MacDonell on QE

Gerard MacDonell has a lovely noahpinion guest post "So Much for the QE Stimulus" (HT Marginal Revolution). Some good bits here, with my bold on noteworthy zingers.

The post is unusual, because practitioners tend to regard the Fed and QE as very powerful. But here he expresses nicely the skeptical view of many academics such as myself.

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

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....

Obvious to us skeptics, not to the Fed or to the many academic papers written trying to explain the supposed powers of QE

The story initially told by the Fed leadership starts with the claim that large scale asset purchases (LSAPs) [lower interest rates]... by removing default-free interest rate duration from the capital markets. ...

Translation: buying bonds to drive up bond prices

That story does not hold much water.

 

The theoretical foundations supporting QE were invented – or really revived from the 1950s [Preferred habitat theory]– 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. 

Translation: The Treasury sold as much as the Fed bought.

 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.

 Translation: When the Fed actually bought securities, yields went up.

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. ...

Evidence that the Fed doesn't believe it any more

...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.

... 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.

...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. 

This is consistent with my view. The large balance sheet is a great thing. Narrow banking has arrived. We live the optimal quantity of money. Interest-paying reserves generate zero stimulus, but great liquidity. Alas, the Fed, having touted the world-saving stimulus of QE, without qualifying that effects might be temporary, now is in a tough spot to turn around and say "never mind." All it can do is be silent and wait.

...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 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....

Announcement effects are a poor measure of fundamental effects that will endure long enough to affect the economy... markets typically act more segmented in the short run than over time,.... But smart and credentialed people argued otherwise and the FOMC may have been comforted by that.

I have puzzled at this as well. Many studies find price impacts of large unannounced trades. But price impact melts away. Why would we treat announcement effects as permanent -- as many Fed speeches did?

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. ...

This is the "signaling" channel.

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.

Nice phrases. But..

The problem looking forward is that people may not be so responsive to the symbolism of QE next time around. ... Moreover, the Bank of Japan has got hold of QE, which raises the odds it will be properly discredited, if history guides.

OK, not very nice, but a good snark prize, as much to the B of J as to its many critics. But far more interesting..

The third possibility ..[is] 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...:

"The general argument that the monetary authorities can increase aggregate demand and prices, even if the nominal interest rate is zero, is as follows:..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 indeed the crucial point. In simple quantity theory thought, MV=PY, so you can raise M even at zero rates, and eventually PY must rise. But that's wrong, alas. V becomes undefined when the interest rate is zero, or money pays interest.  As Gerard explains,

... 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...

...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.

Stop and savor just a moment. When the government pays interest on reserves, reserves become the same thing as overnight government debt. They are held as a saving vehicle, and have no "stimulus."

To be fair, I think Bernanke's point might hold if there were a huge QE, a clear promise to leave reserves outstanding when interest rates rise above zero, and then possibly future inflation might work its way back to current inflation. But exit principles that clearly state the large reserves will pay interest so as not to give future inflation undo the possibility.

Gerard leaves out, I think, the most telling mistake in the Bernanke quote,  "monetary authorities could use the money they create to acquire indefinite quantities of goods..." Monetary policy does not buy goods; it does not drop money from helicopters. Monetary policy only gives one kind of debt in return for another kind; roughly speaking making change, giving you two 5s and a 10 for each 20. Buying goods is fiscal policy, and fiscal policy can cause inflation.

Bottom line

...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....

I share this view.

To be clear, both my post and Gerard's are not really critical of the Fed. If "pyrotechnics'' helped, good. If QE is not "mechanically" that powerful, great, we all learn from experience. A large interest-paying balance sheet and silence is probably the best thing for the Fed to do right now.  This question is most important to academic and historical analysis, to learn  what causal mechanisms really did play out, and what will work in the future.