Joe Gagnon Responds to Michael Woodford, Ben Bernanke, and Others on the Risks and Power of Quantitative Easing: Friday Focus (December 20, 2013)
One way to think about things is that there are three important macroeconomically-relevant prices in financial markets. (1) There is the liquidity discount: how much you have to pay in order to hold your investible wealth in a form in which you can spend rather them in the form in which it grows. (2) There is the slope of the intertemporal price system: the real interest rate at which safe invested wealth grows. (3) And there is the risk premium: how much extra you get on average for being willing to bear the risks of enterprise and battle the forces of time and ignorance.
Conventional monetary policy tools focus on the first. But in so doing, they may create distortions in the second as they try to correct problems with the first. And what if the root cause of financial distress is the third: the combination of a collapse in the investor willingness to hold risky assets coupled with a collapse in the financial intermediaries ability to credibly promise to create safe assets?
It is in those situations that nonstandard monetary policy tools--interest on reserves, quantitative easing, and other things--come into their own. But what do they do? How do they work? Do they work?
Let me turn the microphone over to one of the smartest and most thoughtful analysts today, Joe Gagnon:
Joseph Gagnon et al. (2010): The Financial Market Effects of the Federal Reserve's Large-Scale Asset Purchases:
Since December 2008, the Federal Reserve’s traditional policy instrument, the target federal funds rate, has been effectively at its lower bound of zero. In order to further ease the stance of monetary policy as the economic outlook deteriorated, the Federal Reserve purchased substantial quantities of assets with medium and long maturities. In this paper, we explain how these purchases were implemented and discuss the mechanisms through which they can affect the economy. We present evidence that the purchases led to economically meaningful and long-lasting reductions in longer-term interest rates on a range of securities, including securities that were not included in the purchase programs. These reductions in interest rates primarily reflect lower risk premiums, including term premiums, rather than lower expectations of future short-term interest rates.
Michael Woodford... attempted to pour cold water on the idea that the Fed’s purchases of long-term bonds (also known as quantitative easing) could lower bond yields. His contention was that the portfolio balance effect of such purchases would be minimal at best. I disagree, as do the bulk of central bankers. This debate matters because, if Woodford is right, the Fed’s only tool for delivering more stimulus now is to commit to future policy actions that may be viewed as undesirable when they occur—such as promising not to raise interest rates when inflation returns. If the market were to doubt such a commitment from the Fed, the Fed would lose its ability to steer the economy. In reality, the portfolio balance channel gives the Fed a tool to guide the economy without unduly restricting future policy choices...
A paper I wrote two years ago... showed that Fed purchases of long-term agency and government bonds in 2008 and 2009 lowered a range of long-term interest rates. We argued that most of those declines appeared to reflect a reduction in term premiums rather than a reduction in expected future short-term interest rates. We posited that those reductions in term premiums were required to induce investors to accept the shift in their portfolios engendered by the Fed’s purchases; this is what Nobel Laureate James Tobin and others have long referred to as the portfolio balance effect. Woodford asserts instead that most or perhaps all of the declines in bond yields might have been caused by the market’s interpretation of the Fed’s statements and actions as indicating that the path of future short-term interest rates would be lower than previously expected.
Our paper, and more recent papers, presented evidence that counters most of Woodford’s empirical claims (D’Amico and King 2010, Neely 2010, D’Amico, English, Lopez-Salido, and Nelson 2011, Hamilton and Wu 2012, and Li and Wei 2012).... Some Fed statements and actions clearly had no implications for the path of future short-term rates, and yet they still affected some asset prices. This evidence comes from a range of investigations, not solely from event studies, and the conclusion is not sensitive to changes in the underlying model used to identify movements in the term premium. These effects of Fed asset purchases are fully consistent with what would have been expected based on data from before the financial crisis, and with the portfolio balance view....
For more theoretical arguments for and against portfolio balance, see... Cohen-Selton and Monnet.... Woodford asserts that there can be no portfolio balance effect if two conditions hold: (1) the assets being bought and sold are valued only for their pecuniary returns, and (2) all investors can purchase and sell unlimited quantities of these assets. A third requirement he does not mention is that investors are rational, forward-looking, and fully informed about how the economy and political system operate. These conditions are violated in clear and obvious ways.... Money has a non-pecuniary return—transactions services—which is required for conventional monetary policy to work. There is no reason to assume that money is the only asset with a non-pecuniary return. The violation of Woodford’s second theoretical assumption is even clearer, as it requires that private agents have an unlimited ability to take short positions.... It is common in economics to make the benchmark assumption of rational, forward-looking, fully informed agents. Woodford suggests that some of the empirical evidence cited in favor of portfolio balance—the large movements of bond yields in anticipation of future Fed purchases—are in fact evidence that investors are rational and fully informed. But it is one thing for investors to respond to a Fed announcement about imminent bond purchases and quite another for them to fully anticipate the implications of those purchases for their taxes and transfers in the distant future. Yet the case against portfolio balance requires precisely that knowledge....
Woodford further argues that even if there is a portfolio balance effect, quantitative easing might have greater costs than benefits because, for example, it could make a given class of assets scarce. But this is comparable to the effects of conventional monetary policy, which alters the relative returns on different assets...
At Jackson Hole last week, Federal Reserve Chairman Ben Bernanke provided more detail on the “costs and risks” he had cited in his June Federal Open Market Committee (FOMC) press conference as the main reasons why the Fed has been slow to use more quantitative easing to fix the economy. But the details make it clear that these costs are very small indeed, even if Bernanke was not inclined to admit it. Bernanke did acknowledge that there have been enormous costs from the unusually weak recovery—costs that would have been reduced by more aggressive quantitative easing. The Fed will almost surely announce further actions at its policy meeting next week, but I am concerned that an inappropriate balancing of the costs and benefits is likely to cause the Fed to err on the side of doing too little.
The first cost of quantitative easing cited by Bernanke is that the Fed could become the dominant buyer and holder of long-term Treasury and agency securities. According to Bernanke at Jackson Hole, “trading among private agents could dry up, degrading liquidity and price discovery … [and] impede the transmission of monetary policy. For example, market disruptions could lead to higher liquidity premiums on Treasury securities, which would run counter to the policy goal of reducing Treasury yields.”
But the Fed could address this problem by announcing adjustable daily targets for the yields of the securities it is buying. To hit these targets it would accelerate or decelerate its rate of purchase within the day. That would give market participants some assurance about the price for which they could buy and sell Treasury securities at any time, which is the operational definition of a liquid market. More broadly, one of the main purposes of quantitative easing is to force investors out of the market being targeted and into other markets, which would become more liquid. The Treasury yield curve can still provide a market benchmark even if private investors have most of their portfolios in other markets.
The second of Bernanke’s costs of quantitative easing is that the public might believe that it will be difficult for the Fed to tighten policy at the right time to prevent excessive inflation in the future. This fear might increase uncertainty and instability in markets. But so far there is not a shred of evidence to support this cost. No one I have spoken to at the Fed is concerned about the Fed’s ability to fight inflation in the future. The key to preventing this cost from materializing is constant communication about the Fed’s intentions. Experience shows that inflation fears are highly sensitive to strong policy actions (or the lack thereof) in response to observed inflation. Thus the Fed needs to calibrate its policy stance visibly in response to deviations of both unemployment and inflation from their previously projected levels. As discussed below, targeting a path for nominal GDP that is consistent with low inflation may be a good way to provide stimulus in the short run and clarity about the Fed’s intentions over the long run.
The third cost is that low long-term yields may encourage risky behavior that threatens financial stability. Bernanke claims to see little evidence of such behavior and he points to new financial supervisory tools designed to prevent it. Moreover, a monetary boost to economic recovery would reduce risks to financial stability by improving profits and decreasing the number of bankruptcies. Bernanke all but admits that this cost is immaterial. Some observers have argued that we are already seeing a risky bubble in the bond market. But low long-term yields are not a bubble when they are intentionally engineered by monetary policy. It is unlikely that systemically important institutions are holding excessive long positions in bonds, and it is the job of the Financial Stability Oversight Council, newly established by the Dodd-Frank Act, to prevent such behavior.
The fourth cost is the possibility that the Fed could incur financial losses on its enlarged balance sheet. Bernanke simply dismisses this cost altogether when it is viewed in the overall context of the national balance sheet. To date the Fed has earned extraordinary profits from quantitative easing. The Treasury also has gained both from lower borrowing costs and from higher tax revenues. The Treasury’s gains far exceed any possible losses to the Fed. And private citizens receive further benefits to the extent that quantitative easing has boosted employment.
All of the above costs combined are far smaller than the benefits from aggressive monetary easing. Next week the Fed should promise to hold the prime mortgage rate below 3 percent for at least 12 months. It can do this by unlimited purchases of agency mortgage-backed securities. By giving people a fixed time period to take advantage of the lowest mortgage rates in history, the Fed could meaningfully boost the housing market just when buyers are beginning to believe that prices are starting to head up. The Administration could capitalize on this opportunity by forcing the housing agencies and jawboning the banks to stop applying excessively high credit standards for prime mortgages.
To maximize the potential benefits of sound monetary policy, the Fed should seriously consider the proposals of Christina Romer and Michael Woodford to target a fixed path of nominal GDP, the broadest measure of economic activity in dollar terms. The path should be based on a year of normal conditions, such as 2007, and should increase at a rate of 4.5 percent, which would allow for average growth of 2.5 percent and average inflation of 2 percent. Because we are far below such a path right now, it would take a few years of growth above 2.5 percent and/or inflation above 2 percent to return to normal. This policy would allay market fears of premature Fed tightening while being consistent with the Fed’s stated long-run inflation goal of 2 percent.