After my previous post on the QE taper there was some discussion on the INET YSI Commons Facebook page about the QE programs. I think it might be constructive to sum up what was there discussed as it provides a very good overview of what the QE programs do, what they do not do and how they work.
First of all, however, it should be noted that the objectives of the QE programs appear to have changed over time. When the program was initially put in place by the Fed in 2008 — or, if one wants to go further back in time, when it was first enacted by the Bank of Japan in 2001 — it was generally thought that the program would boost investment in the real economy and thus create employment.
This would be the truly monetarist component of the QE program. The idea is that you increase the amount of money in the system, this money flows from the banks into the real economy and thus increases investment and employment. A variant on this — what might be called the New Keynesian variant — is very similar: the QE program increases the amount of money in the system, this drives interest rates down across the board and these lower interest rates force businesses to invest in tangible assets.
Such ideas were the initial impetus for the QE program and by these criteria it failed spectacularly — as MMT and endogenous money proponents suspected that it would. Over time, however, the commentariat have revised their estimations of the QE programs in line with what it has actually done and attempted to justify its results post factum; the Fed, in turn, has endorsed such maneuvers with glee and run with them.
These maneuvers are why I think the QE program to be a largely false distraction, ultimately cooked up for the amusement of economists and economic commentators; a soporific ingested in order to distract oneself from the true determinants of our current problems. If the initial impetus for the QE programs has proved false and pundits nevertheless judge it based on some of the things it has accomplished in a peripheral manner one is certainly hard pushed to think that it is not largely a nonsense policy — a mask, covering up the impotence of central banks since 2008.
All that said, let us now consider briefly what QE actually does and how it does it.
As everyone knows, the program works by central banks creating money and using this newly created money to purchase various assets — mostly bonds, but also securities and some other stuff. When these assets are purchased two things effectively occur: their value increases and their yield falls.
Another way to think about this process is that the central banks are limiting the supply of assets. Imagine that there a set number of such assets in a given market — say, 1,000 — and that the average price is also set — say, at $1,000. Now, say that the central banks steps in and uses newly created money to buy up half the assets and this, in turn, doubles the price. The supply of assets in the market falls by half and the price doubles. (This is not an accurate portrayal of either the extent of central bank purcahses or of the price dynamics, but just a stylised example to help us understand the dynamics at work).
At the same time, however, that the price of the assets rise, their yields fall. Thus, again for the sake of an example, imagine that the assets initially had an average yield of 5%. But then, after the central bank purchases, their yield falls by half to 2.5%.
The situation is now clear. Holders of the assets have seen an increase in their net worth as the value of the asset has doubled, but they have seen a fall in their income streams as the amount that their assets yield has halved. In the economics jargon we might say that as their stock of wealth has increased, their income flows have diminished. This is what we might call the “primary effect” of QE.
There are, however, secondary effects. Because the yield has fallen on their assets and because some people who used to hold assets but sold them to the central bank now hold cash, which basically yields 0% (actually, the real rate is 0.25% in the US and 0.50% in the UK), these investors will now search out other markets in which to make money. In doing so, this will drive up the value of the assets in these markets and drive down their yields. Thus we have a sort of cascade effect where the initial burst of value given by the QE is translated from one market into another. These are the secondary effects.
Neil Lancastle has reminded me that there is also a tertiary effect. When companies see the value of their assets rise, they also see the value of their equity rise. This encourages them to take on more leverage and spend this on more assets. This, in turn, boosts the value of the assets even more.
As we can see, however, this cascade process eventually comes to an end. And what we finish with is a market in which asset prices are substantially higher but yields are suppressed. This proves to be something of a double-edged sword for savers and investors. On the one hand, they are glad to see that their assets are worth more money, but on the other their income streams are substantially diminished. After a while, this becomes tedious for investors as it eats into their wealth — this is why some in the financial markets, especially pension funds, get annoyed by the QE programs: they make it extremely difficult to accrue steady flows of income.
While the effects the programs have on investors is mixed, the effects it has on asset prices and leverage are not: it increases them beyond what they would be if the programs did not exist. This can be enormously problematic. Many like Chris Cook and Izabella Kaminska (and myself), have argued that the programs have led to a run-up in commodities prices, for example. Such a run-up in asset prices may also — and on this point the central banks are more than aware — lead to bubbles. I have, for example, discussed how current dynamics in the stock market may become fragile if government spending is cut and the real economy stagnates.
As we can see then, there are risks and downsides to the QE programs. They hurt as well as help investors and savers and they may generate instability and fragility in financial markets. The program, from this perspective, basically provides a sugar rush for the market, but it is in no way clear that as the impetus added to asset prices wears off the overall level of income does not fall due to decreased interest income.
Meanwhile, however, the program has extremely positive effects for debtors. As the cascade drives down yields across the markets, interest rates on all sorts of loans for consumers fall. This reduces the amount that these debtors have to pay in terms of interest on debt. The following chart shows the amount of their disposable income US households are using to service their debts:
As we can see, this fell from some 13.5% before the QE programs to some 10.4% after. This is a net increase in US households’ disposable income of 3.1%. This is nothing to be sniffed at and, because they have more income to spend on other goods and services, this undoubtedly adds to demand and GDP.
It should be stressed, however, that these positive effects can only go so far. The first two round of QE were initiated between November 2008 and April 2011. As we can see, in this period debt service payments as a percent of disposable income for households fell substantially to 10.4%. The third round of QE which was initiated in September of 2012 has not had much of an effect at all; indeed from the data we do have for that quarter it appears that debt service payments as a percent of disposable income for households actually rose by about 0.2%. Talk about diminishing returns!
And that is it really. As we can see the effects of the QE programs are mixed. They can boost asset prices — but this is largely offset by the decline in yields that results. This also may have undesirable results and lead to fragility. The programs also alleviate the interest payment burden on debtors. This has a positive effect, but is subject to seriously diminishing returns.
Again we must stress though, the original idea behind QE was that it should increase real investment and employment. This simply has not happened and by this standard — which is the standard by which QE should be judged — the program has been an abysmal failure. A key lesson should be taken from this: business investment is first and foremost demand-led and does not simply respond to lower interest rates or increases in the base money supply. If the customers are not there to buy the goods and services, the companies will not invest and hire in the real economy.
It is for that reason that the QE programs are largely a distraction talked about by an economic establishment that feels powerless when confronted with the confusing facts of the post-2008 world. Rather than recognising the serious structural problems we face — from moribund governments undertaking failed austerity programs to ever-widening income inequality — the establishment prefers to chatter over the QE programs, as if the wonks still had some control over the system. Well, the harsh reality is that they don’t.
There is another effect to add to the mix. It suppresses the yield on the only substantial injection of ‘new financial assets’ into the economy – ie government bonds.
And given that everybody is encouraged to chase asset prices up with QE, rather than buying real stuff, there is less real spending, and less taxation (due to income vs capital taxation differentials) – which means more bonds get issued than otherwise.
So I’d say that if the central bank buys government bonds, the dynamics of that is that the Treasury then has to issue more government bonds. So the underlying effect is that the Central Bank effectively gives new money to the Treasury to spend – with a few middlemen creaming off their slice in the middle.
If you look at it in terms of Interest paid out, the Treasury gets to hoover up an awful lot more money with bonds per, say, 10 million of net interest paid to the private sector than it would without QE there. And that enables a shift from saving to consumption by the backdoor via the different propensities.
Actually, from the evidence I’ve seen I don’t think that people chasing up asset prices is suppressing consumption. I think that the best way to think of this is that your average investor has a big pot of money for investment and a big pot of money for consumption. What QE does is try to ensure the big pot of money for investment chases assets in the market. But this has no bearing on the size of the big pot of money for consumption.
I not suggesting it is suppressing consumption. I’m saying that it is cover for the government pushing the money circulation round the pipe a bit faster than it otherwise would. So you get an increase (or maintenance) of consumption that you wouldn’t see in the counterfactual. And of course because its counterfactual you can’t really check.
As Warren would say – QE is functionally equivalent to not issuing bonds at all.
Excellent compact discussion on merits and demerits of Quantitative Easing. One question. I believe QE should increase the inflation rates. However, what explains the consistent below 2 % inflation in the US ?
Well, if you follow the above analysis QE cannot increase CPI inflation. It can only increase asset price inflation. This is, indeed, what has happened. The idea that QE generates inflation is simply wrong for the reasons I outlined at the beginning and the end of the piece.
Is it then axiomatic that once QE is removed or scaled back then there will be a commensurate rise in interest rates, which would choke off employment significantly? If so would the Fed be able to effectively target rates absent QE?
But I suppose the larger question is, even beyond the QE question, will rising rates ever be workable in our credit based, consumer economy?
There will be a rise in some interest rates. See the other post I wrote that is linked to at the start of the present post. But the rise will not be very significant. Rates will rise substantially when the central banks decide to raise term. No sooner, no later.
As to the second part of your question, I don’t expect to see rising rates for a long, long time. Unless a good Keynesian president gets into the White House and boosts aggregate demand through a large-scale spending program.
Phil, moving beyond your stylized example based on a fixed supply of assets, isn’t it likely that a real-world effect of the Fed’s heavy participation in the market for mortgage-backed securities would be to increase the supply of MBS? If the Fed is in the market for MBS, then the cost of mortgage securitization goes down, which should increase the availability of mortgages and improve their rates. Following the start of the last phase of QE, we did see a recovery in the mortgage market, and during the recent episode of market worries about tapering, the re was a reversal.
How New Keynesian/Monetarist of you, Dan! Ha, I’m only kidding. No, I don’t think so. Credit is extended based on demand for credit, creditworthiness and interest rates. The effects that buying MBSs has on the market for mortgages will be felt through the interest rate channel and only through the interest rate channel.
Well it seems to me that the market for credit, Phil, like every other market, is governed by both supply and demand. The creditor is willing to offer credit at a given interest rate as a function of the cost to the creditor of offering it at that rate and the demand for loans at that rate. The costs include the perception of risk, which will be reflected in the price. If a mortgage originator can bundle up a bunch of mortgages in an MBS and sell it to a buyer in a way that decreases the upside return but reduces risk, that originator may offer more mortgages (as happened during the derivative-fueled mortgage-bubble.) The lower the yields on the MBS go (i.e. the higher the prices), the lower the originator’s costs. If one of the buyers in the market for MBS is the very deep-pocketed Fed, which is acting in the market not to pursue profit for the Fed, but to pursue a deliberate policy of suppressing rates, then the impact on the mortgage supply side will be even greater.
I’m not saying this is a good thing. During the most recent stage of QE, we did indeed see a big surge in mortgage-lending and home-buying, but some worry that this is a speculative bubble driven by stupid speculators and flippers. And when the Fed flirted with its taper talk, markets drove up long-term yields in anticipation, which seems to have slowed down the housing market.
Shorter version: I’m not disagreeing that central bank impacts go through the interest rate channel. But in this case reducing the rate the originator has to pay for securitization makes mortgage origination more profitable.
This is an impact the Fed can’t have right now in the ordinary market for bank loans, because it can’t reduce bank lending costs lower than they already are and banks have no need for further liquidity, and so all of the policy work to be done is on the demand side. But in the housing market, driven by long-term rates, the later rounds of QE did succeed in driving down those rates.
And saying that the Fed impacts the economy through the interest rate channel by influencing the rates for various classes of assets, is just another way of saying that the Fed acts by increasing the demand for assets in that class. If you move the demand curve for an asset class to the right and the supply curve stays where it is, then more will be supplied.
This has nothing to do with monetarist analysis which is based on the idea that the Fed is “pumping money” into “the economy” as a whole, and creating impacts via portfolio re-balancing and hot potatoes etc. The Fed doesn’t pump money into the economy. It offers money in exchange for other assets in the market for those assets.
Are you saying that the effect is through the interest rate channel or not? If you are saying this, then I dealt with it in the original piece on the taper. If you are not saying this, then I am not clear what you are saying.
Yeah, that’s fair enough. Just pointing out that by lowering the yields on MBS (same as interest rates if we were talking bonds) and raising their prices, that increases the desirability for the originators of those MBS to supply them. And that means they have an added incentive to originate more mortgages at lower rates and package them into MBS. It’s hard to deny the empirical evidence that the agency security phases of QE are associated with an untick in the housing market.
The question is whether it is healthy. I think if you frankly asked the Fed governors why they first signaled they were going to taper soon, they would say, “We’re worried about another bubble in the housing market.” And if you asked them they they changed their minds, they would say, “We got scared about the impact of popping the bubble in the housing market.”
I’m uncomfortable with the way you’re putting this, Dan. You write:
“Just pointing out that by lowering the yields on MBS (same as interest rates if we were talking bonds) and raising their prices, that increases the desirability for the originators of those MBS to supply them.”
That is true of any of the debt instruments the Fed buys — and even those it doesn’t directly buy but which are bought with QE money. The “incentive to supply them” is only that they have a higher price/lower interest rates. There is nothing special, unique or even interesting about MBSs in this regard.
I think you’re concerned with whether this is dodgy or not. Well, I think you’re fooling yourself with a bit of reification here. The securities in the banks didn’t drive the US housing bubble, they just accommodated it. The bubble was driven by a demand for mortgages. I know that the popular mantra is “blame the banks for the housing bubble” and “blame the MBSs for the crash”, but that’s really just a hoary load of old populist BS.
You can have a housing bubbles with or without MBS. Ask Ireland how big a property bubble you can have without MBS. They’ll tell you “the biggest in the world”. To understand the effects of QE you have to look at the liabilities side of the balance sheet, not the asset side.
This is something I’m confused about. The Fed is only allowed to buy agency backed securities … they can’t by law buy just any MBS out there. Does the supply from said agencies (Fannie/Freddy) really depend on the demand for them? I was under the impression that they would securitize any conforming mortgage sent their way … thus the number of home buying consumers would determine the supply. In which case I don’t fully understand how the FED purchases would actually filter through to mortgage rates offered to the consumer.
I’m wondering to what extent QE even affects asset or commodities prices. The people holding gov’t bonds are obviously very conservative investors to begin with. Taking away some of their bonds isn’t going to turn them into greedy commodities speculators … the level of risk is too high.
So I would think that there would be some modest rise in asset prices as these people rebalance their portfolios, but I’m not sure that would drive a “bubble”, since there is only so much risk these folks are willing to take, and if P/E gets too high they will shy away.
An alternative explanation for rising markets is the fact that productivity has been rising without firms having to pay more to employees (wage/salary demands disciplined by high unemployment) … so they are more profitable, hence higher stock prices.
I’m actually pretty sympathetic to your argument. As I note in the piece pension funds hate the QE program. They’re always complaining about it. And yes, this stifles what I called the “cascade effect”. But there are plenty of other investors out there who do not mind taking on such risk. And there seems little doubt that they are entering the stock market and the commodities — the sheer force of the lobbying indicates that there’s a lot of money in the latter.
Besides, it’s hardly a coincidence that the stock market rallies substantially after QE in both the US and in Japan. But again, I do think that you are partially correct and that QE is even a bit weaker than people would assume in the way it drives up assets.
The people holding gov’t bonds are obviously very conservative investors to begin with.
True enough. But if there are quick and easy arbitrage profits to be made by reselling Treasuries to the Fed, then people will take advantage of them. The Fed doesn’t participate in the primary market for Treasuries. But by adding heavily to the demand for Treasuries in the secondary market, that should increase the demand in the primary market.
The whole “portfolio re-balancing” seems distorted to me. The Fed doesn’t force people to sell Treasuries, thus un-balancing their portfolios. It offers securities which the purchasers voluntarily buy. Clearly the purchasers prefers the asset balance they end up with over the one they started with, or else they wouldn’t have sold.
It is slightly different though, Dan. If I buy treasuries there is a good potential I will resell them at some point in the future. The Fed are buying purely to hold.
Ok, well in the case of investors who are merely holding the gov’t bonds as a transition, they may very well just hold onto the cash proceeds from the bond sale for the short period of time until their next risky investment. Doesn’t seem to be anything about QE per se that would entice them to buy riskier assets than they otherwise intended to, thus inflating a bubble.
Right, but the fact that the Fed is buying Treasuries makes others more eager to buy, because there is big aggressive buyer they can re-sell them to at a profit. Suppose a big rich guy, who is prohibited by law from buying hamburgers directly in fast food restaurants, walks into McBurger and says “I want hamburgers and I have $10,000 to spend!”. Then everybody in the shop is going to buy hamburgers and sell them to him. How much they make depends on how many people are there, how much they have to spend and how they organize the auction. With QE and Treasuries, it’s probably not that big a deal. Some people are making easy, but small arbitrage profits, and that’s just adding a few extra bucks to the already overstuffed reserve accounts of financial institutions. And with the longer term debt, the sellers just get quick dollars now in exchange for interest income they are foregoing later.
Right, but these “other investors” entering the market aren’t doing so as a direct result of QE operations … more a “placebo” effect, as Mosler would say. They are reacting to what they *think* QE will do, or what they think other people think it will do … which relates to the fact that they don’t actually understand it.
Again, yes, I think there is a very large component of that which makes it very hard to distinguish what effects QE is having versus what effects Bernanke opening his mouth is having. However, I think that Chris Cook’s argument is correct too. Investors are convinced that there is some inflation risk with QE and at the same time they see a lot of negative yield going on in safe assets. So they pile into commodities. Gold is the most obvious in this regard, but commodities have gone up across the board.
Ok, although I think that’s mostly saying the same thing.
Well, the first component — i.e. hedging against inflation — is based on ignorance, yes. But the second component — i.e. the reaction to negative yield in the face of inflation of 1.5-2.0% a year — is very real. These two things, I think, are combined. The latter feeds into the former and the former into the latter.
So, there is an element of ignorance in such hedging. But there is an element of realism too. And once the juggernaut gets going and commodity prices start to rise, its perfectly rational to ride the wave. That’s almost certainly what happened so obviously and clearly in the gold market.
Ok, but I would think rational and risk adverse investors would buy relatively safe blue chip investments as a hedge against a very modest inflation, and only to the extent that prices didn’t get too ahead of earnings.
These wouldn’t be the people jumping into the gold market. Those are speculators, and they will always exist QE or no QE … QE is just the current excuse.
People in finance think that commodities are negatively correlated to stocks and bonds. That is why they use them:
My feeling is that speculation plays an absolutely enormous role in all these markets (apart from those in direct control of the Fed). Perhaps its an excuse, but it still works.
Here’s why I find this question so interesting:
In the world imagined by most MMT folks, the gov’t would deficit spend without issuing any bonds. This would amount to “permanent QE”, since the Fed buying up gov’t bonds is the functional equivalent of never issuing them in the first place.
So in such a world, there would be no such thing as a “risk free rate of return”, and any available yields would reflect the amount of risk you are willing to take.
So if we believe that “QE drives asset bubbles”, does that mean that there will be no relatively stable markets in MMT world?
Personally I think that markets would more or less stabilize in that environment as different types of investors and speculators and hedgers find the level of risk they are comfortable with. There will still be the occasional bubble, as now … it will just need a different excuse to set it off.
In the MMT world of perma-ZIRP and no bonds, ceteris paribus, financial markets would be far more unstable. I think the MMT guys realise this. Well, Wray certainly does.
I don’t think Mosler believes that. It’s not clear to me that this would be the case.
Where has Wray written about that?
He has certainly never said that MMT would fix the financial markets. No Post-Keynesians believe in the “euthanisation of the rentier” argument anymore.
Oh, and he favourably linked to my Guardian piece which made the case that there was no fixing financial instability.
Not arguing that MMT would “fix finance” … just that permanent zero-risk free rate would not necessarily be a new source of instability, at least not after an initial period of adjustment. All the same old problems would still be there.
The policies on banks do their best to ‘fix’ the financial markets – by removing the lender of last resort access to ponzu finance. Narrowing banks heavily (but not completely) makes more room for fiscal policy to take up the strain (larger tax cuts and/or more govt spending).
Also, the cartoon at the top is misleading for those who understand what’s going on, since QE isn’t really “feeding money” to the banks … really just an asset swap, bonds for reserve balances.
All that seems to me a ver parcial analysis. The important matter is to see if investment has positive correlated to the fall in interest rate. I think so. Perhaps the recovery y is too slow, but We must ask if whitout QE things wouldn’t be worse.
I think the main positive efect of QE has been to reduce prívate endebtment. In Euro Zone, without QE, We are very worse in this an other aspects.
Such a correlation would prove nothing. Investment may well have been responding, as I think it was, to the increase in effective demand from enormous government deficits and a decreased current account balance. To prove that investment was being affected by QE substantially I would want survey data of investors saying that they were increasing output and employment because of the easing program. All the surveys I see say that they are more concerned with sales — i.e. effective demand.
Pingback: The Economics of Counterfeit Money | Fixing the Economists
Pingback: Bank of England Endorses Post-Keynesian Endogenous Money Theory | Fixing the Economists
Pingback: Time to Rewrite Econ Textbooks: Endogenous Money | dismalscienceblog