Skip to main content
Menu

Main navigation

  • About
    • Annual Reports
    • Leadership
    • Jobs
    • Student Programs
    • Media Information
    • Store
    • Contact
    LOADING...
  • Experts
    • Policy Scholars
    • Adjunct Scholars
    • Fellows
  • Events
    • Upcoming
    • Past
    • Event FAQs
    • Sphere Summit
    LOADING...
  • Publications
    • Studies
    • Commentary
    • Books
    • Reviews and Journals
    • Public Filings
    LOADING...
  • Blog
  • Donate
    • Sponsorship Benefits
    • Ways to Give
    • Planned Giving

Issues

  • Constitution and Law
    • Constitutional Law
    • Criminal Justice
    • Free Speech and Civil Liberties
  • Economics
    • Banking and Finance
    • Monetary Policy
    • Regulation
    • Tax and Budget Policy
  • Politics and Society
    • Education
    • Government and Politics
    • Health Care
    • Poverty and Social Welfare
    • Technology and Privacy
  • International
    • Defense and Foreign Policy
    • Global Freedom
    • Immigration
    • Trade Policy
Live Now

Cato at Liberty


  • Blog Home
  • RSS

Email Signup

Sign up to have blog posts delivered straight to your inbox!

Topics
  • Banking and Finance
  • Constitutional Law
  • Criminal Justice
  • Defense and Foreign Policy
  • Education
  • Free Speech and Civil Liberties
  • Global Freedom
  • Government and Politics
  • Health Care
  • Immigration
  • Monetary Policy
  • Poverty and Social Welfare
  • Regulation
  • Tax and Budget Policy
  • Technology and Privacy
  • Trade Policy
Archives
  • April 2021
  • March 2021
  • February 2021
  • January 2021
  • December 2020
  • November 2020
  • October 2020
  • September 2020
  • August 2020
  • July 2020
  • June 2020
  • May 2020
  • April 2020
  • March 2020
  • February 2020
  • January 2020
  • December 2019
  • November 2019
  • October 2019
  • September 2019
  • August 2019
  • July 2019
  • June 2019
  • May 2019
  • April 2019
  • March 2019
  • February 2019
  • January 2019
  • December 2018
  • November 2018
  • October 2018
  • September 2018
  • August 2018
  • July 2018
  • June 2018
  • May 2018
  • April 2018
  • March 2018
  • February 2018
  • January 2018
  • December 2017
  • November 2017
  • October 2017
  • September 2017
  • August 2017
  • July 2017
  • June 2017
  • May 2017
  • April 2017
  • March 2017
  • February 2017
  • January 2017
  • December 2016
  • November 2016
  • October 2016
  • September 2016
  • August 2016
  • July 2016
  • June 2016
  • May 2016
  • April 2016
  • March 2016
  • February 2016
  • January 2016
  • December 2015
  • November 2015
  • October 2015
  • September 2015
  • August 2015
  • July 2015
  • June 2015
  • May 2015
  • April 2015
  • March 2015
  • February 2015
  • January 2015
  • December 2014
  • November 2014
  • October 2014
  • September 2014
  • August 2014
  • July 2014
  • June 2014
  • May 2014
  • April 2014
  • March 2014
  • February 2014
  • January 2014
  • December 2013
  • November 2013
  • October 2013
  • September 2013
  • August 2013
  • July 2013
  • June 2013
  • May 2013
  • April 2013
  • March 2013
  • February 2013
  • January 2013
  • December 2012
  • November 2012
  • October 2012
  • September 2012
  • August 2012
  • July 2012
  • June 2012
  • May 2012
  • April 2012
  • March 2012
  • February 2012
  • January 2012
  • December 2011
  • November 2011
  • October 2011
  • September 2011
  • August 2011
  • July 2011
  • June 2011
  • May 2011
  • April 2011
  • March 2011
  • February 2011
  • January 2011
  • December 2010
  • November 2010
  • October 2010
  • September 2010
  • August 2010
  • July 2010
  • June 2010
  • May 2010
  • April 2010
  • March 2010
  • February 2010
  • January 2010
  • December 2009
  • November 2009
  • October 2009
  • September 2009
  • August 2009
  • July 2009
  • June 2009
  • May 2009
  • April 2009
  • March 2009
  • February 2009
  • January 2009
  • December 2008
  • November 2008
  • October 2008
  • September 2008
  • August 2008
  • July 2008
  • June 2008
  • May 2008
  • April 2008
  • March 2008
  • February 2008
  • January 2008
  • December 2007
  • November 2007
  • October 2007
  • September 2007
  • August 2007
  • July 2007
  • June 2007
  • May 2007
  • April 2007
  • March 2007
  • February 2007
  • January 2007
  • December 2006
  • November 2006
  • October 2006
  • September 2006
  • August 2006
  • July 2006
  • June 2006
  • May 2006
  • April 2006
  • Show More
December 11, 2015 10:19AM

Quantitative Easing: A Requiem

By Tom Clougherty

SHARE

When the Federal Open Market Committee (FOMC) meets in Washington next week, its members are widely expected to vote to raise interest rates for the first time since June 2006.  By doing so, they will move towards monetary policy normalization, after more than seven years of near-zero interest rates, and a vast expansion of the central bank’s balance sheet.

But how did monetary policy become so abnormal in the first place?  Were the Fed’s unconventional monetary policies a success?  And how smoothly will implementation of the Fed’s so-called “exit strategy” go?  These are among the questions addressed by Dan Thornton, a former vice president of the Federal Reserve Bank of St. Louis, in “Requiem for QE,” the latest Policy Analysis from Cato’s Center for Monetary and Financial Alternatives.

Thornton begins with an account of the Fed’s deliberations and actions during the early stages of the financial crisis.  What’s particularly striking, looking back, is how the Fed resisted letting its balance sheet grow, or otherwise departing from its conventional, funds-rate targeting procedure, until the Great Recession was well underway.

In fact, from August 2007, when BNP Paribas suspended redemption of three of its investment funds, to September 2008, when Lehman Brothers filed for bankruptcy, the Fed loaned banks and others more than $300 billion.  But these loans were sterilized—meaning that the Fed sold an equal amount of government securities.  As a result, the Fed’s balance sheet didn’t grow, and neither did total bank reserves or the monetary base.  For over a year, in other words, the Fed reacted to a growing liquidity crisis not by taking steps to boost credit in general, but rather by reallocating the existing supply of credit towards particular, troubled firms — a move George Selgin examined (and criticized) in detail in a recent post on this blog.

The Fed’s approach flew in the face of widely-acclaimed research presented by Milton Friedman and Anna Schwartz in their A Monetary History of the United States.  As Thornton points out, Friedman and Schwartz “connected substantial reductions in the nominal quantity of money and credit to correspondingly large declines in economic activity, and declared it the Fed’s duty to act quickly to prevent such reductions by expanding the monetary base.”  In 2007–08, however, no such action was forthcoming, and the crisis continued to intensify.

The sad part is that then-Fed chairman Ben Bernanke knew all this.  Back in 2002, he concluded a speech in honor of Milton Friedman’s 90th birthday by declaring: “I would like to say to Milton and Anna:  Regarding the Great Depression.  You’re right.  We did it.  We’re very sorry.  But thanks to you, we won’t do it again.”  And yet, as Thornton makes clear, “it” — failing to expand the balance sheet in order to prevent a collapse of credit — is “precisely what the Fed did in the months leading up to Lehman Brothers’ failure.”

Eventually, the Fed was forced to change tack.  Once Lehman Brothers collapsed, it found itself lending and buying assets on a scale that couldn’t possibly be sterilized via correspondingly large asset sales.  The Fed’s balance sheet grew, bank reserves began to pile up, and the federal funds rate dropped well below the FOMC’s target.  Unofficially, and almost by accident, quantitative easing (QE) began.

Quantitative easing was put on a formal footing in March 2009, when the FOMC announced the combined purchase of $750 billion of mortgage-backed securities and $300 billion of Treasuries.  From the very beginning, however, it was clear that the Fed was not belatedly adopting a Friedmanite approach.  The stated purpose of their asset purchases was not to boost the monetary base — that was just a side effect.  Instead, the Fed’s goal was to manipulate the yields on certain long-term assets, in the hope that this would spill over into broader markets, and the economy as a whole.

How was it meant to work?  Well, as Thornton points out, the rationale was “vague and highly uncertain,” and developed over time as QE was put into effect.  But the general idea was twofold.

First, by forcing down yields on the long-term assets it was purchasing, the Fed hoped other investors would be induced to substitute those assets for similar, but somewhat higher-yielding alternatives.  In turn, that shift in demand would push down yields on the alternative assets, encouraging investors who held them to rebalance their portfolios as well.  As this ripple effect spread through the financial markets, equilibrium interest rates would fall.

Second, the Fed hoped that QE announcements would signal to markets that monetary policy was going to be “persistently more accommodative” — Ben Bernanke’s words — than previously thought.  This would lower investor expectations for the path of short-term interest rates, and in so doing put additional downward pressure on long-term interest rates.

In short, then, the Fed expected QE to boost the economy through the interest rate channel of monetary policy: lower interest rates would boost equity prices and weaken the dollar; lower borrowing costs, higher wealth, and greater international competitiveness would drive spending, investment, and exports, and stimulate an ailing economy.

So did QE actually work in this way?  Thornton assesses these claims in detail (see, in particular, pp. 12–22 of his analysis), and finds little — either in economic theory or in empirical evidence — to support them.

For one thing, as large as the Fed’s asset purchases were relative to previous open market operations, they were modest compared to financial markets as a whole.  It is therefore “difficult to believe,” as Thornton puts it, “that the distributional effects of the FOMC’s quantitative easing policy could have had a significant effect on either relative yields or the level of the entire interest rate structure.”  What’s more, the event-study literature on QE announcements does not offer any convincing evidence of their effectiveness, once you account for the effect of other, simultaneous announcements (Fed statements typically contain a variety of news capable of influencing bond yields).

The claim that QE announcements changed expectations for the path of short-term interest rates is similarly hard to substantiate, not least because event studies only show the immediate impact of such announcements — and for QE to reduce long-term interest rates via this signaling channel, its effect on expectations must be persistent.  It is telling, moreover, that the Fed’s QE announcements did not even produce a consensus among FOMC participants about the expected path of the federal funds rate.  That being the case, it is hard to see how those same announcements could have had a significant impact on market expectations — especially when it is well-established that interest rates are, in Thornton’s words, “essentially unknowable beyond horizons of a few months.”

Of course, that QE did not work as the Fed hoped does not mean it had no effect at all.  As Thornton points out, “a monetary policy directed at keeping interest rates on low-risk securities near zero … is sure to cause people to seek higher yields by purchasing more risky assets.”  Thornton suggests that pension funds, in particular, have been forced to hold riskier portfolios to generate the returns necessary to meet their obligations.  As well as raising concerns about future financial crises, this distortion of investor behavior has had distributional effects: wealthy investors, who are better able to assume more risk, have benefited from booming equity prices, whereas as less well-off pensioners — who have good reason to be risk averse — have had to settle for miserly returns on their fixed-income portfolios.

What QE hasn’t done, however, is enhance the aggregate supply of credit to the market.  This is hardly surprising, given that the Fed began paying interest on bank reserves in October 2008 — a move designed to encourage banks to build up excess reserves, instead of increasing lending.  Indeed, when it came up at FOMC meetings, Ben Bernanke, Janet Yellen, and others expressly rejected the idea that QE would stimulate the economy by boosting bank lending.  Still, when you couple this absence of increased credit with the lack of evidence that QE worked the way the Fed thought it would, you would be forgiven for wondering whether QE had any significant impact on output and employment at all.

What now?  The Fed’s large-scale asset purchases are over, and the FOMC’s interest rate target looks set to gradually rise.  But the Fed’s “exit strategy” remains a work in progress.  Interest on reserves (IOR), for example, may yet prove a troublesome way of raising the federal funds rate.  As Thornton points out, “An IOR of 3 percent … would see the Fed paying nearly $80 billion a year in interest to the commercial banking sector — something that is unlikely to prove popular in Congress or among the general public.”

Meanwhile, the Fed’s preferred alternative, overnight reverse repurchase agreements, would have to be rolled over continuously to have any effect on the size of the Fed’s balance sheet.  A better approach, according to Thornton, would be to “begin the process of policy normalization by selling long-term securities slowly … If things go well, sales could subsequently be accelerated.”  But the Fed seems reluctant to consider outright asset sales at all.  This suggests that the bloated central bank balance sheet that QE created could be with us for some time to come — whether or not the FOMC votes next week to begin the process of policy normalization.

Yet the real legacy of QE may come in how the FOMC reacts to the next crisis.  One concern is that the Fed seems to have lost “all confidence in the ability of markets to heal themselves,” and now assumes that “only monetary or fiscal policy actions” can “restore the economy’s health.”  Another worry is mission creep: “If the Fed can support the mortgage and commercial papers markets … why shouldn’t it support the market for student loans — or any other market for that matter?”  It’s a dispiriting prospect, but both of these observations suggest an increasingly hyperactive monetary authority going forward.

Ultimately, says Thornton, we should prepare ourselves for more of the same: given the opportunity, “the Fed will continue to distort markets until, by some as-yet-unknown magic, those markets return to normal.”  One suspects that such magic may be a long time coming.

[Cross-posted from Alt-M.org]

Stay Connected to Cato

Sign up for the newsletter to receive periodic updates on Cato research, events, and publications.

View All Newsletters

1000 Massachusetts Ave. NW
Washington, DC 20001-5403
202-842-0200
Contact Us
Privacy

Footer 1

  • About
    • Annual Reports
    • Leadership
    • Jobs
    • Student Programs
    • Media Information
    • Store
    • Contact
  • Podcasts

Footer 2

  • Experts
    • Policy Scholars
    • Adjunct Scholars
    • Fellows
  • Events
    • Upcoming
    • Past
    • Event FAQs
    • Sphere Summit

Footer 3

  • Publications
    • Books
    • Cato Journal
    • Regulation
    • Cato Policy Report
    • Cato Supreme Court Review
    • Cato’s Letter
    • Human Freedom Index
    • Economic Freedom of the World
    • Cato Handbook for Policymakers

Footer 4

  • Blog
  • Donate
    • Sponsorship Benefits
    • Ways to Give
    • Planned Giving
Also from Cato Institute:
Libertarianism.org
|
Humanprogress.org
|
Downsizinggovernment.org