QE Has Worked Before and It is Not Just About Lowering Interest Rates

Felix Salmon tries to defend his criticism of QE2:

I don’t think that we’re hysterically attacking QE2, so much as pointing out that it’s never been done before, that we don’t know whether it will work, and that, if it doesn’t work, we don’t know how it’s going to fail, either.

No, QE2 has been done before and it worked quite well.  As I showed in this post and as noted by Paul Kasriel, the original QE started in in late 1933 and was very effective at spurring a robust economic recovery.  And contrary to conventional wisdom, the key to making QE work then and now was not the lowering of long-term interest rates.  It was about addressing the excess money demand problem and thereby spurring a recovery in nominal spending.  Yes, interest rates may initially fall,  but if QE2 works according to plan there should ultimately be an increase in yields. In short, QE2's success is not contingent on a sustained lowering of interest rates.

Case Closed: Milton Friedman Would Have Supported QE2

The debate over what Milton Friedman would say about QE2 can now be closed.  Below is a Q&A with Milton Friedman following a speech he delivered in 2000.  In this excerpted exchange with David Laidler, we learn that Friedman's prescription for Japan at that time is almost identical to what the Fed is doing now with QE2: (my bold below)

David Laidler: Many commentators are claiming that, in Japan, with short interest rates essentially at zero,  monetary policy is as expansionary as it can get, but has had no stimulative effect on the economy. Do you have a view on this issue?

Milton Friedman: Yes, indeed. As far as Japan is concerned, the situation is very clear. And it’s a good example. I’m glad you brought it up, because it shows how unreliable interest rates can be as an indicator of appropriate monetary policy.

During the 1970s, you had the bubble period. Monetary growth was very high. There was a so-called speculative bubble in the stock market. In 1989, the Bank of Japan stepped on the brakes very hard and brought money supply down to negative rates for a while. The stock market broke. The economy went into a recession, and it’s been in a state of quasi recession ever since. Monetary growth has been too low. Now, the Bank of Japan’s argument is, “Oh well, we’ve got the interest rate down to zero; what more can we do?”

It’s very simple. They can buy long-term government securities, and they can keep buying them and providing high-powered money until the high powered money starts getting the economy in an expansion. What Japan needs is a more expansive domestic monetary policy.

The Japanese bank has supposedly had, until very recently, a zero interest rate policy. Yet that zero interest rate policy was evidence of an extremely tight monetary policy. Essentially, you had deflation. The real interest rate was positive; it was not negative. What you needed in Japan was more liquidity.

So Milton Friedman said in 2000 that the Bank of Japan should do what the Federal Reserve would be doing 10 years later!  In fact, if names, dates, and places were changed in the above excerpt one could get a 2010 Ben Bernanke Q&A. Friedman's belief that a zero policy interest rate could be contratctionary and thus required the central bank to buy long-term securities shows that he understood unconventional monetary policy long before it was vogue.  He truly was a great economist.

Note, though, that his emphasis is still on expanding the monetary base as much as needed to start and maintain an economic expansion.  This implies he saw an excess money demand problem in Japan, just as there is one today in the United States.  He understood, though, the need to expand the monetary base through purchases of long-term securities rather than short-term ones.  This is because short-term securities are close to a perfect substitute for the monetary base at a zero percent policy rate. Swapping perfect substitutes does not change anything in one's portfolio of assets and therefore has no effect on spending.  Thus, Friedman saw the need for purchasing long-term securities, which are not perfect substitutes with the monetary base.

Although Milton Friedman probably would have preferred a rule-based approach to QE2, this excerpt is the smoking gun that ends all debate on whether he would have supported QE2. The case is closed.

Thanks to Doug Irwin for locating this gem.

Would FA Hayek Favor QE2?

I made the case earlier that Miltion Friedman would have endorsed QE2 in some form.  So what would F.A. Hayek say about QE2?  Where would he stand on this issue?  Larry White says he would not support QE2 , but he would have supported QE1:  

But Lawrence White, an economist at George Mason University in Washington, DC, argues that this is an unfair characterisation. “Hayek was not a liquidationist,” he says, referring to the philosophy of Andrew Mellon, President Herbert Hoover’s Depression-era treasury secretary, who wanted to “purge the rottenness out of the system”. Hayek believed the central bank should aim to stabilise nominal incomes. On that basis Mr White thinks the Fed was right to pursue the first round of quantitative easing, since nominal GDP was falling, but wrong to pursue a second round with activity recovering.

Yes, F.A. Hayek was a fan of stabilizing nominal spending, a point I have discussed before on this blog. The question that I don't know the answer to is whether he would have stabilized nominal spending around its existing trend level or some other value. If Hayek were stabilizing it around its existing trend level then he would be in favor of something like QE2. Presumably, though, he would have implemented it in a more rules-based form than the current ad-hoc design of QE2.

White believes, however, that Hayek would not have maintained nominal spending at its existing trend level.  Okay, let's assume as a baseline case Hayek would  have  stabilized nominal spending at the point where it was before its collapse in 2008.  If this were the case and if we looked to nominal spending per capita, I think one can make the case that Hayek might have been sympathetic to a rules-based version of QE2.  Here is the reason: (Click on figure to enlarge)

This figure shows that domestic demand per capita is only at its 2007:Q2 value.  Aggregate demand per capita shows the same thing: nominal spending per person has yet to reach its previous peak.  So  maybe Hayek would be sympathetic to further monetary stimulus.  Again, there is no doubt he would have objected to the way QE2 is being implemented. I would love to know what type of nominal spending target he  would have favored.

A Note To Ben Bernanke

Dear Ben Bernanke,

Many years ago a good friend invoked a boxing analogy in advising me on one of my many futile romantic pursuits. He told me that if in my pursuit of a certain woman I go down, I should go down swinging. Never look back with regret.  I couldn't help but think of his advice when considering your pursuit of  a more robust economic recovery via QE2.  There is no romance in this case, but you do claim to be passionate about stimulating more economic activity via a monetary-induced surge in nominal spending.  As you know, a key part to fulfilling this  passionate pursuit of yours is to meaningfully raise inflation expectations (and by implication expected nominal spending).  So are you giving it your all? Are you willing to go down swinging?  The bond market says you ain't really trying: (Click on figure to enlarge.)

This figure shows average annual expected inflation over the next five years has been flatlining around 1.55% over most of November.  For all the hopes and fears of QE2, this response is underwhelming.  There is no passion in this figure!  Time to change that.  Come out swinging with an explicit nominal level target--preferably a nominal GDP level target--and a commitment to maintain it no matter the cost.  Stand tall when blows from the political left and right try to undermine your efforts.  Make the markets believe you are serious about shoring up nominal spending. Make them believe you will go down swinging if needed.  Show them you are the man!

Oh No, QE2 Might Actually Work!

Lawrence Lindsey is concerned that QE2 might work as intended.  He is afraid that if QE2 actually spurs an economic recovery there will be higher interest rates that, in turn, will create a fiscal crisis:

Now suppose quantitative easing is “successful” in the way the Fed intends, taking inflation close to the average 2.4 percent rate of the last two decades and government borrowing costs back to their two-decade average of 5.7 percent. To get an idea of what happens to the budget, assume this transition happens over three years, so that by 2013 interest rates are back to “normal.” This “return to normal” will mean the government’s interest costs will rise to $847 billion by 2015 and $1.15 trillion by 2019

[...]

Interest rates could also rise for a variety of other reasons. Much faster real economic growth could have the same effect. An additional point of real growth for five straight years would help by raising revenue by about $450 billion over five years, but a parallel increase in real rates would raise interest costs by $700 billion over the same period. The higher real rates and larger deficit would likely put a lid on the sustainability of any growth spurt

Lindsey is correct that an economic recovery will raise interest rates. In fact, rising yields will be a sure sign of economic recovery. His concerns, however, about a fiscal crisis seem rather misplaced on several fronts.  First, it would be easier to deal with fiscal problems in a growing economy created by QE2 than in a Japan-style economic slump created by an aborted QE2.  Second, keeping monetary policy tight by having no QE2 would create other problems that his analysis ignores, like further pressure for trade protectionism.  Third, tight monetary policy would increase the likelihood of more fiscal deficits and fiscal problems. Consequently, I will cast my lot with QE2 and pass on the Lindsey prescription of tighter monetary policy.

Too Much Focus on Interest Rates

Though much needed, QE2 it is far from perfect.  One problem with QE2 is that it is being marketed as a monetary stimulus program that works by lowering long-term interest rates.  Dropping long-term rates, the story goes, will in turn spur interest-sensitive spending and jump-start the economy.  This marketing strategy seems wrongheaded to me because it (1) ignores other  important channels through which monetary policy can work and (2) creates the wrong expectation that QE2 will only be successful if it maintains long-term interest rates at a low level.

The emphasis on the so called "interest rate" channel through which monetary policy actions are transmitted to the economy is pervasive in QE2 discussions.  For example, here is Greg Ip explaining how QE2 works:

Under QE, the Fed shifts its focus to long-term rates from short-term rates, and buys as much debt as it needs to get long term rates down. If it ever gets long-term rates to where it wants, it will stop buying. If it thinks long-term rates have gone too low, it could sell...Monetary policy stimulates demand by lowering the real interest rate...

It is understandable that journalists would invoke this monetary transmission channel when explaining QE2 since Fed officials are doing the same.  Here is this channel being endorsed by Ben Bernanke:

[A] means of providing additional monetary stimulus, if warranted, would be to expand the Federal Reserve's holdings of longer-term securities. Empirical evidence suggests that our previous program of securities purchases was successful in bringing down longer-term interest rates and thereby supporting the economic recovery.

This view is further reinforced in the FOMC minutes for the October 15 meeting. These minutes show that the FOMC considered targeting an long-term interest rate: 

[P]articipants discussed the potential benefits and costs of setting a target for a term interest rate. Some noted that targeting the yield on a term security could be an effective way to reduce longer-term interest rates and thus provide additional stimulus to the economy.

This narrow emphasis on the interest rate channel ignores the fact that monetary policy can influence the economy through various transmission mechanisms.  This New York Fed article, for example, notes that the transmission channels include the bank lending channel, the balance sheet channel, the wealth channel, the interest rate channel, the exchange rate channel, and the monetarist portfolio adjustment channel.  I see the portfolio adjustment channel being much more important for QE2 than than interest rate channel for several reasons.   

First, the portfolio channel acknowledges the reality that Fed purchases of government securities will affect the prices and yields of  one's entire portfolio of assets, not just treasuries.  This includes real money balances and the demand for them as an asset.  Thus, it is through this channel that the real issue behind the weak U.S. economy  can be addressed: the excess money demand problem.  Ironically, Ben Bernanke acknowledged the importance of this channel at his Jackson Hole speech back in August, 2010.  Unfortunately, his other speeches and Fed statements more generally create the impression QE2 is all about the interest rate channel.  

Second, the interest rate channel works through a lowering of interest rates that stimulates interest-sensitive spending.  This cannot be an important channel, however, if QE2 actually works.    For if QE2 is successful in stimulating economy activity it must be the case that (1) expected inflation  picked up at some point and (2) real interest rates picked up at some point in response to the recovery of the real economy.  In other words, nominal interest rates--the sum of the real interest rate and expected inflation--will increase if QE2 is successful.  This channel, then, will at best be fleeting.   

That the interest rate channel will be fleeting if QE2 works is another reason why the narrow emphasis on this channel is wrongheaded: it creates the wrong expectation that QE2 will only work if long-term interest rates remain low.  Thus, QE2 is bound to be plagued by second guessing and criticism from observers who only see monetary policy through the prism of the interest rate channel.   For example, imagine there is a sustained rise in interest rates.  I would view this as a sign that QE2 is working. Many observers, however, would probably view such a development as failure of QE2.   I fear the  Fed is setting itself up for trouble by framing QE2 as working solely through the interest rate channel. 

Bernanke Does Not Have a Magical Commodity Price Wand

A few weeks back, Paul Krugman made the case that surging commodity prices do not necessarily mean U.S. inflation is about to take off:

A bit more on commodity prices: among other things, all of those pointing to rising commodity prices as a sign of runaway U.S. inflation seem oddly oblivious to the fact that commodity prices are a global phenomenon, driven by world demand... recovery in the emerging world has led to a recovery in commodity prices, which had plunged in 2008. How much does all this have to do with Ben Bernanke, or U.S. policy in general? Not much.

Scott Sumner recently made a similar argument  in terms of gold prices:

The TIPS spreads over the next 5 years suggest roughly 1.7% annual inflation—slightly below the Fed target, even after the announcement of QE.  Some point to the world gold market, but unlike TIPS spreads this doesn’t provide a point estimate of expected inflation in the US.  Rather it reflects all sorts of factors such as expected new discoveries of gold, negative real interest rates, and gold acquisition by developing country central banks.  Furthermore, gold prices have also risen sharply in yen terms; does anyone believe this is a forecast of high inflation in Japan?

The key point being made here is that commodity prices are influenced by many factors, not just U.S. monetary policy.  Therefore, it would be difficult to draw any conclusions about expected inflation from them. I decided to do a quick check on these claims by looking at the relationship between the year-on-year percent change in commodity prices and the year-on-year percent change in industrial production for  both emerging economies as whole and the United States for the period 2007:12 - 2010:8. The data comes from the IMF and the Netherlands Bureau for Economic Analysis. What I found is that the the emerging economy group rather than the Unite States was more closely associated with changes in commodity prices: (Click on figure to enlarge.)

 

These figures indicate that the wide swings in commodity prices over the last few years have more to do with the emerging economies than with the U.S. economy.  The Federal Reserve, then, may not  be as important a determinant of commodity prices as some observers believe.  More importantly, there are no sure signs that the Federal Reserve is unleashing a massive inflation.  If anything, the Fed is keeping inflation too tame.