Quantitative Easing, Now, In the Rear-view Mirror.

-By Josh S | [email protected]

How did it start and what was its Legacy?

On March 21, 2018, Jerome Powell, Chairman of the Federal Reserve (referred to as The Fed, Central Bank, CB), raised the U.S. Federal funds rate often referred to as the benchmark rate another 0.25% to 1.5%-1.75%. This is the second time the Fed has raised its benchmark rate in the last 4 months as the Fed distances itself from the era of quantitative easing (QE), which officially ended in 2014 when the Fed raised the lower bound of the benchmark rate to 0.25%. Since then, the Fed has continued to increase the rate; the more time that passes, the more analysis can be done with regards to why QE began and its legacy.

QE started because in 2008 short-term interest rates, the favourite mechanism that the Fed uses to transmit monetary policies and regulate the quantity of money, could no longer decrease any further. The Fed’s only other option was to increase base money, known by economists as MB. Historically, the link between interest rates and monetary growth has been more stable at stimulating aggregate demand than the expansion of MB but this stronger link breaks down when rates approach 0%.

In economic theory, the changes between MB and interest rates should be similar. For example, if one wanted to change the price level of oranges, one could either change the supply of oranges (base money) or adjust the price (interest rates) and the effects on supply and demand would take hold. If there are more oranges the price would drop and if the price drops more people would demand oranges. If the Central Bank is credible, a change in rates sets in motion a series of events that affects spending, production, employment and ends with an affect on prices or inflation. The credibility of the CB is important because market participants will not alter their behavior if they do not believe a policy will be sustained. Someone would not lend money at 1% if that person knew that rates would soon rise to 5%.

The Federal Reserve controls short-term rates by using open market operations, which means the Fed is buying or selling securities from the open market—typically banks. When the Federal Reserve sets the benchmark rate at 1.5%-1.75%, it is telling the non-government banking system (banks excluding the Fed) that it expects them to settle any shortfalls of cash between each other within this interest rate range—this ensures the banks lend at a consistent rate. The Fed will intervene if the yield deviates outside this range. For instance, If the yield moved above 1.75%, the Federal Reserve would start buying bonds from the banks giving them more cash and thus a higher supply of money. With this excess supply of cash, the banks would be willing to lend the excess cash to the other banks at lower rates because the alternative is to hold cash, which does not earn interest. If yields went below the bottom part of the range (1.5%), the Fed would sell bonds draining liquidity from the banking system, having the opposite effect. The Fed’s primary job is to ensure stable prices and typically uses the interest rate mechanism to control the money supply.

High interest rates lead to contractionary monetary policy while low interest rates are stimulative and can cause inflation. The Fed will therefore lower rates when it wants to prevent a recession. Inflation has been an issue throughout the 20th century. However, deflation, the opposite monetary phenomenon, has not been as carefully discussed. Deflation occurs when the prices for goods start to fall, causing the real rate of interest to rise and demand for goods to drop. For example, if prices were to decline 2% over the year then one would make 2% by simply holding cash and be able to purchase even more assets the following year. This makes loans in real dollars more expensive because the person borrowing would have to repay the loan with a higher amount of real dollars. This dilemma was elucidated during the Great Depression when deflation averaged roughly 7% a year from 1929 to 1934. Capital spending declined because people could earn more money holding cash.

Ben Bernanke, the former Chairman of the Federal Reserve, stated that many have concluded that a zero-bound interest rate means the Central Bank “runs out of ammunition and no longer has the power to expand demand.” However, the Fed still can expand demand, but it must do so by moving outside its comfort zone. Historically, the solution to the problem has been looked through a Keynesian lens

The Capulets and the Montagues (the Keynesians & the monetarists)

Keynesianism Tradition

John Maynard Keynes, in the 1930’s, challenged the classical theories of economics and had a profound impact on the field. Keynes suggested that a liquidity trap could emerge when rates fall to around 0% because nominal interest rates cannot feasibly be negative. Because, if nominal rates were negative, people would choose to hold their money in cash. Keynes said at 0% people would be indifferent between holding cash and bonds. At this point, Keynes asserted that the monetary authority had lost control over the rate of interest. To solve the problem, Keynes believed fiscal policy (tax cuts or government spending) could solve the crisis by increasing demand through government spending. Keynes famously stated that targeting monetary policy instead of fiscal policy while at 0% would be like trying to “push on a string” and in his view was ineffective at combatting the liquidity trap.

Keynes’s views were radical at the time because they challenged classical economics, but soon his ideas became the dominant ideas in economics until the mid 1970’s. So dominant was Keynes’s views that in 1971 U.S. President, Richard Nixon, said “we are all Keynesians now.” Despite following Keynesian policies, the economy deteriorated in the 1970’s and high inflation and unemployment emerged in tandem without the growth predicted by Keynes; politicians began to debate the Keynesian orthodoxy.

Monetarist critics such as Milton Friedman and Robert Lucas gained prominence. Monetarism was an economic philosophy believing the economy’s performance is mostly related to changes in the money supply.

In the 1970’s, Robert Lucas wrote a critique, known as the Lucas Critique, of the Keynesian view that helped pull the string away from Keynesian models towards monetarism. According to Lucas, many of the models of Keynes were based on short-run empirical data in which a relationship was asserted without being tested over the long run—Milton Friedman agreed with this contention. Friedman, considered the father of monetarism, in the 1960’s debated the idea that government could reduce unemployment through inflation—a claim of Keynes. He asserted that the Phillips curve, which measures the relationship between inflation and unemployment would break down over time and that government spending would just raise inflation and not lower unemployment.

By 1979, the British under Margaret Thatcher abandoned Keynesian economics. During a 1981 recession, Thatcher cut the British fiscal deficit. 364 Keynesian economists responded to this saying that the “present policies will deepen the depression, erode the industrial base of our economy and threaten its social and political stability.” However, the 1980’s marked an era of above average British growth.

Paul Krugman, a Nobel Prize winning economist, explored the debate of government spending, which he called “pump priming.” Krugman stated that the belief in the efficacy of pump priming occurred because of the large amount of spending caused by World War II lifted the economies out from the Great Depression. But Krugman pointed out fiscal expansion did not provide relief in Japan in the 1990’s. Keynes believed in “sticky prices,” meaning variables such as wages would take longer to adjust than prices. Therefore, an increase in government spending would boost demand for goods, which would eventually raise prices—but before raising prices, it could lead to stores hiring more personal and therefore a governmental boost could stimulate the economy for the long term. Keynesian economic thought, in the 1960’s, believed that a natural rate of unemployment could be achieved by accepting a high steady rate of inflation.

In the 1990’s, the Bank of Japan (BOJ) was unable to stimulate its economy by following the traditional Keynesian diet of fiscal stimulus. What the government found was spending did increase aggregate demand for a temporary period. But this spending did not in turn cause an increase in private demand. In fact, the opposite effect occurred, and private demand began to fall. Because positive benefits of stimulus failed to materialize in Japan and with the economy facing deflationary pressures, economists began looking at new approaches. Books written on Quantitative Easing skyrocketed.

The Monetarist Approach

In the 1960’s, Milton Friedman’s monetarism began to gain prominence. He, also, had a different untraditional approach with regards to solving the liquidity trap. Friedman believed that Keynes’s view was damaging because it believed the “government was there to solve problems.” Friedman said that fiscal policy shifts move resources from the private to public sector and does not increase demand. He famously stated:

“inflation is always and everywhere a monetary phenomenon.”

This indicated that inflation is always caused by the printing of money. To solve the problem of the liquidity trap, Friedman believed that increasing the supply of money would lead to people spending their excess money, which would stimulate aggregate demand—this was preferable to government spending because this approach allowed the private sector to work and thus used voluntary cooperation. The monetarist logic behind quantitative easing was that expected inflation rises and encourages banks to lend rather than earn a negative real rate of return on its cash balances.

Monetarists point to Japan in the mid 1990’s as proof of the failure of fiscal policies. Government debt rose by phenomenal amounts, but Japan was unable to grow the economy. Paul Krugman, wrote an article in 1999 regarding the liquidity trap and the preferential treatment of the monetarist ideas over Keynesian, but he still felt Keynes ideas had merits in certain situations. Regarding Japan, Krugman said, “we have all become sort-of monetarists.” Krugman argued quantitative easing could be effective if it was able to change expectations.

Not everyone believed in the monetarist approach. In 2001, Mark Spiegel, a senior economist at the Federal Reserve, asserted that the Fed taking a low yielding bond off a bank’s balance sheet would unlikely have an effect. He said because both assets yield low returns, the bank would see these assets as interchangeable and hence there would be no material change in demand. However, Spiegel theorized that if a Central Bank credibly adopted inflationary policies that the initiative could work.

The Path Towards Testing the Monetarist Solution in Unfamiliar Territory
In a 2000 Speech to the Bank of Canada, Friedman suggested the following for the BOJ to combat its deflation:

“It’s very simple. They can buy long-term government securities, and they can keep buying them and providing high-powered money until the high-powered money starts getting the economy in an expansion. What Japan needs is a more expansive domestic monetary policy.”

Friedman noticed that even though Japan had an interest rate policy of 0%, Japan was still wrought with deflationary pressures because holding cash was yielding positive returns. Friedman argued that Japan needed to convince the market of expected future inflation. In March 2001, the Bank of Japan began a quantitative easing program. Prominent economists such as Krugman and Bernanke were soon suggesting that if it could happen in Japan, it could happen elsewhere.

The Path Towards A Crisis in the US
In 2002, Ben Bernanke, the future Chair of Federal Reserve, gave a speech titled, “making sure it doesn’t happen here,” regarding the issues of Japanese deflation. Bernanke noted that most economies thrived despite inflationary pressure, yet there was limited research that they could do so with deflationary pressure. He said the chance this issue would be seen in the US was “extremely small.”

Bernanke was concerned with the Central Bank’s prospective actions when interest rates reached near 0% and entered a liquidity trap. Bernanke did not believe the Fed runs out of “ammunition” when this occurs, but it must use non-traditional methods. Bernanke said one tool the U.S. could use would be quantitative easing and argued that this policy could be enhanced with a fiscal policy such as a tax cut.

During a Speech for Friedman’s 90th birthday, in 2002, Bernanke said “I would like to say to Milton and Anna: regarding the Great Depression. You're right, we did it (The Federal Reserve). We're very sorry. But thanks to you, we won't do it again.” This quote was about the shrinking money supply during the great depression, which caused deflationary pressures. This thought was on Bernanke’s mind when he pursued the Fed’s future initiatives six years later.”

No Longer an “Extremely Small” Chance.

The U.S. Subprime mortgage crisis began in 2007 and triggered a large decline in housing prices. On September 30th ,2008, the credit markets froze as banks refused to lend. Libor, a rate similar to the overnight rate, surged between 2% and 7%.

Bernanke began aggressive action, determined to avoid a Great Depression. By December 17, 2008, Bernanke had already exhausted the traditional mechanism as the overnight rate approach zero. Now, the Federal Reserve promised to inject money into the economy through a policy called “Quantitative Easing”. The Fed increased base money from $900 billion in August of 2008 to $1.7 trillion by the end of the year; the balance sheet of the Federal Reserve swelled to $2.2 trillion from $900B by the end of 2008.

The Fed continuously purchased securities from banking institutions (most prominently mortgage backed securities) and credited their accounts with deposits at the Federal Reserve. The banks had more cash on its books but less securities and therefore were more inclined to lend. Inversely, because of this, the Federal Reserve had more securities on its books, but also more deposits as it replaced the banks securities with deposits at its Federal Reserve bank. In 2013, the Federal Reserve was buying $85 billion per month of securities from the banks. However, Bernanke hinted that this policy may be coming to end. Base money peaked in 2014 and it has slowly started to come down ever so slightly since. In its Q4 2017 report, the Fed had $4.5 trillion in assets consisting of various securities and $2.2 trillion in deposits along with $1.5 trillion of currency in circulation. In June 2017, the Fed unveiled a plan to start shrinking its balance sheet.

Various types of assets on the Fed’s balance sheet. The largest assets that the Treasury owned was U.S. government debt followed by Mortgage Backed Securities.

Legacy of U.S. Quantitative Easing

Whether the unprecedented steps to lower interest rates and boost aggregate demand that the US Federal Reserve Bank took is a success or not has not been completely decided. Fed officials contend that the unconventional policy actions of QE saved the U.S from a larger and longer crisis. Others say, it could still create large inflation. Professor, Allan Meltzer, of Carnegie Mellon University supported the first stages of QE but said, "the benefits ended long ago." In favor of QE, a senior fellow at the Peterson Institute for International Economics, Joseph Gagnon who worked at the Fed claimed that research showed quantitative easing succeeded in lowering the US long-term interest rates and considered the result an “overwhelming answer” to the challenges the country faced.

Since 2009, US GDP has recovered and has remained steady at around 2%.

The U.S. has experienced a long run of steady job creation and falling unemployment. Unemployment stood at 4.1% in Feb 2018 down from 10% in 2009. Many investors and economists believed QE would result into future hyperinflation due to the large injections of liquidity through the banking system, believing as money increases so do prices. However, U.S. Inflation has remained low.

US public debt has soared by 115% since 2009. There are concerns with regards to inflation as the government tries to payback its debt. However, some argue that the US debt is not a concern as the country’s GDP stood at $19.7 trillion at the end of 2017. The country has a Debt-to-GDP ratio of 104% but a public debt is only $14.5 trillion or 76%. Furthermore, the large debt increase is related to expansionary fiscal policies not monetary.

Finally, one must consider the measurable impact of the QE process on the US stock market. QE is considered responsible for some of the growth of the stock market because excess liquidity could have been used to buy securities. However, this evidence is not conclusive. According to a study by McKinsey Global Institute, the boost in stock prices cannot be reliably tied to the Federal Reserve's stimulus programs.

The Fed is in the process of winding down its $4 trillion-dollar balance sheet. In effect, this is a reverse of the QE policy, 10 years after it decided to take this step. It will let billions of dollars of securities mature each month without reinvesting them. This is based on the conclusion that there has been a substantial improvement in the outlook of the labor market and there is sufficient underlying strength in the broader economy. In 2017, Janet Yellen, the former Chair of the Federal Reserve, quoted an analysis done by Fed economists, Eric Engen, Thomas Laubach and David Reifschneider, stating that the effect of the entire QE programme was to reduce 10-year term premium, and therefore the bond yield, by 120 basis points. This program resulted in reducing US unemployment by about 1.25% and increasing inflation by about 0.5%.

The legacy of the 2008 crisis is one that mixed and matched monetarism and Keynesianism. George Bush and then Barack Obama pursued expansionary fiscal and monetary policies. In 2010, most Keynesian economists were undecided about the efficacy of fiscal stimulus despite many of them in 2008 being for expansionary fiscal policies while monetarists such as Bernanke believed that they avoided a disaster with the monetary policy chosen. Bernanke explained his rationale in a 2010 article and how this process was necessary to achieve price stability. Others note the persistently slow rate of recovery since 2009. However, none of this is proof that QE didn’t do as it was intended to do. QE was never promised to be a panacea.

Friedman said in 1998 that if the BOJ followed his plan inflation would increase more rapidly, output will grow, and inflation will increase moderately. It can be assured to say that the U.S. did not fall into the deflationary spiral that Japan suffered through and exited the liquidity trap of zero bounded rates . But still a challenge remains, reversing the QE process is a new path that has not been done before. But until the Federal Reserve unwinds its security positions, the final conclusion may not be known.

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