Monday, April 4, 2011

How QE2 Worked

Paul Krugman has a post explaining the monetary policy transmission channels for QE2. His explanation is that there was a rise in wealth effect-driven consumption spending via the rising stock market and a rise in foreign spending on the U.S. economy via the depreciated dollar.  While true, there is a far richer story to tell with the portfolio rebalancing channel of monetary policy. Here is how I described it before:
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.  
Note that the rise in stock prices and the drop in the dollar's value all  occur as result of the portfolio rebalancing above.  This description so far, however, is incomplete because it ignores the effect of expectations on the portfolio adjustment channel:
If the Fed could convince investors that it is committed to the objective of higher nominal spending and higher inflation... 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 portfolios toward higher yielding assets.  In other words, by properly shaping nominal expectations the Fed could get the market to do most of the heavy lifting itself.
What is remarkable is that QE2 has done as much as it has given that (1) the U.S. Treasury has been undermining QE2 by increasing the average maturity of the U.S. debt and (2) QE2 being implemented in a less than optimal fashion.  It must be that QE2's ability to rebalance portfolios and improve the economy has come largely from its changing of  expectations as outlined above.

Update I: Here is a figure showing how QE2 has changed expected nominal spending growth:

While there is a marked improvement, the need for catch-up growth to return  nominal spending to its trend means the rise in expected nominal spending growth is far from adequate.

Update II:  Marcus Nunes shows that Fed policy (including QE2) over the past few years  has been constrained by the "memory-less" nature of inflation targeting.


  1. David
    Much more encompassing and clear than Krugman´s "wonkish" post.
    I just did a post commenting on DeLon´s "Anatomy of a Slow Recovery". The recovery is slow because the Fed is constrained by IT from getting people´s "expectations going". So you basically have left the "higher real returns" channel and that is unlikely to be enough.

  2. Thanks for the link to your post. I have it linked on my post now.

  3. Excellent post.

    I think the pro-NGDP targeting and QE crowd need to start talking about the need for QE3.

    A rash of "pro-QE3" posts and articles is needed.

  4. Benjamin,

    The problem is that another round of quantitative easing is not ideal. QE3 would be just as unsatisfactory as QE2 -- better than nothing, but far from a long term solution.

    We need NGDP level targeting, maybe NGDP futures markets, some kind of arket-oriented explicit target. Occassional rounds of quantitative easing at the discretion of central bankers a dangerous tool.

  5. Lee Kelly-

    I'll admit to somewhat talking out of school. I am not a trained economist, thought I took enough in college for a BA, and was a financial reporter for 20 years.

    I became interested in QE through Scott Suymner's (now in remission) blog.

    Still, you have economists such as Martin Feldstein saying QE boosted the stock market, and that had a postive effect, and Beckworth's post here. Milton Friedman advised QE for Japan, and John Taylor (!) sang QE's praises for Japan in a piece he authored in 2006.

    I like the sound of NGDP targeting and fees or at least no interest on reserves.

    BTW, I also agree with many "conservative" ideas on limiting impediments in our economy (although is getting rid of the USDA "conservative? How about trimming the $147 billion a year in veterans and VA outlays)?

    For now, I see QE3 as perhaps doable, and not sure how to start with NGDP targeting.

    How would you start the ball rolling on NGDP? Who should take the lead? What pundits would you try to get onboard?

  6. Benjamin,

    I agree that another round of quantitative easing is more likely than an explicit NGDP target. However, monetarists should be wary about supporting more quantitative easing given the present monetary and political institutions. The Fed's discretion over monetary policy and the absence of a real target help destabilise NGDP expectations; and the same powers the Fed can use to do good can also be used to do great harm. It was precisely the lack of something like an NGDP target that allowed spending to collapse in 2008.

    Commentators like David Beckworth came out in support of QE2 and all too often got lumped together with crude Keynesians.

    Oh, and Benjamin, you are much better qualified to talk about this than me. I have only taken a couple of introductory classes in economics, and so I am certainly no authority -- it's just a hobby.

  7. David,

    Sumner's last post,

    It sounds like he's arguing for what Krugman is arguing, the wealth effect... no?

    Also, quick question. Are the A) traditional Keynesian interest rate channel, and B) tobin's q, and C) Krugman's wealth effect channel, examples of the portfolio rebalancing channel?

    I ask because since reading quasi-monetarist ideas I have been under the impression that ALL monetary transmission channels are through portfolio re-balancing, but now I am confused...

    Would it be possible, if I were to perhaps send you an email to explain my confusion, if thats ok of course?



  8. Benjamin and Lee:

    Yes, more monetary easing would be nice but Lee is correct that it would be far better to do it in the context of an explicit rules-based approach. All of the QEs have been so ad-hoc and while midly effective are widely unpopular. The pushback the QEs are creating is eroding the Fed's ability to do something bold like NGDP level targeting. I fear that the Fed's chance to do something like NGDP level targeting is long past.

  9. JoeMac:

    I think all of the standard transmission channel stories can be seen as part of a broader portfolio rebalancing channel. It is just that folks tend to stress that channel they think is most important.

    I am not positive what Sumner believes is the most important channel, but he definitely sees many more transmission channels than the interest rate one.

  10. David wrote:
    "What is remarkable is that QE2 has done as much as it has given that (1) the U.S. Treasury has been undermining QE2 by increasing the average maturity of the U.S. debt and (2) QE2 being implemented in a less than optimal fashion."


    But given Krugman's faith in the concept of the liquidity trap it is also remarkable in the face of what devotees of fiscal stimulus were predicting starting 2010Q4:

    With ARRA in full retreat, and even tighter fiscal policy probably on the way courtesy of the Republican controlled House, we should be spiraling downward into a double dip recession just right now. And yet reality is totally confounding their vector autoregressive driven predictions. Curious that the foes of QE2 on the left have conveniently forgotten this "fact" little over a year later.

  11. David Beckworth:

    I roughly think you are right, but then I wonder if "average voters" even give a hoot about QE and NGDP. That is to say if Obama backed Bernanke, they could go ahead and do it (either QE3 or NGDP), and the "pushback" would strike the voting public as mumbo-jumbo.

    Also, there is an obvious approach that NGDP and QE diminish the argument for federal deficit spending, and so true conservatives should embrace QE. I wrote an op-ed to this effect, but I can't get it published.

    Really, I think getting more QE and NGDP is a matter of good spin and PR. Something Obama and Bernanke are weak at.

    On top of that, nothing succeeds like success. If the economy continues to improve, then people will love QE3. I am sure you noticed that few are bashing QE2 anymore. They seem to be saying "no more," but they said that before QE2.