Thursday, February 17, 2011

Is the U.S. Treasury Department Undermining QE2?

According to Jim Hamilton, the answers is  yes.  He shows that the average maturity of publicly-held U.S. debt continues to grow despite the Fed's QE2 program.  This should not be the case.  Under QE2, the Fed is purposefully trying to lower the average maturity of Treasury securities for reasons that will be explained later.  The fact that the Fed is not shortening the average maturity means that the Treasury is issuing long-term debt faster than the Fed is buying it up.  Nonetheless, there is still evidence that that QE2 is having an effect on nominal and real expectations as seen here.  Thus, the U.S. Treasury Department has not completely thwarted the Fed's efforts, but it is surprising to see fiscal policy and monetary policy working against each other here.

So why does the average maturity of Treasury securities matter?  The standard answer is that if the Fed reduces the average maturity then there will be a drop in the net supply of long-term Treasuries.  This will cause their prices to go up and their yields to drop.  The drop in yields, in turn, would affect interest sensitive spending.  This interest rate effect, however, is only part of a bigger, richer story that gets overlooked.  This bigger story is how the shortening of the average maturity will lead to a rebalancing of assets in investors' portfolios and, in so doing, affect nominal spending.  This  rebalancing story is the portfolio balancing channel of monetary policy.  
The portfolio balancing story goes as follows.  Currently, short-term Treasury debt like T-bills are near-perfect substitutes for bank reserves because both earn close to zero percent and have similar liquidity.  In order for the Fed to get investors to spend some of their money holdings it must first cause a meaningful change in their portfolio of assets.  Swapping T-bills for bank reserves will not do it because they are practically the same now. In order to get traction, the Fed needs to swap assets that are not perfect substitutes.  In this case, the Fed has decided to buy less-liquid, higher-yielding, longer-term Treasury securities.  Doing so should lower the average maturity of publicly-held U.S. debt.  It should also overweight investor's portfolios with highly-liquid, lower-yielding assets and force investors to rebalance them.  In order to rebalance their portofolios, investors would start buying higher-yielding assets like stocks and capital.  This would ultimately drive up consumption spending--through the wealth effect--and investment spending.  The portfolio rebalancing, then, ultimately cause an increase in nominal spending.  Given the excess economic capacity, this rise in nominal spending should in turn raise real economic activity.

My description of the portfolio channel so far ignores the importance of expectations.  If the Fed could convince investors that it is committed to the objective of higher nominal spending and higher inflation (say through an  explicit  nominal GDP target) then much of the rebalancing could occur without the Fed actually buying the securities.  For if investors believe there will be a Fed-induced rise in nominal spending that will lead to higher real economic growth and thus higher real returns, they will on their own accord start  rebalancing their portfolios toward higher yielding assets. Likewise, if investors anticipate higher inflation, then the expected return to holding money assets declines and causes them to rebalance their portofolios toward higher yielding assets.  In other words, by properly shapping nominal expectations the Fed could get the market to do most of the heavy lifting itself. I believe this is why QE2 is still having some effect despite the Treasury working against it.

To put this portfolio rebalancing issue in perspective, it is useful to see how the combined portfolios of households and non-financial firms are weighted toward highly liquid assets.  Using the Flow of Fund data, the figure below shows for the combined balance sheets of households, non-profits, corporations, and non-corporate businesses the percent of total asset that are highly liquid ones (i.e. cash, checking accounts, saving and time deposits, and money market funds) as of 2010:Q3: (Click on figure to enlarge.)

The figure shows that the spike in demand for liquid assets that began in the 2008 financial  crisis remains elevated through 2010:Q3.  This is why there is still an aggregate demand (AD) problem.  The nonfinancial private sector is still reluctant to spend its money holdings--there appears to still be an excess money demand problem.  The Fed' s job, then, is start a rebalancing of portfolios that is vigorous enough to bring the holdings of  money assets more into line with historical trends.  Once this happens the aggregate demand shortfall should disappear. 

P.S. It will be interesting to see what has happened to the above figure once 2010:Q4 data comes out.  Given the rise in inflation expectations and the improved economic outlook, we should see some meaningful adjustment to share of assets held as money.


  1. John Cochrane, U.Chicago:
    "Unemployment is not high because the maturity structure of government debt is too long, thank you, nor from any lack of “liquidity” in a banking system that is sitting on a trillion dollars of cash. It’s time to focus on the real, microeconomic, tax, and regulatory barriers to growth, not a policy that creates a lot of noise but no real effect."

  2. I presume the Cochrane quote comes from--

  3. David,

    I understand how QE-induced portfolio re-balancing might have real effects through the wealth effect channel. However, there are forces that act against this dynamic. First, investors may choose to reduce their longest-duration bond positions in the face of inflation uncertainty. This would steepen the curve and increase the cost of capital for long-term projects (the 2yr to 30yr spread is at a record level). Second, some of the re-balancing might take the form of commodities speculation. This, in turn, might hurt both consumer confidence and corporate margins. Also, portfolio flows into emerging markets might exacerbate their inflation problem, which would lead to higher import prices that hurt households and firms (import prices ex-fuels rose .8% in the latest report). Lastly, if the re-balancing does not reverse declining real estate prices, then the wealth effect from stocks alone might be muted. I believe there is evidence of each of these forces in the recent data.

  4. David,

    Do you know of a source that can carefully explain the monetarist transmission process, the portfolio adjustment theory. I've tried everything to understand it and just can't figure it out? Perhaps you've had some posts on it?



  5. ECB:

    I don't deny there are real problems. But to dismiss the sluggish growth entirely on structural issues throws the baby out with the bathwater.

    Regarding Cochrane's comment, surely IOR is playing some role in the banks sitting on a trillion dollars of cash. Even the Fed believes that point.

    Also, if this were all about real, structural problems then why did it take so long for the recession to turn virulent? As I show here, the recession was mild initially and employment in non-construction industries was growing and absorbing the labor coming out of construction. It was the Fed's passive tightening in mid-2008 that turned stress in the financial system into a financial crisis and a mild recession into the Great Recession. Then, the Fed remained tight thereafter with IOR and it failure to stabilize nominal expectations.

  6. Okay David, how do you then explain the turnaround in inflation expectations?

  7. JoeMac:

    Allan Meltzer has an excellent article on the monetarist transmission channel that can be found here:

    Unfortunately, this is a gated article so you will need find a library that has access to it or purchase it.

  8. David,

    I agree that QE2 raised inflation expectations. It is quite possible that market expectations of higher commodities and import prices contributed to that turnaround. Consider also that Case-Shiller house prices have fallen since August, and that shelter is 40% of core CPI. Therefore, it is natural that any change in overall CPI expectations would be concentrated in the non-shelter components.

    BTW, the Philly Fed survey offers a glimpse of firms' input price inflation expectations. The Future Prices Paid component is now at its highest level since 1988 (73.1). Clearly, we are seeing pass-through from commodities prices, through imports, to a wider array of industrial materials. Since the 70's, the Fed has never been accommodative at these levels of ISM Prices Paid.

  9. DB: Well as we know, the stagnation started with the dotcom crash in 2000. A bubble in housing that was aided by lax monetary policy disguised the growing structural problems. As Minsky pointed out 40 years ago, the balance sheet structure of the economy gradually becomes ever more fragile, and eventually becomes susceptible to even a small shock, such as the Fed raising interest rates. Once the bubble bursts, the full extent of the structural problems become clear.

  10. ECB, okay you are pointing to bigger, trend decline. I agree with you to an extent on that point. But is that what Cochrane had in mind?

  11. Prof. Beckworth, I have some questions about the operationalization of QE2. Since nominal new money will have to be dispersed into the broader economy via an increase in bank reserves, all this additional money is expected to lead to additional lending to be effective in stimulating the economy. Do we have enough borrowers? Bank capital? This is the longer explanation of why I’m asking

    I don’t know if I’m missing a key ingredient in understanding why QE2 is good, and I have been rattling against monetary easing as a stimulus in my little corner. But perhaps you can shed light on whether QE2 actually increases systemic debt/risk, or I'm just imagining things.

  12. No it's not what Cochrane had in mind. I think he is saying that he just doesn't see the point of quantitative easing. I was using him to make a point that we have such massive problems now that it is folly to waste our time getting sucked into debates about a minor tweak. Tragically, so polarized is the US political system now that we cannot get anything important done. Thus do great nations stagnate.

  13. Some random comments:

    "Currently, short-term Treasury debt like T-bills are near-perfect substitutes for bank reserves . . . ." Then shouldn't T-bills (that bear zero interest) be treated as part of the money supply, for the purpose of economic analysis? And (it would seem) treasury securities that have slightly longer maturities or that bear slightly higher interest should be treated as "n% moneys," with n > 0; they should be figured into the money supply, discounted to n%. In fact, all assets could be rated for their "nearness" to money, and counted (appropriately discounted) as part of the money supply. (Would this be M7 or M8?)

    "In order for the Fed to get investors to spend some of their money holdings it must first cause a meaningful change in their portfolio of assets." I don't accept the temporal (and quasi-causal) priority posited here. First, note in passing that the Fed is interested not in *spending simpliciter* but in *net spending*: it would like to see people try to rid themselves of *more money than they take in*, so that their money holdings decrease. *More spending* would not help if it were accompanied by an equal increase in *selling*, within the private sector. Second, and mainly, this net spending would not *follow upon* people's changing their portfolios: it would *constitute* that portfolio change. The way in which someone would change his portfolio in a direction welcome to the Fed is by acquiring some non-money item in exchange for money; the portfolio change would not *precede* the spending. Finally, the Fed really has no reason to deplore people's new-found desires to hold more money, no reason to want those desires to subside quickly. Instead it should simply accommodate those desires by providing sufficient extra money.

    "T]he Fed has decided to buy less-liquid, higher-yielding, longer-term Treasury securities. Doing so should lower the average maturity of publicly-held U.S. debt." Well, if it buys *intermediate* maturities, that might leave the average maturity unchanged; it would have to buy securities the average maturity of which was greater than the Treasury average to shorten that average. ("Publicly held" means *held by someone other than the government*.)

    "QE2 is still having some effect despite the Treasury working against it." By your lights the Fed wouldn't have had to do anything if the Treasury had simply stopped selling notes and bonds, offering only T-bills. (By the way, how *does* the Treasury decide on the maturity structure of its debt offerings?) But you may be focusing on the wrong factors (such as current debt maturities), if it is really *expectations* (for future Fed actions) that matter. Perhaps it doesn't much matter what the Fed (and the Treasury) are doing now, except insofar as this affects the market's expectations for its (their) behavior in the future. They needn't do anything now if they can create the impression that they will act, vigorously and resolutely, in some particular way in the future.

    "The figure shows . . . the spike in demand for liquid assets . . . ." Well, it equally well shows the spike in *supply*! But, really, it just shows the spike in *quantity* (as a percentage of the total, perhaps largely due to the decline in value of most non-liquid assets).