Ramin Toloui on QE

David Beckworth directed me to a new paper by Ramin Toloui, which examines the various transmission mechanisms for quantitative easing. This might be the single best paper I’ve read on the effects of Fed policy during the Great Recession and its aftermath.

In the past, I’ve often criticized people who judge the effectiveness of QE by looking at the impact on interest rates. Toloui does a nice job explaining why macroeconomists should avoid reasoning from a price change:

First, evaluating the effectiveness of quantitative easing by focusing solely on realized bond yields is inherently flawed. The conventional narrative for QE’s transmission mechanism to the broader economy focuses on the causal chain whereby central bank purchases boost bond prices, thus stimulating investment and consumption via the intermediate channel of lower bond yields. But this ignores the powerful expectations channel through which central bank policy operates. If central bank actions positively shock expectations for future economic prospects, that may directly shift the willingness of businesses and households to invest and consume. Success in breaking deflationary expectations can catalyze increased consumption and investment.

But such a shift toward reflationary expectations—higher growth, higher inflation—also tends to increase bond yields! In theory, therefore, the impact of “successful” central bank balance sheet policy on realized risk-free yields is ambiguous. At minimum, any central bank success in generating reflationary expectations would mitigate observed downward effects on yields, understate the full impact of QE policies, and help account for why bond yields increased during some implementation periods cited by QE skeptics.

Then Toloui develops a very clever way to address the identification problem:

First, this study explicitly models how changes in Fed balance sheet policy shifted market expectations for the Fed’s future policy reaction function. It achieves this by using a Taylor Rule-based framework to model the market’s future expected policy rate as a function of the market’s expectations for future inflation and output. Controlling for these variables makes it possible to identify periods when the market perceives there to be outright shifts in the central bank’s future policy reaction function—that is, when the market expects that the central bank will select a different policy rate in the future than it would have previously given the identical expectations for inflation and output.

It is useful to illustrate this concept with an example. Assume that the month before a Federal Open Market Committee (FOMC) meeting, the market expects that the policy rate three years in the future will be 2 percent, expected inflation will be 1½ percent, and the expected output gap will be zero. The FOMC then meets, leaving the policy rate unchanged but taking other actions. In the month after the FOMC meeting, the market shifts its expected policy rate to 1¼ percent while the market’s expectation for inflation and the output gap remain unchanged at 1½ percent and zero, respectively. This indicates that the market anticipates that there has been an accommodative shift in the central bank’s future policy reaction function—i.e., the market expects the Fed to choose a policy rate that is ¾ percentage points lower than before, despite identical inflation and output gap expectations.

This is indirectly related to a point I’ve made about “forecast targeting”.  The point is not to get the market forecast of inflation, or the market forecast of future levels of the fed funds rate; rather you want the market forecast of the fed funds rate that is likely to lead to on-target inflation.

Toloui also understands that any evaluation of interest rates should be conditional on the state of the economy.  Instead of using this approach to identify the optimal policy rate, he uses it to identify the impact of monetary policy.  He finds that the effect of QE on interest rates is even greater than estimated in previous studies, when conditioned on the state of the economy.

He also has some very interesting things to say about the impact of Fed policy on riskier assets:

But that is where the future Fed reaction function becomes important. To the extent that the market believes that the Fed will be more quiescent in face of future inflationary pressures, the risk that the punch bowl will be removed diminishes and prospects for a boisterous party increase. The market’s expectation for the Fed’s future policy reaction thus affects the attractiveness of a wide range of financial assets, not just U.S. Treasury bonds.

It is worth emphasizing this point, since investment committees around the world were focusing intensively on Federal Reserve policy during the post-crisis period. The interest of investors in new policy announcements was not limited to the technical dimensions of particular initiative. Rather, market participants were looking for what these announcements revealed about the character of the central bank. Was the Federal Reserve willing to do “whatever it takes” to secure a recovery and clip the tail risk of a deflation scenario? If so, portfolio managers would have a “green light” for investing in riskier assets that would benefit from a reflationary scenario. Each additional policy innovation provided more information about the Fed’s attitudes.

Lots of people have in mind a model where monetary stimulus inflates asset prices by lowering interest rates.  But that’s not actually what’s going on.  Asset prices plunged during 2008-09 even as interest rates were cut to zero.

Toloui has a much better explanation.  Monetary stimulus creates a macroeconomic environment (basically “prosperity”) where risk assets do well.  It has nothing to do with creating bubbles; it’s all about the fact that what’s good for America (in a macroeconomic sense) is more often than not also good for the stock market and credit spreads.

I strongly encourage younger academics to take a look at this paper, it provides lots of ideas that point the way toward future research opportunities.



11 Responses to “Ramin Toloui on QE”

  1. Gravatar of rayward rayward
    20. November 2019 at 10:10

    The first successful effort to mitigate a financial crisis and collapsing asset prices with QE occurred during the Panic of 1792, when Alexander Hamilton, the Treasury Secretary, made or funded open market purchases of securities, including bonds and bank stocks, thereby stabilizing the market. Hamilton’s goal then was, and the goal now is, to stabilize prices. The Fed succeeded again with QE in the financial crisis of 2008-09. Asset prices not only recovered but have exceeded the level at the inception of the crisis. Unfortunately, the Fed has felt compelled to maintain rising asset prices with historically low interest rates; even the threat of raising interest rates has caused asset prices to fall. The Fed’s official position is that low interest rates induce business to borrow and invest in productive capital, thereby increasing productivity, wages, and economic growth, which was the same justification for the 2017 tax cuts for corporations. Alas, corporations used the tax cuts to fund stock buybacks, not to invest in productive capital; indeed, the stock buybacks help maintain the high asset (share) prices. What would Hamilton do?

  2. Gravatar of ssumner ssumner
    20. November 2019 at 10:15

    That’s wrong, as I point out in the post. Next time try to read it and respond to my arguments, instead of just endlessly repeating fallacies.

  3. Gravatar of Brian Donohue Brian Donohue
    20. November 2019 at 10:57

    I’m working my way through the paper, but I saw this:

    “But such a shift toward reflationary expectations—higher growth, higher inflation—also tends to increase bond yields! In theory, therefore, the impact of “successful” central bank balance sheet policy on realized risk-free yields is ambiguous.”

    This is why I think long-term TIPS yields are a better indicator, since they don’t include the confounding effect of higher inflation expectations. 30-year TIPS bottomed out at 0.31% on 8/29/2019. The only time they were ever lower than this was in December of 2012.

  4. Gravatar of Kevin Erdmann Kevin Erdmann
    20. November 2019 at 11:52

    It’s an interesting paper.

    I was thinking about this the other day when I heard someone say on a podcast that they thought QE mainly had pushed up asset prices. First, in regards to housing, there is absolutely zero correlation with QE. Prices declined until 2012 in spite of the first two rounds of QE.

    But, more to the point, the people that make that argument are saying that the price of homes in 2012 should, rightfully, have been much lower. They are advocating that QE should not have been done and that the reason not to do it would have been to push home prices down much further. It’s an indefensible point, and they should be called out on it.


  5. Gravatar of John Hall John Hall
    20. November 2019 at 12:14

    That’s a good one. Thanks.

  6. Gravatar of Brian Donohue Brian Donohue
    20. November 2019 at 14:16

    30-Year TIPS back below 0.5% today. CME futures indicate 2.2% chance of RATE HIKE in December.

    You and your big mouth Jerome.

  7. Gravatar of Benjamin Cole Benjamin Cole
    20. November 2019 at 15:45

    All well and good but Toloui should recognize he is discussing a globalized capital market reacting to not only changes in Fed policy but changes in the monetary policy of the other major world central banks, including the Bank of Japan the Bank of England, the European Central Bank, and the People’s Bank of China.

    Toloui says that Federal Reserve QE was more effective than understood, but does he clarify that Fed QE or reverse QE was working in concert and sometimes against the quantitative-easing actions of the other major central banks?

    We have liquid globalized capital markets, and money is a fungible commodity. So why do macroeconomists treat Fed policy as if it is operating in a closed economy without free and open borders for capital flows?

    Interesting side note: The Swiss National Bank printed up nearly a trillion dollars and purchased global sovereigns in an effort to restrain appreciation of the Swiss franc. This was also quantitative-easing and must have had 25% of the effect of the Federal Reserve’s $4 quantitative easing program. I have never heard an orthodox macroeconomist refer to this odd reality.

    When I read a Toloui, I get the impression the US operates in a vacuum.

  8. Gravatar of ssumner ssumner
    21. November 2019 at 09:01

    Ben, I suggest you read my posts on Switzerland; you are misinformed on what happened there.

  9. Gravatar of bill bill
    21. November 2019 at 10:31

    I’m a tiny bit surprised about the impact on risk free yields being ambiguous under successful QE. I know that there are forces working in both directions. But under current conditions in the US, I’d expect rates to rise in the US when QE is successful enough to be seen as expansionary.

  10. Gravatar of LK Beland LK Beland
    21. November 2019 at 12:15

    It’s a fantastic read. Market monetarists would benefit from more papers of this type.

    An interesting aspect is that the policy reaction function is inversely proportional to fiscal support. This seems to me like solid evidence that monetary offset is real.

  11. Gravatar of Lorenzo from Oz Lorenzo from Oz
    25. November 2019 at 14:28

    Great read, thanks for the tip. The blogosphere can be a great avenue to useful research.

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