Sunday, January 10, 2016

So much for QE (guest post)


I thought it would be interesting to post a private-sector economist's views on macroeconomic policy. So here's a guest post by Gerard MacDonell, who was an economist at Point72 Asset Management, (previously SAC) from 2004 through 2015:


"So Much for the QE Stimulus"

Last month’s Press Release from the FOMC announcing the first rate hike in a decade contained a seemingly-innocuous and yet telling discussion of the interaction between interest rate and balance sheet policy.  It marked the end of false confidence in the efficacy of quantitative ease (QE), which can be traced to a technical error Ben Bernanke made while lecturing the Japanese on deflation in 1999.
The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.  
…The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way. 
The passages above were not a major departure or surprise to the markets, but they confirm that the Fed leadership has now abandoned its original story about how QE affects the economy and has conceded that the tool is weak.  If QE were strong, the balance sheet could not remain large even as the Fed promised to raise rates only gradually.

It has long been obvious that QE operated mainly through signaling and confidence channels, which wore off on their own without any adjustment in the size or composition of the Fed’s balance sheet. Accordingly, QE cannot be relied upon to provide much help in the next economic downturn, which means the Fed will have to tread carefully to avoid a return to the zero bound.

The story initially told by the Fed leadership starts with the claim that large scale asset purchases (LSAPs) reduce the term premium and expected returns in government securities, by removing default-free interest rate duration from the capital markets.  This is meant to encourage portfolio flows out of government securities and into corporate debt, equities and foreign currencies. And the resulting easing of financial conditions is supposed to stimulate spending to reduce unemployment, contain deflation risk and eventually push inflation back to target.

That story does not hold much water. The theoretical foundations supporting QE were invented – or really revived from the 1950s – in an effort to justify a program that had been resolved upon for other reasons.  LSAPs did not actually succeed in reducing the stock of government rates duration because they were fully offset by the fiscal deficit and the Treasury’s program of extending the maturity of the federal debt. And while the estimated term premium and bond yields did go down during the QE era of late 2008 through late 2014, they had a disconcerting tendency to rise while LSAPs were ongoing.  This latter point squares with contemporary finance theory but not with the 1950s-style portfolio balance channel asserted by the Fed, which presumes more durable segmentation than applies to US government securities.

There are still believers in the QE story, in both academia and the markets.  However, the Fed has abandoned the flock it once led.  If the leadership still believed the official story, it could not promise both to maintain the size of the balance sheet and raise rates at an historically slow pace.  That would deliver far too much stimulus, particularly with the economy now near full employment. The obvious way to square this circle to recognize that the Fed does not believe the story, which is an advance.

Peak QE gullibility seems to have been reached in the late summer of 2012, with Ben
Bernanke’s presentation to the Kansas City Fed’s monetary policy conference at Jackson Hole.  In that speech, the Chairman asserted that the first two rounds of LSAPs plus the maturity extension program (to that point) had reduced 10-year Treasury yields by 80 to 120 basis points.

Since these comments were made, further maturity extension and the third round of QE have raised the total stock of rates duration on the on the Fed’s balance sheet (measured in 10-year equivalents and as a share of GDP) by about 50%.

So assuming assuming a linear relationship between QE and yields, the estimated impact of the entire QE program would be a reduction in the 10-year Treasury yield of 120 to 180 basis points. That is a lot.   Moreover, according to the original story, little of this presumed stimulus would unwind without asset sales or a passive shortening of maturities, both of which have largely been excluded for now.

Roughly around the time of QE3, it became fashionable to measure quantitative ease in terms of a fed funds rate cut (below zero) that it effectively equated to. Thus was born – or again revived – the so called shadow fed funds rate.  In fairness to advocates of the concept, some of whom were Fed officials, the shadow rate was estimated with bond yields and was not just the result of an accounting exercise chopping presumed QE effects off the nominal funds rate.

Still, the fashion was to ascribe the negativity of the shadow rate largely to the LSAPs or what we call QE.  Estimates of the shadow funds rate at the conclusion of the LSAPs in late 2014 ranged from -2 to -5%, which meant -- if taken seriously – that the Fed would have a lot of wood to chop once the time to tighten policy had arrived.

Readers of this comment may recall those charts circulated by Wall Street showing the fed funds equivalent going deeply and shockingly negative after 2009. In retrospect, those charts are cringe-inducing and best forgotten.  It is a mercy that the Fed has participated in the forgetting. For those who do not want to forget, the estimated shadow rate has recently spiked to around the nominal funds rate, even without asset sales from the Fed’s balance sheet. Oops.

This raises the question of why the Fed initially promoted a story that so obviously would not stand the test of time.  We can imagine three possibilities, the third of which is the most speculative and, if true, the most interesting.

The first possibility relates to the first round of event studies, which measured the immediate effects on the term premium and bond yields of QE-related news.  The initial application of QE occurred in the context of financial crisis and unusually high market segmentation, even in Treasuries, so those event studies understandably found large effects.

Announcement effects are a poor measure of fundamental effects that will endure long enough to affect the economy, particularly when markets are functioning normally, as they roughly have since mid-2009.  The reason is that markets typically act more segmented in the short run than over time, and this is particularly the case in the market for government securities.  But smart and credentialed people argued otherwise and the FOMC may have been comforted by that.

The second possibility is that the Fed wanted to raise confidence in the markets and real economy and thus chose to communicate that it was wielding a new and fundamentally powerful tool, even if Fed officials had their own doubts.  Unlike in the case of the term premium and bond yields, there is compelling evidence that applications of QE led to durable changes in equity prices and inflation expectations that may have been somewhat stimulative.

It is best to lift confidence with tools that have a mechanical force and do not rely purely on confidence effects. But if such tools are not readily available, then it probably does not hurt to try magic tricks and pyrotechnics.

The problem looking forward is that people may not be so responsive to the symbolism of QE next time around.  After all, the Fed is now revealing its true or updated beliefs, which may be hard to cover back up come the next downturn.  Moreover, the Bank of Japan has got hold of QE, which raises the odds it will be properly discredited, if history guides.

The third possibility involves some “blue-sky thinking”, to steal a term Ben Bernanke used in his book, The Courage to Act.  It is possible, although unproven, that Bernanke and his colleagues in Fed circles were durably confused by Bernanke’s early and mistaken relation of the Quantity Theory to the efficacy of LSAPs.

He made this mistake most famously in his 2002 Helicopter Ben speech, but it is easier to identify in his 1999 essay lecturing the Japanese on how to escape deflation.  To motivate his recommendation of LSAPs and other stimulative measures the Japanese might take, Bernanke made the following points:
The general argument that the monetary authorities can increase aggregate demand and prices, even if the nominal interest rate is zero, is as follows: Money, unlike other forms of government debt, pays zero interest and has infinite maturity. The monetary authorities can issue as much money as they like. Hence, if the price level were truly independent of money issuance, then the monetary authorities could use the money they create to acquire indefinite quantities of goods and assets. This is manifestly impossible in equilibrium. Therefore, money issuance must ultimately raise the price level, even if nominal interest rates are bounded at zero. This is an elementary argument, but, as we will see, it is quite corrosive of claims of monetary impotence. 
There are a couple striking aspects of this passage.  For starters, Bernanke attempts to port the spirit of inevitability implicit in the Quantity Theory over to the idea of LSAPs. This is inappropriate because there is no quantitative aspect to the program, as Bernanke himself would later insist, while assuring us that QE would not be inflationary. But one must wonder if this misapplication of the Quantity Theory to LSAPs created in Bernanke and associates an excessive confidence in the efficacy of the program.  As late as 2002, he seemed to believe there was a sense in which simple logic implies LSAPs just had to work as a matter of “elementary” quantitative logic.

Separately and amazingly, Bernanke actually makes a technical error of economics when he claims that increments to the money stock, as he defines it, always have an infinite maturity.  A rise of the monetary base will indeed have infinite maturity if it driven by normal economic growth and the Fed successfully pursuing its inflation objective. In such a situation, gains of the monetary base will show up in higher currency in circulation and (to a lesser extent) a rise of required reserves.

However, that is not really relevant to the case for LSAPs. Increases of the narrow money stock driven by a surge in excess reserves to fund asset purchases designed to drive the economy out of liquidity trap do not have infinite maturity.  Again, Bernanke would later argue this point himself, and demonstrate it by paying interest on excess reserves, thereby by converting them from money to debt. Bernanke’s money injection actually had ZERO maturity.  Or more to the point, it did not even happen.

The only way LSAPs could be considered a quantitative operation would be if the scale of them communicated something about the tolerable inflation rate. But this was specifically excluded in 2012 when Bernanke and colleagues on the FOMC formalized 2% as the unchanged inflation objective.

The Fed leadership has come a long way from believing that QE had something to do with the power of the printing press to a recognition that the program is a combination of an indirect and transitory rates signal, a confidence game, and a duration take out that probably achieved much less than was advertised. But at least the journey has been made, which has reduced the risk of a contractionary policy error.


Updates

Tony Yates responds.

27 comments:

  1. I didn't find it very interesting. Every time inflation expectations dipped, they did a QE and they went back up again, and this in the face of unprecedented fiscal austerity courtesy of the Republicans in Congress.

    I would agree that they did the weakest possible version of unconventional policy. They could target long-term rates outright and/or raise the inflation target.

    They could do a "People's QE" also known as monetary-financing. Any of those would work much better and the recovery wouldn't take 8+ years.

    It's a mistake to give the impression that QE doesn't work and the Fed will run out ammunition the next time it hits the Zero Lower Bound.

    If QE didn't work that means the economy simply "healed itself." I don't buy it. Without QE it would have settled into a lower equilibrium.

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    1. That's not what the author is arguing. He is saying that QE didn't work by the mechanism that Fed officials originally claimed. And he is noting how subsequent behavior neutralized the ostensible reasoning behind QE.

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    2. I found it difficult to understand what the writer was saying. Perhaps he share the criticism of David Glasner:

      http://uneasymoney.com/2015/10/15/bernankes-continuing-confusion-about-how-monetary-policy-works/

      http://uneasymoney.com/2012/09/02/the-good-news-and-the-very-bad-news-about-bernankes-speech/

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    3. Anonymous7:57 AM

      I agree with Peter here. This guy is clearly quite confused and just wrote a lot of nonsense.

      Every time QE was done, it had precisely the impact in the market consistent with QE working. This includes the impact on LT bonds, inflation expectations, and the exchange rate. The author seems to explain this by the market being "fooled" each and every time... This despite that a basic model or intuition suggests that the Fed should be able to push down LT yields if it wants, or debase the value of the dollar if it pleases. Thus, I see no reason to believe that all the immediate impacts we see in the markets were just that the Fed (and ECB, Bank of England, Japan, etc.) were just able to pull the wool over the eyes of the markets each and every time. Thus, he must believe that agents aren't rationale, markets aren't efficient, or that every bond trader on Wall Street is an idiot.

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  2. That's very perceptive. Probably the best thing I've read in the blogosphere about QE. Though I'm not sure about this:

    "...the Fed leadership has now abandoned its original story about how QE affects the economy and has conceded that the tool is weak."

    I think if you read their public statements, you won't come away with that impression.

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    1. Not sure what you're objecting to. Gerald seemed to get most of this right, including:

      1. The justification for QE came from 1950s economic "theory."
      2. Empirical support for its claimed effects is weak or non-existent - mainly event studies.
      3. The likely effects, if there were any, come from how QE signals the path of future policy.

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    2. Isn't 3 rather important, though?

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    3. Isn't 3 rather important, though?

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    4. Not sure. Obviously hard to measure.

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  3. Anonymous6:24 PM

    Guy who spent 8 years acting as window dressing for the biggest inside trader in the US market turns out not particularly good at understanding QE, but enjoys verbosity. Whats the matter, Noah, was Madoff's economist unavailable?

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    1. Anonymous11:19 AM

      I'm on side with this guy.

      I generally love the content of this blog so I was interested to see what you brought in as a guest post. Unfortunately the entire thing was borderline incomprehensible.

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    2. I think it's very interesting to see how financial-sector economists think about these things. Don't you???

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    3. Anonymous10:16 AM

      I suppose when you put it that way it was rather "interesting".

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  4. Noah, I'm not an economist, and I read you because you explain stuff in clear, understandable English. Clearly, economists understand this guy, bit I can't. The man can't write two coherent sentences in a row, and he's too lazy or ignorant to proof read. If you're going publish stuff like this, please edit aggressively.

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  5. The post makes several claims that do not seem to hold water:

    1. Large-scale asset purchases were not responsible for pushing down interest rates. There is no way this can be theoretically correct. If the market price of a bond is $100 and its yield is x%, then to persuade the holder of the bond to sell the bond the Fed would have to offer him more than $100 and that would automatically lower the yield below x%.

    The graph on http://www.philipji.com/item/2015-08-26/real-interest-rates-paint-a-gloomy-picture seems to confirm this.

    2. If the Fed can maintain the size of the balance sheet and still raise the Fed Funds Rate, its claim that asset purchases lowered interest rates must be wrong.

    But this assumes that the size of the Fed's balance sheet is a proxy for the economy's money supply and the Fed Funds rate is a proxy for the economy's interest rates. Both are wrong as can be seen from http://www.philipji.com/item/2015-12-05/the-fed-is-set-to-squeeze-during-a-monetary-contraction

    Since QE ended, the growth in money supply (my measure) has fallen steeply and at the same time the real interest rate seen in the first graph has risen.

    The YoY growth rate of money supply is now about 4% and getting close to zero. Towards the later part of this year we will be sure to see a major asset market crash. So only one claim in the post is correct: that QE has only served to inflate the prices of risk assets.

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  6. This post is completely wrong. As the Director of the Fed's Monetary Affairs division, Thomas Laubach, makes clear in his paper at the IMF's Polak conference last November, Fed staff believe that QE purchases continue to weigh on long-term interest rates as long as the Fed holds the assets. Most market participants understand this. (http://www.imf.org/external/np/res/seminars/2015/arc/index.htm)

    The Fed is free to raise the short-term rate as it wishes. The portfolio continues to weigh on the slope of the curve. You can be sure that if they were to sell a lot of long-term bonds, the curve would get steeper. Bernanke's 1999 paper was written before the Fed had the power to pay interest on reserves and thus raise the short rate with a large balance sheet.

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  7. "The only way LSAPs could be considered a quantitative operation would be if the scale of them communicated something about the tolerable inflation rate. But this was specifically excluded in 2012 when Bernanke and colleagues on the FOMC formalized 2% as the unchanged inflation objective."

    So why is the author railing against QE, rather than railing against the inflation ceiling (as many in the blogosphere have done)

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  8. "The obvious way to square this circle to recognize that the Fed does not believe the story, which is an advance."

    It may be an advance of understanding, but the Fed is undermining itself if it repudiates its own tools.

    The thing that makes QE work is the Fed's belief that QE works. Because if the Fed believes in it, then it can be taken as an authentic statement of Fed policy, i.e. what the Fed really wants, as opposed to what it says it wants. That's a valuable thing to be able to communicate.

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    1. You're a smart guy, Max to make sense of that god awful semi-literate sentence. Why make the effort?

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  9. Can someone tell me what "stock of rates duration" means? I'm imagining that MacDonell means the average maturity of liabilities of the Fed's balance sheet. Is that correct?

    This post strikes me as a death spiral of reasoning from a price change. Imagine my surprise upon finding that, after traversing this mine field, MacDonell comes out on the other side with the conclusion that monetary policy has not been accommodative in the 2007-present period. I don't agree with the exact steps he takes to get there, but at least it is the correct conclusion.

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  10. Seconding Sam's observation - the author seems to be saying - 'such a terrible lunch, and the portions are so small'...

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  11. Sam H3:36 PM

    He seems to be unfamiliar with recent empirical work (or just doesn't believe it). See e.g. supporting evidence of price effects and looking more at quantity effects in the mortgage market: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2700354

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  12. Sorry if this response to comments reads a bit conclusory. Noah very kindly indulged me by allowing a longish post and I don’t want to stink up the comments section too. So I put a premium on being brief. Even with that, I still end up long.

    First, thanks to all for reading and commenting on my ridiculous post. Not everybody agrees on this stuff, perhaps because the view that QE is potent has proven such an impressive aid to forecasting. Guys just go from success to success.

    It is obvious that the story about how QE works or would work has shifted radically over the past fifteen years or so. For turn-of-century Bernanke, LSAPs were meant to be an expression of the quantity theory or the “power of the printing press”, whose efficacy was inevitable and “elementary.” By 2009 it had morphed into something that relied on market segmentation and event studies that assume it away. And for the recent Yellen Fed, QE is something that can be pretty safely assumed a zero, while they go about using their relevant tool, which is interest rate policy and the guidance around it. In my view this is progress and a sign that the Fed is ultimately practical. But it does not reflect very well on the original story or the show put on at half time.

    The Treasury owns the financial results of the Fed and the Fed’s inflation objective is explicitly independent of the size of the LSAPs. Given these facts, it is “elementary” that the MECHANICS of QE are a fiscal operation, specifically a shortening of the effective maturity of the federal government debt. Woodford and Summers have been clear on this, perhaps clearer than me. You might want to read Woodford to Jackson Hole or Summers to Brookings. Not that they are necessarily right. Maybe they just put it more convincingly than I have.

    Beyond the mechanics, there is the symbolism and signaling, which is where the action has been. Importantly, the signaling and symbolism has nothing to do with inflation, though. QE says nothing about the Fed’s inflation objective, regardless of how long the monetary base expansion is left in place. The Fed has an explicit inflation objective and the part of the monetary base that expands on QE is systematically the part that is converted to debt anyways. In my view, market monetarists do a bit of disservice when they don’t lead with this simple point.

    Rather, the signaling and symbolism come in two other forms. First, there is the implied interest rate signal. As I mentioned in the post, this is important, but not part of the original story. And the Fed’s behavior after QE was wound up has shown that rates signaling does not require reinforcement from the balance sheet. Rates signaling requires only that the Fed be clear, which it has occasionally had trouble with, understandably. But when the Fed was clear, the markets snapped to attention.

    The relevant symbolism is the Lethal Weapon effect. For a while there, Mel Bernanke was strutting around with his eyes bulging out, shaking visibly and making crazy talk about using the “printing press.” That probably scared and confused the bad guys into briefly looking for higher inflation and buying equities, which may have been marginally helpful to the economy, even though they could not really tell a coherent story about why they were doing it.

    But none of this has anything to do with what was on the label when QE started. I find it odd that these simple points always meet resistance. Maybe I could have expressed them more clearly? For me, it has been several years now. You’d think people would grow tired of endorsing a perspective that predicts so badly. But you would be wrong.

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  13. And for the recent Yellen Fed, QE is something that can be pretty safely assumed a zero, while they go about using their relevant tool, which is interest rate policy and the guidance around it.

    Where do you get that Yellen's Fed is ascribing a weight of zero to QE? If I look at the December press release when they raised rates, they explicitly mention that they're going to keep rolling the portfolio and that this will "help maintain accommodative financial conditions". That may not be what was originally promised, but it's not quite zero either.

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  14. Also, if the Fed's QE program only worked initially because people didn't understand it, why did other central banks, such as Japan and the ECB, take up QE just as the Fed was scaling it down? Surely if it had proven to be meaningless they wouldn't have bothered.

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  15. This is actually quite good, as an analysis of the evolution of Bernanke/Yellen thinking. But it is indeed difficult to read. For all the Sumnerites and other devotees of the quantity theory of money who are objecting, the key point is that Bernanke’s 1999 comments didn’t hold true for QE as he practiced because it wasn’t spent in the real economy.

    What he doesn’t get into is the possibility that the next downturn will create a consensus for doing that – either monetary financing of fiscal stimulus, a la Wren-Lewis or MMT, or central bank lending to / purchases of bonds from non-financial companies, as Sumner and Cowen seem to be suggesting.

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