What's in a name
Let's start by clearing up an oft-misunderstood point. The Fed did not actually engage in what we typically think of as "quantitative easing", the way that the Bank of Japan did during the early 2000s.
So "QE2" (I'll revert to the common shorthand for convenience) was not intended to create money, and did not create money. Instead, the program was intended to help the recovery by reducing long-term interest rates. The Fed did that by selling short-term assets and buying long-term bonds -- that's really the essence of LSAP. (Since the Fed doesn't normally buy a lot of long-term bonds, this program was new and got a special name, but it's fundamentally quite a simple idea.) And the hope was that by buying some long-term bonds and thereby lowering long term interest rates, QE2 would help stimulate demand.(2)
What QE2 didn't do
Before we examine what QE2 did do, it's helpful to understand what it didn't do. A lot of the evils of the world have been wrongly attributed to QE2 in recent months. Here are some frequent criticisms:
- QE2 has caused rampant inflation.
- QE2 has artificially inflated asset prices such as the stock market.
- QE2 has devalued the dollar.
- QE2 simply didn't work.
1. Inflation: Critics say that all of the money pumped into the economy by QE2 has caused a surge in prices. Yet we know that QE2 has actually not created any additional money. So it's hard to see how QE2 has caused inflation. Furthermore, it's quite straightforward to trace the recent rise in global food and commodity prices to certain specific factors such as turmoil in the Middle East and several bad harvests for grains and vegetables (Russia, Argentina, Australia, Mexico).
2. Asset prices: Critics say that by purchasing long-term assets, the Fed has flooded the financial markets with cash, causing all asset prices to rise. A more sophisticated variant of this criticism is that by driving long-term interest rates down, QE2 has forced investors to seek higher returns in other types of assets, driving their prices up. But there are several problems with this theory. First, QE2 created no money (not to beat a dead horse or anything), so any notion that there was a broad injection of liquidity that caused commodity price inflation is wrong. Second, many of these same critics say that QE2 hasn't worked (point 4), and they point to the fact that long-term interest rates are no lower now than they were in the fall of 2010. But if interest rates weren't driven down, how could QE2 have caused asset prices to rise? (As shown below, the evidence is that interest rates actually did go down in response to QE2, but that is not generally recognized by QE2's critics.) Finally, the Fed has only purchased $600bn in long-term US government bonds. That's less than 5% of the US government bonds in existence, and probably well under 1% of the value of all types of traded assets (stocks, bonds, commodities, real estate). Even though the evidence (see below) is that QE2 was able to push down interest rates a bit, it doesn't seem likely that such a relatively tiny influx of demand into bond markets could cause a dramatic change in overall asset prices outside of the bond market.
3. The value of the dollar: Critics say that QE2 weakened the dollar by causing inflation and/or by causing a loss of confidence in the dollar. But the dollar is just as strong as it was in the middle of 2008, and only about 3% weaker than it was in Oct 2010 when QE2 started. So no systematic weakening of the dollar is apparent, which makes it unclear why the critics of QE2 raise this complaint, since they do not typically make the correct comparison against what the dollar exchange rate would have been in the absence of QE2. But more importantly, even if QE2 has caused the dollar to be weaker than it would otherwise have been, we should be thankful for that -- a weaker dollar is exactly what the US economy needs right now to help stimulate demand. It would be a good thing right now, not a bad thing.
4. QE2 simply didn't work: Some critics say that it was a waste of money -- it cost $600 billion but the economy is still lousy. First of all, QE2 didn't actually cost anything -- the Fed still has that $600bn, it's just now in the form of US government bonds. But second, yes, I agree, the economy IS still lousy... but that doesn't tell us anything about whether QE2 worked. Without QE2, it's entirely possible that the economy could have been in even worse shape. So the correct comparison to understand the effects of QE2 is to try to understand what would have happened in the absence of QE2. This, the critics of QE2 do not do. (Plus, if you think that QE2 didn't have any effects, then you should really drop criticisms 1-3, which rely on the premise that QE2 was effective.)
In short, it's pretty unlikely that QE2 caused any of the terrible things its critics attribute to it. So did QE2 actually accomplish anything?
What QE2 did do
The correct way to figure out what QE2 did is to first try to estimate what would have happened without QE2, and then compare that with what actually did happen. And while that can be a tricky exercise, that's what economic research is all about, so let's see what the research has found.
- Krishnamurthy and Vissing-Jorgensen (Kellogg Northwestern): "The Effects of QE2 on Long-term Interest Rates" (pdf). They find that QE2 was likely to reduce interest rate on long-term AAA bonds by about 30 basis points, and rates on average long-term corporate bonds and mortgage loans by about 10 basis points, compared to what they would otherwise have been. They do not estimate what impact, if any, those interest changes had on real economic activity.
- Gagnon, Raskin, Remache, and Sack (New York Fed): "Large-Scale Asset Purchases by the Federal Reserve: Did They Work?" (pdf). Using two completely different methodologies they find that QE1 (which was about 3 times the size of QE2) reduced long-term interest rates by between 50 and 80 basis points. Based on that estimate, the implied effect of QE2 would be to reduce long-term interest rates by between roughly 15 and 30 basis points.
- Hamilton and Wu (UCSD / Chicago): "The Effectiveness of Alternative Monetary Policy Tools in a Zero Lower Bound Environment" (pdf). They estimate that a $400bn LSAP by the Fed would reduce long-term interest rates by about 13 basis points; a simple linear extrapolation of this result implies that QE2 would have reduced interest rates by about 20 basis points.
- D'Amico and King (FRB): "Flow and Stock Effects of Large-Scale Treasury Purchases" (pdf). They look at the stock and flow effects of the Fed's purchases of Treasury securities in 2009 to estimate their impact on interest rates. Their estimates imply that QE2 would have had a total impact on long-term interest rates of between 15 and 30 basis points.
- Chung, Laforte, Reifschneider, and Williams (FRB / SF Fed): "Estimating the Macroeconomic Effects of the Fed's Asset Purchases". Using the Fed's own large-scale model of the US economy (FRB/US), they estimate that QE2 pushed down long-term interest rates by about 25 basis points. They also use the FRB/US model to estimate the impact that this had on unemployment and output, and find that QE2 raised GDP by about 0.75%, and employment by about 700,000.
So... Was QE2 a good idea?
Unfortunately, QE2 is not the only thing that has affected the US economy over the past 6 months, and many of the other forces at work have negatively impacted the economy. So the small but positive effects of QE2 were swamped by the other things going on such as supply-side shocks, contractionary fiscal policies, the US Treasury's program of large scale asset sales (i.e. bond sales to finance the deficit) that directly undid much of the effect of QE2 on interest rates (see Jim Hamilton for more on that), and a discouraging lack of private demand.
So yes, I would say that QE2 was probably a good idea, but it was simply not a sufficiently powerful tool to be able to single-handedly ensure a good recovery in the face of all of these headwinds. It helped a bit at the margin, and may have played a crucial role in helping the US step away from a dangerous flirtation with deflation in 2010... but the problems facing the US economy are just too numerous and substantial. My conclusion is that the only policy tool powerful enough to really help the US economy right now would be a new round of expansionary fiscal policy. Unfortunately, that's about as likely as me winning an Oscar this year.
That doesn't mean that QE3 would be a bad idea. In fact, given the new and alarming weakness in the US recovery, I think that further expansionary monetary policy would be very much worth trying. I wouldn't expect a dramatic impact, but right now the US could use every little bit of help it could get. Unfortunately, QE3 is only slightly less unlikely than a new round of expansionary fiscal policy (maybe on par with the likelihood of me winning a Grammy). And that's too bad, because every month that goes by with current levels of unemployment causes permanent long-term damage to countless individual lives, as well as to the US economy as a whole.
UPDATE: text edited slightly for clarity.
(1) For more on the distinction between what the Fed actually did and "quantitative easing", take a look at this speech by Ben Bernanke from January 2009, especially the part about halfway through.
(2) There are a number of channels through which lower long-term interest rates could possibly stimulate demand, including wealth or portfolio effects, exchange rate effects, and direct interest rate effects.
You seem to contradict yourself here. In the first part, you seem to say that QE2 didn't affect asset prices, but in the second part you present evidence that it did affect asset prices (since bonds are assets -- and also substitutes, to some extent, for other kinds of assets). Moreover, I think some of those studies also suggest that QE2 affected (or would affect) the value of the dollar, and it seems implausible to me that QE2 could fail to affect the value of the dollar if it did affect bond yields.
ReplyDeleteAlso, you seem to ignore possible expectation/signalling effects of QE2. TIPS and other data suggest that inflation expectations increased fairly dramatically during the period that QE2 was being discussed and announced. That may be a coincidence, but I doubt it. I would say that the Fed's willingness to do something when the inflaiton rate got too low was a signal of the Fed's intention to avoid excessively low inflation rates. (The implication is that QE3, and QE4, and QE17, if necessry, will happen also if the inflation rate goes below 1% again.)
OK, I'm slow, so indulge me.
ReplyDeleteYou say that the Fed never intended for banks to actually lend out their new liquid reserves. They only wanted to reduce long-term interest rates.
So why did the Fed want to reduce long-term interest rates? Isn't the point of targeting low interest rates to spur additional lending?
I'm normally a big fan of your writing, Kash. Today, not so much. The habit of comparing some result now to a result at another time, as you did in your 4 points, is a bad one. We need to aim at understanding what the counterfactual would have been. Long end yields are no lower now than in the fall of 2010, but where were they likely to have been if the Fed had not engaged in a second round of asset purchases? The dollar is "only about 3% weaker" than at the beginning of the 2nd round of asset purchases, but where would it have been absent additional Fed purchases? There is lots more going on than just Fed purchases, so using market prices as evidence in isolation leads to mistaken conclusions. Counterfactuals are tough, particularly with exchange rates in the short term, but presenting the argument in any other way tempts us to make all sorts of specious comparisons.
ReplyDeleteYou earn only partial redemption by citing studies which do consider counterfactuals later on.
kharris: In fact, one of the central points of this post was exactly what you say: you cannot judge the effects of QE2 without looking at counterfactuals. None of the 4 criticisms of QE2 that I listed do that, however, which is a part of why they are misguided. That is why I wrote: "to understand the effects of QE2 is to try to understand what would have happened in the absence of QE2". That is also why I wrote: "QE2 is not the only thing that has affected the US economy over the past 6 months, and many of the other forces at work have negatively impacted the economy. So the small but positive effects of QE2 were swamped by the other things..." The four points I listed were my distillation of the criticisms of QE2, not my own analysis.
ReplyDeleteGuest: There are a few ways in which lower interest rates can spur demand even without increased bank lending. They can increase asset prices and thus wealth, stimulating demand. They can help persuade corporations to make investments in plant and equipment (since the alternative, keeping money in bonds, pays relatively poorly). They can help reduce the value of the dollar, spurring exports.
Andy Harless: I do agree that QE2 affected the price of long-term bonds; the point I was trying to make is that it is a leap to then say that it affected the price of other assets. Regarding the dollar, yes, it is likely that QE2 did weaken the dollar somewhat (though I haven't seen specific estimates of that); but my point was that that would be a good thing, not a bad thing. (I should clarify that in the post, since my original text was obviously not sufficiently clear on that point.) Finally, yes I agree that expectations are critical here, and that's exactly why I think QE2 may have played an important role in helping to avoid deflation in 2010. So if anything, QE2's effects were even more positive than the strict numerical estimations suggest.
Also, you ignore the way the program was actually set up to work. Sure, the reserves might stay with the banks, but the investors who would have purchased those bonds in the absence of the Fed program instead purchase stocks, commodities, and other assets that might earn higher rates than Treasuries, whose yields are suppressed. They may not be getting cash directly from the Fed, but investors's own cash reserves are freed up for other work. Fed officials have themselves stated this is the case. And it appears that at least some of that is speculative investment in food and energy. And none of it has ended up in the pockets of people who actually work for a living.
ReplyDeleteThe fact that QE2 did or did not create any money is irrelevant. For example, although reserve requirements were not binding in 1937, the increase in reserve requirements is still widely creditied with causing the 1937-38 contraction.
ReplyDeleteMy 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
8/26/10 0.92%
5/2/11 2.72%
6/3/11 2.10%
2) Asset Prices
S&P 500
8/26/10 1047
4/29/11 1364
6/3/11 1300
3) Exchange Rate
Trade Weighted Major Dollar Index
8/26/10 76.6
5/2/11 68.2
5/27/11 69.9
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.
(continued)
(continued)
ReplyDeleteIs there reason to believe QE2 has had an effect on real final sales of domestic product (a proxy for aggregate demand) and employment?
1) 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.
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