To QE or not to QE

Over at Mercatus, Andrew Levin and Bill Nelson have an excellent essay on the fiscal cost of the Fed’s QE4 program. There isn’t much that I disagree with, but I’d frame a few of the issues slightly differently. The following reflects my own views, which largely but not entirely overlap with the views of Levin and Nelson:

1. According to Levin and Nelson, the Fed’s QE4 program is ultimately expected to cost taxpayers about $800 billion. This reflects the fact that the bonds that were purchased have sharply declined in value due to rising interest rates.

2. These losses cannot easily be avoided by holding the bonds to maturity and refusing to pay interest on bank reserves. Doing so would cause inflation to explode. The loss is real.

3. However, there is a sense in which these losses are illusionary. The Fed is part of the consolidated balance sheet of the federal government, and the Fed’s holdings of T-bonds are a liability of the Treasury. The Treasury gains when T-bond prices decline. So in one sense the gains and losses net out to zero. Even the fact that some of the bonds are MBSs doesn’t really change that fact.

4. But in a counterfactual sense, the $800 billion loss is real. If the Fed had not purchased these bonds, the Treasury would have profited handsomely from rising interest rates reducing the market value of its liabilities. The Fed took away that profit, and thus effectively cost the Treasury about $800 billion.

5. This loss is similar to the loss that would have been incurred if the Fed had not done QE, but Treasury officials had decided to issue lots of T-bills instead of long-term T-bonds right before a period of sharply rising interest rates. Ultimately, it’s a loss from choosing the wrong maturity structure for federal liabilities—too much short-term debt (or bank reserves) during a period of rising rates.

6. If markets are efficient, then the expected profit or loss from QE is rather small, ex ante. But if the central bank has inside information on its future policy, it may be able to beat the market. Surprisingly, I don’t believe the Fed does have inside information on future Fed policy.

7. The Fed profited somewhat from the first three QE programs as rates remained lower than expected, and lost much more from QE4 as rates rose more than expected.

8. The impact of QE on the fiscal position of the government should also account for changes in the macroeconomy that result from QE. This is an exceedingly complex issue.

9. Two policy reforms would allow the Fed to achieve its macroeconomic objectives with a much smaller balance sheet, and hence much less risk of large losses on its bond portfolio. One reform would be to return regulation to the pre-2008 system, where commercial banks held very small reserve balances. Much of the recent growth in reserve balances has been driven by regulatory decisions of dubious value. Second, a regime of NGDP level targeting would lead to a higher equilibrium nominal interest rate during recessions, and reduce the amount of time that the economy is stuck at the zero lower bound.

10. If policy remains dysfunctional, then QE may be the lesser of evils. It’s better to take on some financial risk and stabilize the macroeconomy, rather than avoid risk and allow deep recessions. The fiscal cost of recessions is much larger than the risk associated with plausible QE programs.

11. However, the actual QE programs have not been optimal. The first three QE programs were too small; in retrospect the policy should have been more expansionary. The final program (QE4) was associated with a monetary policy that was far too expansionary. Thus QE4 was not a “price worth paying” for sound monetary policy, it was a costly program that made monetary policy even more unsound. My own view is that the initial purchases (in 2020) were appropriate, but the program should have been unwound in 2021, before the sharp increase in interest rates. This would have resulted in much smaller losses.

12. Where QE actually is necessary to achieve macro goals, it is worth doing despite the financial risks.

13. If Congress plans to investigate these losses, it needs to consider a wide range of issues. How does Congress feel about giving the Treasury wide discretion over the maturity structure of federal debt? These decisions have huge fiscal consequences and are extremely risky. How does Congress feel about regulators pressuring banks to hold massive reserve balances, even though alternative liquid assets such as T-bills are equally effective at reducing default risk? The inquiry should not merely focus on the Fed’s decision to do QE4, there are much more important questions at stake.

14. Congress needs to also think about how it views a large Fed balance sheet. My own work suggests that in the long run the size of central bank balance sheets (as a share of GDP) is strongly (negatively) correlated with the trend rate of growth in NGDP. Countries with low trend rates of NGDP growth (Japan, Switzerland, etc.) tend to have very large central bank balance sheets. Countries with relatively high trend rates of NGDP growth (Australia) tend to have small central bank balance sheets. This reflects the fact that NGDP growth drives the equilibrium nominal interest rate, and demand for base money rises sharply at near zero rates. This is the “socialism or inflation” dilemma that most conservatives refuse to address.

15. I favor abandoning the experiment of paying interest on bank reserves, which has resulted in much larger than necessary central bank balance sheets, needlessly exposing central banks to the risk of large financial losses. Go back to the pre-2008 corridor system.



14 Responses to “To QE or not to QE”

  1. Gravatar of Solon of the East Solon of the East
    10. January 2023 at 16:40

    Indonesia had success through the pandemic with a money financed fiscal program. Bank Indonesia simply bought bonds directly from the national government of indonesia.

    Indonesia today has moderate inflation and prospects for very strong growth for the next five years. It would be worth exploring what really happened in Indonesia.

  2. Gravatar of Jeff Hallman Jeff Hallman
    11. January 2023 at 00:08

    Agree except that there is a strong case for paying interest on required reserves.

  3. Gravatar of Spencer Spencer
    11. January 2023 at 07:46

    What a joke. Friedman was dead wrong. Required reserves were never a “tax”. And Volcker said all reserves were a tax. Volcker is a perfect example of the “Illusory Trust Effect”

    Banks are credit creators, not credit transmitters.

    The suppression of interest rates (decline in real rates of interest) artificially boosts relative asset prices (causes asset inflation).

    BOE: “QE initially increases the amount of bank deposits (outside and inside money), those bank-holding companies own (in place of the assets they sell). Those companies will then wish to rebalance their portfolios of assets by buying higher-yielding assets, raising the price of those assets and stimulating spending in the economy.”

    Bernanke: “Easier monetary policy, for example, raises stock prices. Higher stock prices increase the wealth of households, prompting consumers to spend more–a result known as the wealth effect. Moreover, high stock prices effectively reduce the cost of capital for firms, stimulating increased capital investment. Increases in both types of spending–consumer spending and business spending–tend to stimulate the economy.”

    Banks should not be permitted to buy their liquidity; they should be required to store their liquidity. As all savings deposits originate in the banks, the banks are just paying for something that they collectively already own.

    Something is radically wrong. In spite of the demographics, labor demand; “real wages fell in December for the twenty-first month in a row.?”

    It’s stock vs. flow. “The Golden Age in Capitalism” (not optimized), was where savings were expeditiously activated (where the thrifts grew faster than the commercial banks) and put back to work into real-investment outlets (increasing the demand for labor and materials).

  4. Gravatar of Capt. J Parker Capt. J Parker
    11. January 2023 at 09:42

    IMHO the headline here is that taxpayers are not totally exposed to short term interest rates to fund US debt. I remember progressives screaming about how Reagan’s tax cuts doubled the national debt. But, it wasn’t tax cuts it was interest expenses:
    History is getting ready to rhyme.

    The other bit of this sorry QE story that makes me bridle is statements to the effect: “Well, if there wasn’t QE expenses then there would have been all kinds other costs from recessions and unemployment.” True to first order. But, it is mindboggling how the Fed always manages to skate free of any culpability for actually causing the need for QE in the first place.

    Sorry for the rant.

  5. Gravatar of Capt. J Parker Capt. J Parker
    11. January 2023 at 09:44

    above should have said “taxpayers are NOW totally exposed” instead of “not totally exposed”

  6. Gravatar of Greg Greg
    11. January 2023 at 10:49

    We need more expansion?
    For what?
    20% inflation?
    It doesn’t make any sense.

    Forcing banks to hold reserves sounds like you want to nationalise the banking industry.

    The best way to resolve this issue is to let the bubble burst, because everytime you intervene it gets worse. If they can get inflation down to 2-3%, without rolling the debt over at 5-6%, then that is a big accomplishment, but I doubt that’s going to happen. You will probably have to raise rates high enough and long enough to roll over the debt which means you won’t be able to service it because it will be a trillion a year.

    The only way out is to renege on half of it, broker a deal with debtors, and go back to the gold standard or some sort of fixed digital asset. That’s the best case scenerio. Worse case scenerio you continue building the bubble until the entire economy explodes one day, splitting the country into a number of pieces, and the dollar becomes as valuable as the toilet paper in your bathroom.

  7. Gravatar of bill bill
    11. January 2023 at 11:04

    I think I recall that pre 2008, the Fed also required a certain amount of reserves, and paid no interest on those reserves. Could the Fed start doing that again? Require reserves? And then pay no interest on them? If it did that, does that change things or is that just shifting the burden in a way that is unfair? Or is it fair?

    Longer term, I hope the Fed gets back to a place where it stops paying interest on reserves.

  8. Gravatar of Matthias Matthias
    12. January 2023 at 00:58

    Thanks for the write-up!

    I have a related question: why do people worry so much about negative interest rates, when the Fed could just buy longer and longer maturity debt instead?

    In the limit they would buy consoles / perpetual bonds. As long as a perpetual bond has any price strictly greater than zero and strictly smaller than infinity, it will have a positive nominal yield, won’t it?

    (I agree with you that the zero lower bound isn’t actually as bit of a problem as people make it out to be. I’m just curious why central banks don’t seem to take the ‘obvious’ route of longer maturities?)

  9. Gravatar of Spencer Spencer
    12. January 2023 at 07:12

    re: “sounds like you want to nationalise the banking industry”

    That’s exactly what should happen. Banking is a staid business. The Gov’t could handle it.

    If the commercial bankers are given the sovereign right to create legal tender, then the DFIs must be severely circumscribed in the management of both their assets and their liabilities – or made quasi-gov’t institutions.

    Economists don’t know a debit from a credit. Banks don’t loan out deposits. Deposits are the result of lending/investing. The NBFIs are not in competition with the DFI’s. The NBFIs are the DFI’s customers. The deregulation of interest rates was a ruse perpetrated by the ABA through their lobbyists.

    All savings deposits originate within the payment’s system. The source of savings deposits is other bank deposits, directly or indirectly via the currency route (never more than a short-term situation), or thru the banks undivided profits accounts. An increase in time deposits depletes demand deposits, dollar for dollar.

  10. Gravatar of Thursday assorted links – Marginal REVOLUTION Thursday assorted links - Marginal REVOLUTION
    12. January 2023 at 08:44

    […] 3. Is the Fed losing money on QE? […]

  11. Gravatar of ssumner ssumner
    12. January 2023 at 09:02

    Bill, That system would be fine. The required reserves were quite small, so the lack of interest was a minor issue.

    Matthias, They do buy longer term bonds.

  12. Gravatar of Ricardo Ricardo
    12. January 2023 at 17:45

    The New England Journal of Medicine just published a paper titled Bivalent Covid-19 Vaccines, in which the author claims that vaccinating children doesn’t make much sense.

    Lo and Behold, according to Sumner, this author must be another M.D who is peddling anti-sciencific misinsformation, malinformation, and disinformation. Don’t listen to anyone that disagrees with the state. Only listen to the fake doctor bots twitter uncovered, and/or “trusted experts.” hand-picked by a political party or government agency.

    Remember when Sumner said Trump should be imprisoned for having a few documents at his house. Hmmm…I wonder if Biden’s documents will create the same hysteria. But I presume not, and do you know why?

    Because Sumner is DELUSIONAL!

    Apparently, one side of the aisle can smoke crack cocaine and help their offspring accquire cozy boardroom jobs, while sending them on missions to start a biolab (Ukraine), contruction company (Kuwait) and an investment firm (china). I didn’t know that crackheads knew so much about finance, biotech and large scale construction projects.

    Sumner’s been too quiet recently. All that Trump rage is boiling inside of him; it’s about to overflow. I can feel it. Shortly, he’ll be telling us how Trump is the antichrist, and how Trump is secretly plotting to take over the world from a hidden bunker at his Florda golf course, situated under the 18th green, where Putin, Bolsonaro, and a 130 year old Hitler meet every Friday at 3:01 in the morning.

    His source of evidence will be something Bolton said in a book, a dossier created by a political party, or certain words that seem harmless but are really a “secret code” that can only be unscrambled with a cryptographic key that has been surgically placed within Bolsonaro’s “hard-right” intestine.

  13. Gravatar of Stephen Stephen
    12. January 2023 at 23:06


    On point 11, I thought I recall you saying in late 2021 or early 2022 that you weren’t sure if the Fed should be raising rates or holding off. It seems like you are saying you were calling for the fed to change course in 2021. I understand you prefer level targeting, but can you point to any articles you wrote that said the fed was overheating the economy a lot in 2021? It seemed you mostly agreed with the consensus at the time.

    I appreciate your work.

  14. Gravatar of ssumner ssumner
    13. January 2023 at 08:38

    Stephen, In 2021, I assumed that the Fed was engaged in average inflation targeting, which I supported. If I had known that they were actually going to allow the average inflation rate to rise far above 2%, I would have been screaming bloody murder about Fed policy at the time.

    Don’t focus on interest rates, which are not policy. What matters is the policy REGIME. Is the Fed willing to control inflation (or better yet NGDP growth), or not. The same interest rate policy can be appropriate under FAIT and wildly inappropriate under discretion.

    If the Fed had truly implemented a average inflation targeting regime, then market interest rates in late 2021 would have been appropriate. But under a discretionary regime, policy was way too expansionary. In 2021, I did not know that Fed policy was discretionary. BUT THE FED KNEW.

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