QE is not a policy, it’s a tool

Tyler Cowen recently linked to a post by Gerard MacDonell on QE:

Last month’s Press Release from the FOMC announcing the first rate hike in a decade contained a seemingly-innocuous and yet telling discussion of the interaction between interest rate and balance sheet policy.  It marked the end of false confidence in the efficacy of quantitative ease (QE), which can be traced to a technical error Ben Bernanke made while lecturing the Japanese on deflation in 1999.

The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.

…The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction, and it anticipates doing so until normalization of the level of the federal funds rate is well under way.

The passages above were not a major departure or surprise to the markets, but they confirm that the Fed leadership has now abandoned its original story about how QE affects the economy and has conceded that the tool is weak.  If QE were strong, the balance sheet could not remain large even as the Fed promised to raise rates only gradually.

It has long been obvious that QE operated mainly through signaling and confidence channels, which wore off on their own without any adjustment in the size or composition of the Fed’s balance sheet. Accordingly, QE cannot be relied upon to provide much help in the next economic downturn, which means the Fed will have to tread carefully to avoid a return to the zero bound.

There’s a lot of confusion about QE, mostly because there’s a lot of confusion about virtually every aspect of monetary policy; including the most very basic aspects, such as what is it, and how we measure it.

At one level QE is nothing new, it’s just changing the monetary base to impact the macroeconomy—what the Fed has been doing for many decades.  With QE, the Fed also says that they are changing the base in order to affect interest rates on Treasury securities.  But that’s also exactly what the Fed has been doing for many decades.  And for many decades the impact of monetary shocks on long-term interest rates has been ambiguous.  So that’s also nothing new.

And monetary policy has always been 1% about concrete actions and 99% about signaling.  That’s also nothing new.  So basically the argument that QE does not work is almost no different from the argument that monetary policy doesn’t work. But of course it is slightly different.  QE is the term used for monetary policy that impacts the supply of base money at the zero bound.  So it’s possible that this type of monetary policy is less effective, although the empirical evidence suggests that QE was effective in the US, and more recently in Japan.  On the other hand future QE might not be effective, it entirely depends how it’s used.  If monetary policy is 99% signaling, then the argument should not be about the 1% (QE) it should be about the 99% (signaling.)  So the post by Gerard MacDonell isn’t so much right or wrong, as mostly beside the point.

The success of future Fed policy will depend almost entirely on the signaling element.  The Fed recently raised rates, which tells us that NGDP is about where they want it.  And by backwards induction it seems like the Fed did not want rapid NGDP growth a few years ago, as if they had wanted it then they would not have raised interest rates this past December.

Here’s thought experiment that might help.  Imagine a NGDP graph built on a large flat piece of plywood.  Drive a stake into the point where NGDP was in mid-2009.  Then drive another stake in where it was at the end of 2015.  Connect the two pegs with a string and pull it tight, so that the string is taut.  That’s the NGDP path that the Fed should have been favoring, if we assume that it was acting rationally.  That is, it behaved over the past 6 years as if it wanted NGDP to growth at a roughly stable pace between the level of mid-2009 and late 2015.  And guess what, that’s almost exactly how it did grow.

Screen Shot 2016-01-13 at 8.59.28 PM

Now you might counter my claim by insisting, “Oh no, the Fed really hoped to get a much faster recovery, a much higher growth rate for NGDP.”  Except there is just one problem with that alternative hypothesis—in that case it would not have been rational for them to raise rates in December.  Because if the market knew (back in 2009) that the Fed would raise rates in December, then the intervening NGDP growth path would have been an equilibrium solution for the economy.  (This is also approximately what New Keynesian theory says.)

Now for the curve ball.  I think the person whining that the Fed actually preferred a faster recovery might be correct.  Who’s to say?  Maybe they were sincerely upset by the long drawn out period of high unemployment.  Maybe they preferred faster NGDP growth.  But even if all that were true, then everything I previously said would still be 100% correct.  I said that if they were rational then their policy would have been consistent with the actual growth path, but I never said they were rational.

Perhaps they thought they could have their cake and eat it too—have a fast growth path then act very conservatively at precisely the moment they raised rates.  Perhaps they never read Krugman’s 1998 paper.  I can’t say.  But if we assume the Fed was rational, then we have to also assume that QE “worked”.  The Fed got exactly the recovery in NGDP that it was acting like it wanted.

When people debate whether QE “worked”, it’s not always clear what’s at stake. Obviously it worked in the sense of impacting market expectations; we know that from asset price responses to QE.  But that doesn’t tell us much about the Fed’s (or BOJ’s) broader economic goals.  I think it makes much more sense to focus on the Fed’s policy goals. What’s it actually trying to accomplish?  Why doesn’t it tell us? What should it be trying to accomplish?  Those are the issues that need to be debated, not whether QE “worked”.

PS.  It’s equally beside the point to debate whether negative IOR “works”, or changes in reserve requirements “work”, or discount loans “work”.  These are policy tools for achieving an objective, when the actual debate should be about the objectives.



18 Responses to “QE is not a policy, it’s a tool”

  1. Gravatar of Major.Freedom Major.Freedom
    13. January 2016 at 18:36

    “That’s the NGDP path that the Fed should have been favoring, if we assume that it was acting rationally. That is, it behaved over the past 6 years as if it wanted NGDP to growth at a roughly stable pace”


    You keep using that word. I do not think it means what you think it means.

    To act rationally is to act in accordance with one’s reason. The Fed’s existence is predicated on coercively suppressing rational activity. If the Fed acted rationally, it would respect the rationality of individuals (whence the term rationally is derived), meaning the Fed would cease to exist.

    Just because communism or fascism exists, it doesn’t mean you have to call it rational.

  2. Gravatar of Gary Anderson Gary Anderson
    13. January 2016 at 19:18

    Even Cullen Roche has said that purchasing non financial assets is the only way to kindle inflation if growth is falling. Any buying of treasuries is resulting in shortages and lower interest rates. Maybe they could buy junk bonds, and save them. Don’t know about that. 🙂

  3. Gravatar of Gary Anderson Gary Anderson
    13. January 2016 at 19:36

    “I think the person whining that the Fed actually preferred a faster recovery might be correct. Who’s to say?”

    I agree with that. You could see it on Bernanke’s face that he was impatient for growth. He must have been thinking the invisible hand would kick in faster, or his visible hand.

    But know this: He allowed the economy to destroy itself, perhaps thinking that it would be an easy and quick fix to bring it up again. That was where the Fed went wrong, in the plan to make easy profits for the banks and their cronies: crash the overpaid jobs, crash the weak companies, crash the housing bubble, crash the stock market. In all that the upper class has made bank, since 2009.

    Did you know that after the crash, investors were not permitted to buy houses for a time in Las Vegas, Scott? And you know what, no one else could get credit so they waved that rule after a time and investors gobbled up the excess supply within 6 months! That is unhealthy.

    Too much money at the top, and too much corporate greed and too much help by the Fed and its banks for the uber rich. That is why people are sitting home not out driving because they can’t afford the gas.

  4. Gravatar of dtoh dtoh
    14. January 2016 at 02:46

    Nice post. As I have said before it’s important to clearly distinguish between..

    1. Goals – Steady real growth without excessive inflation
    2. Target – Level of NGDP
    3. Tools – Expectations and asset sales/purchases from or to the non-banking sector.

  5. Gravatar of Benjamin Cole Benjamin Cole
    14. January 2016 at 05:18

    I won’t whine, but perhaps I will cavil and snivel a little.

    Greenspan never signalled. Great run.

    If the Fed committed to buying $50 billion a month in Treasuries and placing them into the Social Security and Medicare trust funds and the Congress correspondingly cut FICA taxes, would not that obtain results absent any signaling?

    Another snivel: US railroad traffic down 20% yoy in December. How is this a supply-side recession?

  6. Gravatar of Dan W. Dan W.
    14. January 2016 at 05:55


    Have you read Selgin’s criticism of IOR? His argument is IOR resulted in a tightening of monetary policy as it gave an incentive to banks to increase reserves rather than increase lending.
    http://www.cato.org/people/george-selgin (article links at bottom of page)

    I believe Bernanke was rational. He was also wrong. The rational for his plan was that strengthening bank financials would lead to economic recovery. He was wrong in believing this path of recovery would be timely. The quicker way to recovery would have been liquidation of bad debt, bankruptcy for insolvent banks and recapitalization of new lending institutions. Alas Bernanke did not have a stomach for such free-market capitalism.

    The sad reality is policymakers are wary of economic freedom. They do not like the chaos of rampant capitalism. They prefer crony capitalism where economic growth is tepid and they can better protect incumbent firms from competition and market failure.

  7. Gravatar of Postkey Postkey
    14. January 2016 at 06:51

    @Dan W.

    “The rational for his plan was that strengthening bank financials would lead to economic recovery.”

    Bernanke may have been ‘wrong’. However, did it matter?
    This is what the ‘Friedmanite’ Monetarist has to say re Q.E..

    “In short, although the cash injected into the economy by the Bank of England’s quantitative easing may in the first instance be held by pension funds, insurance companies and other financial institutions, it soon passes to profitable companies with strong balance sheets and then to marginal businesses with weak balance sheets, and so on. The cash strains throughout the economy are eliminated, asset prices recover, and demand, output and employment all revive. So the monetary (or monetarist) view of banking policy is in sharp contrast to the credit (or creditist) view. Contrary to much newspaper coverage, the monetary view contains a clear account of how money affects spending and jobs. The revival in spending, as agents try to rid themselves of excess money, would occur even if bank lending were static or falling. 
    The important variable for policy-makers is not the level of bank lending to the private sector, but the level of bank deposits. (Remember Irving Fisher’s reference to “deposit currency”.) Indeed, because companies are the principal employers and the representative type of productive unit in a modern economy, bank deposits in company hands need to be monitored very closely. If these deposits start to rise strongly as a by-product of the Bank of England’s adoption of quantitative easing, the recession will be over.”


  8. Gravatar of François François
    14. January 2016 at 07:37

    Dear Scott, you state that monetary policy is 99% signalling. I would disagree with that.

    In medieval times for example,when gold and/or silver were the monetary standard, there have been several episodes of monetary easing and tightening. For example in the 16th century with the massive import of gold from the Americas into Europe. There was a clear stimulative and inflationary effect then. How would that have been possible if monetary impacts would be mostly about signalling?

    And when I discuss monetary policy with friends and colleagues, it is obvious that their understanding of monetary policy is so low that I can’t see how monetary signalling can work much beyond financial markets participants.

  9. Gravatar of Chris Mahoney Chris Mahoney
    14. January 2016 at 09:58

    We tend to impute too much rationality to “the Fed” which is a large committee of people who don’t agree with each other. Saying “the Fed wants” is like saying “the Supreme Court wants”.

  10. Gravatar of ssumner ssumner
    14. January 2016 at 10:18

    dtoh, Well said.

    Ben, I think Greenspan did signal, using interest rate targets.

    If there is a recession in 2016, it will have been caused by lack of demand, so I agree with you there.

    Dan, You asked:

    “Have you read Selgin’s criticism of IOR?”

    Yes, I’ve been making some of the same arguments over here. The main difference is that I focus more on the demand for reserves, rather than bank lender per se.

    Francois, First of all, it’s signaling about future concrete actions.

    Second, under a commodity money system, newly discovered gold is not later destroyed, so a current increase in the gold stock also signals a future expected increase in the gold stock. That’s much less true under a fiat money regime.

    As far as ignorance, I agree with you. In my view the signals go to the asset markets, asset prices respond, and then your friends respond to the asset markets (say a stock price crash.)

    Chris, Agree, I am talking about them in the sense I talk about what “the market” wants, I’m referring to the median voter.

  11. Gravatar of Majromax Majromax
    14. January 2016 at 12:27

    > Drive a stake into the point where NGDP was in mid-2009. Then drive another stake in where it was at the end of 2015. Connect the two pegs with a string and pull it tight, so that the string is taut. That’s the NGDP path that the Fed should have been favoring, if we assume that it was acting rationally.

    I think you’re missing a time derivative here. This paragraph makes sense if the Fed is supposed to think about the current or future level of NGDP, but instead it thinks about the inflation rate (or in these variable terms the NGDP growth rate).

    That means that the “NGDP path” the Fed was favouring was not necessarily constant over this period, and that early misses caused by randomness or bad analysis propagates into the eventual target — it isn’t corrected.

    Nick Rowe’s recent blog post on “omega points” of price level targets explores this from the opposite angle, where a central bank sets an explicit price level target at some point in the future.

    Unfortunately, because of the Fed’s rate targets any systemic error is left uncorrected.

  12. Gravatar of AL AL
    14. January 2016 at 13:09

    I say whatever its superficial mandates, this is a Fed whose subconscious objective is above all else not to become impotent, because that’s their greatest fear. And thus they are raising rates to convince the economy that it is booming, even if the economy stubbornly refuses to get the message.

  13. Gravatar of bill bill
    14. January 2016 at 15:45

    I’d say the Fed is driving with one foot on the brakes (IOR) and one on the gas (QE/balance sheet). I find it aggravating that they refer to this most recent rate hike as a “normalization” when the Fed has had a 0.00% rate for IOR for over 90% of its history.

  14. Gravatar of bill bill
    14. January 2016 at 15:47

    PS – the discussion of the efficacy of QE also aggravates me because we’ll never know how the gas pedal would have worked for the last 8 years since the Fed has been constantly pressing the brakes at the same time.

  15. Gravatar of Ray Lopez Ray Lopez
    14. January 2016 at 22:41

    Headline correction: “QE is not a policy, it’s a tool” should read: ‘NGDPLT is not a policy, and Sumner’s a tool’.

    Sumner: “And monetary policy has always been 1% about concrete actions and 99% about signaling.” – completely not testable, not falsifiable, and therefore unscientific.

  16. Gravatar of ssumner ssumner
    15. January 2016 at 10:33

    Majromax, The Fed is not just an inflation targeter; it puts equal weight on employment. So it’s not clear that inflation is better than NGDP as a proxy for the Fed’s target variable. In any case, if you constructed a variable out of inflation and employment, and replaced NGDP with that hybrid variable, my argument would probably still hold roughly true.

    It’s easier to simply talk about NGDP.

  17. Gravatar of Gary Anderson Gary Anderson
    15. January 2016 at 17:31

    So, NGDP shows a drop in growth way before the Fed inflation/job model because wages don’t drop immediately The charts show that is true. The Fed is always behind the curve.

    So, now, the Fed knows inflation targeting is not working, and is relying on employment as the only hope? But people keep workers until they have to lay them off. If NGDP is dropping, the Fed still would not know it unless they were paying attention.

    BTW, George Selgin is a nice guy. Willing to engage anyone, even me.

  18. Gravatar of Gene Frenkle Gene Frenkle
    15. January 2016 at 23:17

    The Fed would have wanted a slow recovery because a quick recovery would probably have meant “double downing” on another real estate bubble or even more consumer debt.

    That said, in 2009 once our economy stabilized our economy was actually much more sound than it was in 2001 because fracking for natural gas had been proven economical and the 2000s featured an energy crisis. The “curveball” of the last 7 years has been fracking for oil which it now appears QE fueled and we will be finding out shorty if this was sound investment or just more malinvestment like that of the 2000s Housing Bubble.

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