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May 30, 2013

At Least One Reason Why People Shouldn't Hate QE

You might not expect me to endorse an article titled "The 7 Reasons Why People Hate QE." I won't disappoint that expectation, but I will say that I do endorse, and appreciate, the civil spirit in which the author of the piece, Eric Parnell, offers his criticism. We here at macroblog, like our colleagues in the Federal Reserve System more generally, pride ourselves on striving for unfailing civility, and it is a pleasure to engage skeptics who share (and exhibit) the same disposition. What the world needs now is...well, maybe I'm getting carried away.

Let me instead appropriate some of Mr. Parnell's language. It is worthwhile to explore some of the reasons that people do not like QE from someone who does not share this opposing sentiment. In particular, let me focus on the first of seven reasons offered in the Parnell post:

First, a primary objection I have with QE is that it results in a government policy making and regulatory institution in the U.S. Federal Reserve directly determining how private sector capital is being allocated... in recent years, the Fed has dramatically expanded its policy scope into areas that are normally the territory of fiscal policy. This has included specifically targeting selected areas of the economy such as the U.S. housing market including the aggressive purchase of mortgage backed securities (MBS) since the outbreak of the financial crisis.

This statement seems to presume that monetary policy does not normally have differential impacts across distinct sectors of the economy. I think this presumption is erroneous.

The Federal Open Market Committee's (FOMC) asset purchase programs have long been seen as operating through traditional portfolio-balance channels. As explained by Fed Chairman Ben Bernanke in an August 2010 speech that set up the "QE2" program:

The channels through which the Fed's purchases affect longer-term interest rates and financial conditions more generally have been subject to debate. I see the evidence as most favorable to the view that such purchases work primarily through the so-called portfolio balance channel, which holds that once short-term interest rates have reached zero, the Federal Reserve's purchases of longer-term securities affect financial conditions by changing the quantity and mix of financial assets held by the public. Specifically, the Fed's strategy relies on the presumption that different financial assets are not perfect substitutes in investors' portfolios, so that changes in the net supply of an asset available to investors affect its yield and those of broadly similar assets. Thus, our purchases of Treasury, agency debt, and agency MBS likely both reduced the yields on those securities and also pushed investors into holding other assets with similar characteristics, such as credit risk and duration. For example, some investors who sold MBS to the Fed may have replaced them in their portfolios with longer-term, high-quality corporate bonds, depressing the yields on those assets as well.

I think this is a pretty standard way of thinking about the way monetary policy works. But you need not buy the portfolio-balance story in full to conclude that even traditional monetary policy operates on "selected areas of the economy such as the U.S. housing market." All you need to concede is that policy works by altering the path of real interest rates and that not all sectors share the same sensitivity to changes in interest rates.

Parnell goes on to discuss other problems with QE: stress put on individuals living on fixed incomes, the promotion of (presumably excessive) risk-taking, and the general distortion of market forces. All topics worthy of discussion, and if you read the minutes of almost any recent FOMC meeting you will note that they are indeed key considerations in ongoing deliberations.

These issues, however, are not about QE per se, but about monetary stimulus generally and the FOMC's interest rate policies specifically. As the conversation turns to if, when, and how Fed policymakers will adjust the current asset purchase program, it will be important to clarify the distinction between QE and the broader stance of policy.

Photo of Dave AltigBy Dave Altig, executive vice president and research director of the Atlanta Fed


May 30, 2013 in Federal Reserve and Monetary Policy, Monetary Policy | Permalink


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Sorry, but I think that there is an important difference between conventional monetary policy and current QE. When the Fed buys treasuries only, it is essentially dealing in state assets on both sides of its balance sheet, so any difference in the effects of monetary policy on different sectors of the economy are accidental. When the Fed buys mortgage securities, however, that deliberately, though the asset side of the Fed's balance sheet, favours housing activity. And I have little doubt that, if the US economy did not strengthen as fast as required, the Fed would end up, like the Bank of Japan, buying stocks. In my view (as a former central banker), the Fed has done too little to resist being drawn, by ill-informed politicians, into unsustainable stimulation of popular real economic activity.

Posted by: RebelEconomist | June 06, 2013 at 05:43 PM

I appreciate and agree with your narrow response to the column, "The 7 reasons why people hate QE."  However, it appears that people still have several more (unanswered) reasons for hating QE.  

It is an old debating tactic to take issue with the 1-2 weakest points of an opponent's otherwise strong argument to create the impression that the opponent is altogether wrong.  But debating tactics don't do anything to 'fix' monetary policy or the economy, so ultimately that is not a wise approach for the Fed (its officers) to take.  Unlike high school debates or courtroom arguments designed to persuade an uninformed jury, the 'judges' are monetary economists and money managers who recognize the difference between debating tactics and a response that goes to the core of the issue.

For example, your response to the article's criticism #1 was "even traditional monetary policy operates on "selected areas of the economy such as the U.S. housing market."  That is absolutely true.  But that neither recognizes nor explains why half of the Fed's current open market operations are conducted in mortgage backed securities and related debt instruments.  Aren't those particular bond purchases PURPOSELY geared toward the housing market to the exclusion of other sectors of the economy?

Of course.  That's why your (correct as far as it goes) comment about monetary policy doesn't really address the first complaint of the columnist.  You leave the impression that QE is little different than standard open market operations, though of course differing in magnitude.

I hadn't read the "7 Reasons" column before you cited it in your piece, but after having read it, I was most persuaded by reason #2:

     #2 - Helping Some Market Participants At The Expense Of Others.
     By effectively locking interest rates at 0% since December 2008,
     the Federal Reserve has elected to provide direct and generous support
     to financial institutions and risk takers, some of which directly
     contributed to the cause of the crisis.

I believe that's an accurate description of how things have worked out, though I don't believe it portrays the Fed's motives or reasoning.  Nevertheless, it is incumbent upon Fed officials to consider this criticism to avoid future crises, economic downturns and taxpayer bailouts.

I've recently been reading (and learning from) Nicholas Dunbar's book "The Devil's Derivatives."  For at least the past 50 years, a pattern has emerged whereby well-compensated (highly motivated) bankers develop/discover ways of avoiding and evading the Fed's regulations, followed by the Fed's efforts to regulate the new activities, followed by further work-arounds by bankers.  This is a natural process, but the Fed is playing with both hands behind its back because a) top Fed officials are typically free-market economists with a philosophical appreciation for innovation and a general skepticism of policies which have unintended negative consequences, and b) bankers spend vast amounts of money to hire PhD economists and other smart, experienced people --- then their teams work night and day for months to develop innovative products that Fed officials don't understand and cannot effectively regulate.

This is part of the Regular Business Plans of big banks, not something that has inadvertently happened a time or two.  The not-infrequent outcome of these innovations is to create bubbles which eventually burst, placing major economic sectors at risk.  The next act in the play is a Fed rescue/bailout to "save the economy" --- but then Fed officials explain (with sad faces and shrugging shoulders) that the bad actors had to be saved to avoid another Great Depression.

The bailouts, too, are part of the long-term business plans of the big banks.  The problem is that the Fed doesn't get the joke, and continues playing the same role over and over.  As a historical fact, the Fed DOES provide aid and comfort to the major financial institutions at the expense of taxpayers, households and small business.  (How many times has the Fed saved Citi over the past 50 years?) 

As I said earlier, I do not for a minute believe this is the Fed's intentions: it occurs because the innovative bankers know how draw Fed officials into a game they are ill-equipped to play.  Fed officials aren't in the hip pockets of the big financial institutions because they're corrupt, but because they're ignorant: uninformed and inexperienced.

Now, the Fed can continue down this path ... or its officials could reflect on the pattern that has emerged over the decades and ask whether their appreciation for innovation is well-founded, whether the Fed has been an effective regulator when it has always been behind the curve of innovation, and where all of this is leading: too much leverage, moral hazard, huge risks to America's future economic prosperity, etc.

The strongest argument that bankers make for justifying their innovative activities is that "if we aren't allowed to do it, financial markets will move offshore ... but then same practices will occur anyway." 

That is a nonsense argument.  If America reigns in the profligate bankers, so will most of our closest trading partners.  Second, even if the big US banks became the US branches of foreign banks, the US economy would still receive financing and Americans would still have jobs working in those branches.  Third, future bailouts would fall to a far greater extent on the backs of foreign taxpayers rather than US taxpayers.  Fourth, if the Fed calls the bluff of big banks, the ability of bankers to extract future handouts would be far less (less moral hazard).

Fed officials have done a pretty good job over the past century perfecting its monetary policy tools. At the same time, however, they have been so focused on shorter-term issues that they have failed to appreciate the longer-term game the Fed has been drawn into, where it has become the enabler and protecter of institutions whose prosperity is not essential to the functioning of a modern economy.  The necessity of an efficient banking system does not prove (or even imply) that specific banks are must survive.  The only too-big-to-fail institution is the Fed.

The Fed's original job was to protect the economy by PREVENTING financial crises and panics.  We now know that despite the best of intentions the Fed has failed in that responsibility.  It has unwittingly become a tool of the banking sector, facilitating astronomically high compensation and the accumulation of great wealth --- for bankers --- just #2 of the "7 Reasons" essay claims.

Either the Fed can stay on the merry-go-round or get off of it ... but it can't stay on the merry-go-round and expect to arrive in a new destination one or two cycles hence.  Anyone who has been paying attention knows that. 

The failure of the economy to recover despite the Fed adding $2 trillion in reserves to the banking system means that people do not trust the Fed's current policies to protect their jobs and wealth in the future --- so rather than taking risk and contributing to the economy, they're paying off debt and building up reserves for the next collapse.

Posted by: Thomas Wyrick | June 10, 2013 at 01:57 PM

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