1% of US households receive income that is equivalent to nearly the entire GDP of Germany, with only the US, Japan, and China with larger GDPs than the top 1% receive in income.
Moreover, the top 1% have financial wealth that is significantly larger than the entire aggregate EU GDP.
The top 1% could lose 90% of their wealth and still have wealth exceeding every other country's GDP save for the top eight economies (US, China, Japan, Germany, France, UK, Brazil, and Italy).
The point is that any debt-based growth of spending and asset inflation will by definition benefit the top 1-10% of US households who hold 85% of financial wealth and receive half of US income.
With US and global wealth and income so extremely concentrated to a bit more than 1-10 million US households, the debt- and asset-based economy disproportionately (exclusively?) benefits those with assets, which does not include the bottom 90% of households.
The Fed printing just causes the multiplier and velocity to collapse further as the net liquidity remains circulating in the banking system, net incremental gov't deficits (with low multiplier), and speculative assets, not labor's share of the economy.
Then add in the effect of US oil consumption of 7% of private GDP (growing at 25-30%/yr.), and there can be no net incremental growth of real private per capita GDP, no matter how much the Fed prints and the gov't deficit spends itself into insolvency.
Roll back the so-called Bush tax cuts, and you get perhaps $110 billion in revenues against a $1.3 trillion deficit and gov't spending growth of $225 billion. Where's the net benefit?
Freeze gov't spending at today's level and get rid of the Bush tax cuts, and the nominal GDP will contract ~1.6% or $240 against a revenue increase of $110. No net benefit there.
Posted by: Bruce at July 13, 2011 06:36 PM
But allow bubble mortgage holders to trade the non asset backed portion of their debt for prioritized, unforgivable debt at zero percent. That will be stimulus. Or allow them to refinance at rates reduced by the same amount as the average drop in asset values...
Anything that gets existing financial servicing costs down, will act as stimulus. More importantly, it will move us toward long run growth. The focus on new debt has been a mistake.
And again, so long ad we're confident in low rates, government borrowing isn't such a problem, its how the money is used. Spending is double counted, outlays are considered product regardless of the value. Tax cuts are not.
Posted by: aaron at July 14, 2011 04:08 AM
Wouldn't it be just easier not to issue the bonds in the first place. It's not as if they are needed in a fiat economy.
This idea that reserves causes inflation is based on the money multiplier theories and loanable funds and they've already been debunked fairly thoroughly.
Posted by: Neil Wilson at July 14, 2011 05:55 AM
"...I am pretty sure that the Fed has the resources and intelligence to manage an unwinding of QE2/3 in a fairly orderly fashion...."
I've thought (and read here and elsewhere) about the QE's a bit and keep coming to the same question / conclusion: that the Fed has an inherent problem in that when it raises iterest rates it can adversly affect the value of its assets and its ability to sterilize 100% of excess reserves. And if the Fed wanted to ensure that they could roll back any QE it might make sense to do QE with reverse repos instead of outright purchases.
Am I thinking about this correctly? And thanks for all your thoughtful postings.
Posted by: Rob at July 14, 2011 11:02 AM
This debate is effectively over -- when Bernanke floated QE3, the market roared, when he doused it with cold water, the market retreated.
Gentleman, the market has spoken. QE works.
Posted by: Calomine Lotion at July 15, 2011 09:20 AM
Rob Rolling back QE1 and QE2 is not an immediate problem for the Fed, but (with a little luck) eventually it will be. I suspect that the Fed envisions a very slow recovery over the next several years. Slow enough that the amount of assets on its balance sheet will gradually come down even though the interest rate will be stuck at near zero. But if the economy starts to heat up, the Fed does have a Plan B option, and that's to simply raise the amount that it pays for banks to keep reserves on hand. Between those two tools I think the Fed should be able to unwind QE1 and QE2 in a fairly orderly way. And it's not like these would be especially complicated operations.
Posted by: 2slugbaits at July 16, 2011 07:06 AM
2slugs: Thank you. Prior to your response I had gone searching for the answer and chanced upon the below link, which you crystalized (30 min down to one!). But still no thoughts about reverse repos as a measure to preserve the integrity of the Fed's BS, or thoughts about alternative measures, i.e., increasing reserve requirements? If I'm asking stupid questions, please point out why (I come here to learn and you're a patient prof.).
Posted by: Rob at July 16, 2011 03:16 PM
Rob Increasing reserve requirements seems like overkill. Things would have to get pretty out of control before that would start to look like something we should consider. As to repos, I think the Fed would rather deal with a gradual phasing out of safe assets as they come due and give the higher risk securities time to improve. But at this point I don't believe we really ought to be thinking too hard about unwinding QE1 and QE2. I'd rather the Fed concentrated on QE3.
BTW, I'm not a prof.
Posted by: 2slugbaits at July 16, 2011 09:24 PM
The euro is still over $1.40. I admit I don't know whether a more reasonable level of $1.20 would have much ameliorated the intensity of crisis in the area, but what seems clear is that the overvaluluation of the euro (and a few other currencies that have "played by the rules") is the main effect of Ben's QE, just as the yen carry trade and an undervalued yen were the main effect of Japan's QE. I doubt Ben has done anything with his QE other than the old beggar-thy-neighbor currency devaluation strategy of the GD. Problem is, that policy is being followed much more effectively in Asia and the only party in a position to do something about it (Timmy at Treasury) won't.
Who am I to say the euro "belongs" at about $1.20? The same guy who said (a long time ago and more than once) that the yen "belonged" at about 80/dollar, when it was over 100/dollar and seemed unlikely to be allowed to go below that amount.
Posted by: don at July 18, 2011 11:16 AM