The second round of quantitative easing is drawing to a close. Legitimately, the QE2 trade was ‘officially over’ in late March. My comments from March about a potential QE3 are still operative:
My sense from the totality of Fed communications – from both hawks and doves – is that they will stick to their original timetable and then pause. At that point they have to decide whether to mop up the excess reserves. If the economy is OK, they will start to sell Treasuries. If the economy is too fragile they will simply do nothing and wait. If the economy really sucks, the QE3 speculation can begin. The timetable depends entirely on the economy, of course. And Bernanke has said so. Bottom line: we are a long way away from either QE3 or raising rates. Over the near term, it’s a question of what to do after QE2 is over.
Unfortunately, the US economy has weakened somewhat since that time and so the speculation about QE3 has gathered apace. Let me say a few words on this topic here. But, before I do so, let’s review How Quantitative Easing Really Works.
- Quantitative easing is simply large scale asset purchases (LSAP) by the central bank. The central bank is permitted by law to purchase a wide range of assets including but not limited to Treasury securities, mortgage-backed securities, or municipal bonds.
- In QE1, the Fed purchased nearly $1.75 trillion of Treasury, agency, and agency mortgage-backed securities through the LSAP programs.
- The second round of quantitative easing was concentrated on purchases of medium-maturity Treasury securities only, meaning the Fed bought these securities in exchange for reserve deposits it had created expressly for that purpose.
- As such, QE2 Is Equivalent to Issuing Treasury Bills. As John Cochrane recently stated, “With near-zero short-term interest rates, and bank reserves paying interest, money is exactly the same thing as short-term government debt. A bank doesn’t care whether it owns reserves or three-month Treasury bills that currently payless than 0.1 percent.”
- In engaging in quantitative easing, the Fed has not intended to perform a lender of last resort role. Rather, as both Brian Sack and Janet Yellen have attested, the Fed’s intention has been to artificially suppress risk premia to support economic activity.
- Therefore, all QE2 does is drain the real economy of interest income by swapping an interest-bearing government liability for an essentially non-interest bearing government liability, offset by changing interest rate expectations, which alter private portfolio preferences, and lower risk premia, leading to credit growth, leverage and speculation, forces which should pump up the real economy.
So, what about QE3? My sense is that political pressures to remove both fiscal and monetary stimulus are too much to bear – both from politicians as well as from internal Fed dissent. In late March when the Fed hawks were trying to grab the bully pulpit to disabuse us of the possibility of QE3, I said pressure from the hawks would anchor the debate on QE such that QE2 would end as anticipated, followed by economic weakness without an immediate QE3. We are now experiencing that weakness. But I expect the economy would have to be in or near recession before the Fed acts with more QE.
Barry Ritholtz has a good post up by Invictus on this topic, Revisiting Bernanke’s 2002 Playbook, using Ben Bernanke’s 2002 helicopter speech for clues as to what one could expect if QE3 were implemented at some point in the future.
Now, I parsed part of this speech in December of last year. My conclusion was this:
Judging from Bernanke’s previous writing, he seems to think a combination of fiscal and monetary stimulus are what are needed to prevent debt deflation from becoming entrenched in a way that turns cyclical unemployment into structural unemployment. Based on Bernanke’s commentary on 60 Minutes last night, I believe he will continue to prescribe more cowbell, "nonstandard means of injecting money", unless political forces or internal dissent stop him.
Here’s the part Invictus focuses on that I did not. I have underlined the part relevant to QE3:
So what then might the Fed do if its target interest rate, the overnight federal funds rate, fell to zero? One relatively straightforward extension of current procedures would be to try to stimulate spending by lowering rates further out along the Treasury term structure–that is, rates on government bonds of longer maturities. There are at least two ways of bringing down longer-term rates, which are complementary and could be employed separately or in combination. One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period. Because long-term interest rates represent averages of current and expected future short-term rates, plus a term premium, a commitment to keep short-term rates at zero for some time–if it were credible–would induce a decline in longer-term rates. A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields. If this program were successful, not only would yields on medium-term Treasury securities fall, but (because of links operating through expectations of future interest rates) yields on longer-term public and private debt (such as mortgages) would likely fall as well.
You should recognize much of this argument from Randy Wray’s post highlighting the fact that QE2 was the equivalent of issuing treasury bills. However, if you recall I mentioned in November that the FOMC considered offering unlimited quantitative easing to target long-term interest rates. Ultimately, one can influence the price or the quantity of something, but not both. And the Fed decided to influence quantity when its stated aim during QE2 was to influence price. Ostensibly this was because of political pressure. Read the Invictus piece because it is clear from Bernanke’s writing there that he really thinks fiscal policy is more effective than quantitative easing to the degree you want to add stimulus. And it is also clear that the US has the same political problems regarding budget deficits and fiscal policy as the Japanese.
But, of course, Bernanke has no input into fiscal policy and right now fiscal policy is a dead issue in Washington. Interest rates are already zero percent. So, Bernanke has decided to fall back on the only thing he has left and print money.
Therefore, as I stated at the end of the recent post on Raghuram Rajan’s views on monetary policy, if the economy swoons the Fed will be forced to take more drastic action and that means targeting rates with an unlimited supply of QE as well as other measures.
In the November post on the FOMC considering offering unlimited quantitative easing to target long-term interest rates, I further commented the following:
the Federal Reserve understands it could have done more but is actually only committed to QE-lite as I have called this round of QE. Likely, political constraints or internal dissent explains why the Fed took this route. Here is what the Fed could have done:
- Buy municipal bonds. [David] Blanchflower had said "they are also allowed to buy short-term municipal bonds, and given the difficulties faced by state and local governments, this may well be the route they choose, at least for some of the quantitative easing."
- Set an interest-rate target. As authors here have indicated (see here), the Fed has absolute control over the full spectrum of rates if it is willing to offer unlimited supply of liquidity to target those rates. This is what is meant when the Fed says "participants also noted potentially large risks, including the risk that the Federal Reserve might find itself buying undesirably large amounts."
- Buy only the longest duration Treasury assets. The Fed could have targeted long-lived assets like 10- and 30-year paper. This would have had the largest impact on mortgage rates.
QE3 is still a pretty long way off. But these are the types of policy moves one could expect, something to keep in mind if the economy weakens further.