Friday, June 1, 2012

Quantitative Easing: The Conventional View

I ran across two pieces by well-known macroeconomists that support - wholeheartedly - the Fed's view of why it conducts quantitative easing (QE) exercises, and why QE is supposed to work. The first is by Miles Kimball, in a blog piece intended for a wide audience. The second is this paper by Roger Farmer, which is a quasi-formal approach to the question.

Kimball's narrative would make any Old Keynesian or New Keynesian comfortable. Here's what he says:

1. There is a Phillips curve:
The “natural level of output” is the level of output at which core inflation will be steady. Above the natural level of output, core inflation rises. Below the natural level of output, core inflation falls.
Here's core inflation for the last 5 years, as measured using the core CPI and core PCE deflator.
Core inflation has been rising (mostly) by either measure since late 2010. Does Kimball think the US economy is above the "natural level of output?" I doubt it. If not, he should re-think his definition. Maybe he could tell us how to measure the natural level of output while he is at it.

2. What should a central bank do?
According to Kimball, this prescription need not be modified given the current state of affairs. He says it does not matter if short-term nominal interest rates are zero, or close to it, because:
Whenever the Fed buys any asset, its price goes up.
Kimball makes this seem like a simple application of what we learned in Econ 101, but he thinks we might need a little Finance too:
One of the most useful facts in all of Finance comes into play. For assets, a higher price is basically the same thing as a lower interest rate.
Another useful piece of finance is the Modigliani Miller theorem. Kimball might want to explain to us why, if the Fed issues reserves (overnight liabilities), and buys some other assets, and private financial intermediaries are perfectly capable of issuing overnight liabilities and buying the same assets, that the Fed's QE is not undone.

3. Lowering interest rates increases aggregate demand, and there are no practical limits on the stimulative effects the Fed can have:
What if all the assets in the world got down to a zero nominal interest rate and the economy still didn’t have enough stimulus? Then, and only then, we would be in deep, deep trouble on the aggregate demand front from which there would be no escape through monetary policy. But we are far, far away from that situation. Simple economic models studied by economists often have this happen because they have so few types of assets in them, but the real world has a huge number of different types of assets, some with nominal interest rates that are still very far from zero.
What's wrong with that paragraph? What's right about it? A central bank is a financial intermediary. Its power to alter the allocation of resources and economic welfare derives from its monopoly over the issue of some special kinds of liabilities (currency and reserves) which are used in retail transactions and large-value financial transactions. As Kimball notes, all but a small quantity of the reserves currently outstanding are currently "asleep," i.e. they sit during the day and overnight, and are not so different from T-bills (except that more economic agents can hold T-bills than have reserve accounts). If the Fed issues reserves and buys long-term Treasury bonds under these conditions, that can have no effect, as that's a process of intermediating Treasury bonds that is no different from what can be done by a shadow bank. If the Fed issues reserves and buys mortgage-backed securities issued by Fannie Mae or Freddie Mac, that amounts to the same thing - no effect. However, if the Fed were to, for example, buy mortgages directly, that would be an entirely different game. How good is the Fed at screening mortgage borrowers? Is the Fed going to target particular segments of the mortgage market? Maybe Congress wants some say in how the Fed does that? Maybe some people will be lobbying Congress in a serious way to make sure that their segment of the credit market gets the intervention? Sounds like opening a can of worms, doesn't it?

So, Kimball needs to think harder about QE. What about Farmer? The empirical part of the paper we have mostly seen before. These are the kind of event-study-type pictures that are sometimes used to "prove" that QE works. Any self-respecting economist will take more convincing than that. A serious model and some solid structural work would be nice. The theory part of Farmer's paper is supposed to be model free. It's basic intertemporal asset pricing, and the idea is the following. Suppose there exists nominal government debt of different maturities. In Woodford fashion, we can think of monetary policy as a contingent rule for setting the one-period nominal interest rate. But what if our rule is not feasible, i.e. the one-period nominal interest rate can't be nonnegative in all states of the world, given the rule we would like to impose. Then, it must be optimal for the one-period nominal rate to be zero in some states, but we then need to choose the short nominal rates in the other states. Given term structure relationships, the thought experiment we conduct in determining the optimal policy rule effectively involves changing some long-term nominal rates. Apparently that's how Farmer thinks about QE. Problem: To say how QE works, we have to have the relevant asset swaps in the model. There are no asset quantities in siqht in the framework that Farmer lays out. That isn't much help.


  1. "There is a Phillips curve:"

    (1) There is no Phillips curve. 2% inflation is consistent with any level of inflation whatsoever; you cannot draw a conclusion about the size of the output gap based on inflation.

    "Lowering interest rates increases aggregate demand"

    (2) Maybe someone can tell me what the (unobservable) natural rate of interest is right now. Maybe its even lower than people think. maybe interest rates say nothing about policy stance.

    if i cannot judge policy through inflation (1) and i cannot tell what the natural interest rate is (2) how in the heck do i even know if policy is accomodative?? maybe its just too darn tight.

  2. You already made the relevant points about Kimball. Farmer's paper is more interesting. What always stuns me is how compelling people think these studies are. It amazes me that with these event studies, people seem to believe nothing else is going on in the world. For example, Farmer argues that the MBS purchases that started in January 2009 and where increased in March 2009, caused the stock market to turn around in March of 2009 (never mind the S&P 500 continued to fall a lot once QE1 started - was this causal!?). Let's even accept that it was a government policy that caused the turnaround, which is debatable itself, why couldn't any number of policies being tried by the government during this time have caused the March turnaround in the S&P 500? Maybe it was that $800 billion stimulus package? Maybe it was the billions in preferred stock the Treasury was buying at the time? Maybe it was the Fed's several hundred billion dollar lending facility? Maybe it was the billions in support to both auto companies and "auto suppliers," plus additional liquidity support? If anything, these significant fiscal policy interventions seem much more plausible as causal factors. Maybe it wasn't even policy. I haven't even talked about events in the world that were happening outside U.S. government policy - how do you disentangle all this? Also, Farmer seems to think the ending of QE1 in April 2010 caused the fall in the S&P 500 around that time. Perhaps it had something to do with Greek government debt being downgraded to junk bond status in April 2010, which caused a lot of fear in global markets … just a thought.

  3. Yes, even by astructural standards, the argument is weak. There's not even a regression that we could throw all this stuff into.

  4. "Another useful piece of finance is the Modigliani Miller theorem. Kimball might want to explain to us why, if the Fed issues reserves (overnight liabilities), and buys some other assets, and private financial intermediaries are perfectly capable of issuing overnight liabilities and buying the same assets, that the Fed's QE is not undone."

    Steve, if I might ask you a question, if I had a trillion dollars and used it to buy gold, do you think I could push the price up, or would you just say, Miller-Modigliani, the market is fully capable of reversing this transaction, and they will?

    I'm assuming your answer will be that I can push up the price of gold with a trillion dollar buy, and the market will not fully reverse that.

    Then, if the government prints up $1 trillion and uses it to buy 10 year bonds, why won't they push up the price of 10 year bonds?

    Please also note that MM is partial equilibrium. A firm sells debt lifting its D/E ratio from 0% to 50%. That firm's stockholders will just buy an equivalent amount of debt so that the debt level of their portfolios stays the same. But of the many assumptions in MM, one is a fixed r. It's assumed that the corporation never bought enough to move the price of debt, perfect competition is assumed – look at the paper; MM use the term atomistic competition. The government buying $1T in debt is not atomistic.

    1. "Then, if the government prints up $1 trillion and uses it to buy 10 year bonds, why won't they push up the price of 10 year bonds?"

      the ten year treasury is at 1.45%, the lowest in 60 years. why arent we in the middle of the biggest boom in history? mortgages rates are also at record lows, why aren't we having the housing recovery of a lifetime?

      low interest rates don't seem to be the problem? or are they? i am confused.

    2. Think of the counter-factual, the would it be even worse otherwise.

      Yesterday the average rate on a 15 year mortgage for someone with good standard credit, not necessarily awesome, and a 20% downpayment went to 2.95%, the lowest ever recorded.

      But believe me, if the fed started heavily buying up more long term debt, as long as 30 years, and pushed mortgage rates down into the 1's, then payments on a home plunge. You're going to start seeing home sales go up -- at least compared to what they would have been if the rates didn't drop.

      At 1.5%, the payment on a $200,000 home, 30 year fixed is under $700! Less than the rent you'd expect on two-bedroom apartments in a comparable neighborhood, so rents drop, but then renters have more money to spend, and they have a higher propensity to spend than the rentiers.

      And the lower interest rates go the more corporate projects turn from negative NPV to positive and start them.

    3. Also, real rates aren't necessarily capped at zero. One of the reasons Krugman and others want more inflation is so real rates can go lower, and ex-post real rates on even 6 month government bonds have gone far into the negative territory before, see:

    4. only about a third of the existing mortgage debt is refi-eligible (good crefit, positive equity). thats why there has not been a pickup in refi activity (check MBA stats).

      new home builds are still being held back by 3.7 million foreclosures and 90+ day delinquencies. foreclosures are still high in juducial forclosure states like FL.

      read the SFFRB econ letter, for various reasons, rates are not passed through much to consumers either.

      low interest rates are not the problem. low rates do not compensate for unanchored expectations wrt unemployment.

    5. just to be clear: I think QE has an effect, just not through the interest rate channel, not really. QE is not going to have much effect as long as the FOMC remains behind the curve and shows no tolerance for the 5-6% growth that would close the output gap.

    6. Richard,

      Read this:

      Or work through the Ricardian equivalence theorem. Neutrality theorems go through in spite of the fact that you have a large actor - the government - involved.

    7. hmm, irrelevance is violated when there is a legal requirement to hold reserves or storage subsidies (interest on reserves). silly assumptions, silly conclusions. wish i had a nickel for all the silly models ive seen.

    8. 1. The reserve requirement obviously isn't binding, so that doesn't matter.
      2. Interest on reserves does not make a difference either. Of course changing the interest rate on reserves is NOT irrelevant.

    9. You are just describing the IOR policy in a nutshell: demand for reserves is perfectly (infinitely) elastic as long as supply is sufficiently large (because IOR acts as a price floor).

      The fact that demand for excess reserves is perfectly elastic is a feature not a bug of the interest on reserves (IOR) policy, which is also a policy choice. QE works through other channels besides bank channels. The Fed made a conscious choice to mitigate some of the "hot potato" bank channel effects through IOR policy, so seems like you are merely observing that the IOR policy is highly effective at mitigating the inflationary effects of QE. true!

      The IOR policy admittedly makes the real effect smaller than it would otherwise be, but still the effect is not zero because we have other channels (most importantly, signalling).

      Although, I would agree if the Fed does not tell us where they are going with this next round, QE will not have much effect.

    10. So just keep in mind when you are saying QE is ineffective, you are really saying IOR policy is making QE ineffective. The Fed could change IOR policy, even make IOR negative if they wanted, flush all those reserves into the economy.

      That's why I say it all comes down to where do they want to drive the bus. If they are willing to do whatever it takes, including make IOR negative, they they could create any level of inflation they wanted. It all a matter of credibility with respect to the nominal target they set.

  5. Richard Serlin,
    "The government buying $1T in debt is not atomistic."

    This is an interesting argument. I think you are saying there is some barrier to arbitrage here -- financial intermediaries cannot reconstruct a security whose cash flow mimics that $1tr in debt securities.

    In what state of the world is this arbitrage unlikely? We face such a state today: unrecognized losses in the financial system create a lemons problem that makes counterparty risk dominant. In such a world, there are significant limits to arbitrage, particularly in manufacturing cash flows that perform as advertised during "tail" events.

    So perhaps the Fed can affect the prices of securities with large purcahses, but only because the financial system is impaired. In such a state of the world, a $1tr mortgage buy might produce 1% mortgage rates. However, that state also corresponds with tighter lending standards, such that the lower rate may have no impact. You could argue the government could just guarantee those mortgages, which might also produce rising sovereign credit risk that offsets that guarantee (roughly the current Spanish dilemma). In this state, a central bank credit guarantee is also roughly equivalent to that of the fiscal authority's (roughly the current ECB dilemma).

    So if the financial system functions normally, a $1tr should have no effect; if it functions abnormally, it could also have no effect.

    1. Conventional lender-of-last-resort arguments for central bank lending have to rely on some information friction like the "lemons problem" you mention. The idea seems to be that the market is not pricing the collateral correctly, and that the central bank knows how to apply the appropriate haircut. Some of the academic papers that came out of the financial crisis struggle with the idea, though I don't know that anyone has been that convincing. In any case, it seems hard to apply that idea, either to the market for Treasuries or to the market for GSE-issued mortgage-backed securities, to argue for a role for QE under current circumstances.

  6. BTW, the above implies that saying, "a shortage of safe assets exists", is simply another way of saying, "the financial system is undercapitalized".

    1. No, that's a different issue. The safe assets in the financial system are supporting exchange and credit. Firm-level capitalization matters for risk-sharing and incentives for the firm.

    2. Not sure I understand: with a lemons problem, firm-level capitalization affects the perceived safety of safe assets manufactured by the financial system as a whole -- i.e., all bank deposits, AAA-rated tranches of structured deals, etc. This limits the number of securities actors are willing to use to support exchange and credit.

  7. Steven, if I could issue reserves and buy a trillion dollars in gold (or pratically any other asset), that would make the price of gold through the roof. There are limits to arbitrage (including those related to the capital position of arbitrageurs). Besides, any trader who dared to propose taking the contrarian view while I am loading up on gold would be laughed out of his hedge fund (if his colleagues do not vandalize his Porsche). MM is partial equilibrium. And if you read Wallace's paper with attention, you would have seen the caveat in the last paragraph: "Since I use all these extraneous assumptions, this paper ought to be viewed as providing only a suggestion for a general Modigliani-Miller theorem for open-market operations".

    1. "MM is partial equilibrium. "

      Nonsense. If MM holds, then there are no GE effects to take into account. If nothing changes, then nothing changes.

  8. ...if I could issue reserves and buy a trillion dollars in gold (or pratically any other asset), that would make the price of gold through the roof."

    Why? Suppose the people that formerly held the gold now hold your gold-backed liabilities. Those are equivalent from their point of view, right? So what is supposed to have changed?

  9. There's a lot of talk now about MM, Kimbell's just up reply, Noah.

    I don't know Wallace's MM analogy, but I do know MM very well. I've had 7 or 8 professors go over this at the bachelor's, master's, and PhD levels, and have read about it in some of the biggest books at each level. It's unanimous, it far from holds in the real world.

    They all start with MM, and then they say, but then there are bankruptcy and financial distress costs, so the debt level of a corporation matters greatly. Next, there's differential tax rates; it matters even more. Next, shareholders often can't borrow as easily and cheaply as corporations, so it matters even more, then there's incentive effects on management, and liquidity, and in the end it's unanimous that debt level is ridiculously far from irrelevant. It can make an enormous difference.

  10. The question is whether monetary policy -- QE -- can affect the prices of securities in the presence of large excess reserves. Some answer, "yes, because MM does not hold."

    This is a less than useful answer. The exceptions to MM apply to any size buyer of securities. Thus, Treasury could announce a $1tr gold buy in exchange for T-bills. This is equivalent to a Fed swap of ER's for gold.

    So Treasury can exactly replicate the effects of a Fed asset purchase. Seems to me QE in this case is not "monetary policy", but instead just a conveniently undemocratic form of fiscal policy. Why not call it that?