Teaching note: QE FAQs from Ben Bernanke

Ben Bernanke has a very interesting review paper on QE.  Here are some excerpts.

1.       He focusses on large-scale asset purchases when the Central Bank (CB) has got to the effective lower bound.

2.       The Fed focus was “former emphasized the effects of buying longer-term assets on longer-term interest rates”

3.       To know if QE will work we have to know what determines long term yields.  “Longer-term yields can be conceptually divided into (1) the average expected short rate over the life of the security, and (2) the difference between the total yield and the average expected short rate, known as the term premium.”

4.       He then splits the effects into two

a.       “To a first approximation, portfolio balance effects work by affecting the term premium, while the signaling effect works by influencing expectations of future short rates.”

5.       These effects are:

a.       “portfolio balance effect.  if investors have “preferred habitats” because of specialized expertise, transaction costs, regulations, liquidity preference, or other factors, then changing the net supplies of different securities or classes of securities should 6 affect their relative prices.

b.       signaling effect.  if QE serves as a commitment mechanism, or perhaps as a signal of seriousness, leading investors to believe that policymakers intend to keep short-term policy rates low for an extended period….market participants are typically confident that central banks will not raise shortterm interest rates so long as asset purchases are continuing. Since QE announcements typically include information about the likely duration of purchases, which may be measured in quarters or years, and since QE programs are rarely terminated prematurely (because of the likely costs to policymakers’ credibility), the initiation or extension of a QE program often pushes out the expected date of the first short-term rate increase. Observing this signal that short rates will be kept low, investors bid down longer-term rates as well.”

6.       He then goes onto the evidence.

a.       The early data were on event studies and appeared to show important effects. “Evidently, QE1 had powerful announcement effects, including a full percentage point decline in the yield on 10-year Treasuries and more than a percentage point decline in the yields on mortgage-backed securities. Qualitatively, these results hold up well for different choices of event days or for shorter or longer event windows.”

Table 1. Responses of asset prices and yields to QE1 announcements

2-year Treasuries -57

10-year Treasuries -100

30-year Treasuries -58

Mortgage-backed securities -129

AAA corporate bonds -89

SP500 index 2.32

b.       But is this evidence clear?  He continues

                                                               i.      “First, in contrast to the results shown in Table 1 for QE1, event studies of later rounds of quantitative easing have tended to find much less dramatic effects. …. A possible interpretation is that the initial rounds of QE were particularly effective because they were introduced… in a period of exceptional dysfunction in financial markets.

                                                             ii.      “second point raised by critics is that event studies, by their nature, capture asset market reactions over only a short period. ... A variant of this objection, which takes a slightly longer-term perspective, begins by pointing out that longer-term Treasury yields did not consistently decline during periods in which asset purchases were being carried out. For example, the 10-year yield at the termination of QE1 purchases was actually higher than it was before QE1 was announced…Using time series methods, Wright (2011) argues that the effects of post-crisis policy announcements died off fairly quickly.”

c.       However, he believes these criticisms are overblown.

                                                               i.      “If later QE rounds were largely anticipated, then their effects would have been incorporated into asset prices in advance of formal announcements, accounting for the event-study results (Gagnon, 2018).”

                                                             ii.      “the prices of assets not subject to Fed purchases—including corporate bonds, equities, 13 the dollar, and a variety of foreign assets—moved substantially following announcements of asset purchase programs…QE also appeared to stimulate the global issuance of corporate bonds... The cross-asset impacts seem inconsistent with the view that the event-study findings reflect only asset-specific liquidity effects.” (longer-term yields did not reliably decline…in part, this pattern can be explained by the confounding influences on yields of other factors, including fiscal policy, global etc.)

d.       This relates to stocks and flows “The portfolio balance channel of QE, recall, holds that policymakers can affect longer-term yields by changing the relative supplies…a stock view of QE…The alternative flow view holds that the current pace of purchases is the critical determinant of asset prices and yields…The flow view would be correct if QE affected asset prices and yields primarily through short-run liquidity effects”.

He then talks about other policies

1.       forward guidance. “.

a.       Forward guidance takes many forms (such as the specification of policy targets, economic and policy projections) and occurs in many venues (speeches and testimonies, monetary policy reports).”

b.       “Delphic guidance is intended only to be informative, to help the public and market participants understand policymakers’ economic outlook and policy plans. In contrast, Odyssean guidance…. incorporating a promise or commitment …to conduct policy in a specified, possibly state-contingent way in the future “.

c.       He remarks that guidance has worked, but is hard to disentanglbe from QE.

2.       Other New Monetary Policy Tools. Various forms

a.       central banks also purchased a range of private assets, including corporate debt, commercial paper, covered bonds.  These have greater effect on private yields, (but there are general equilbirm effects )credit risk and political controversy.

b.       “subsidized bank lending through cheap long-term funding”.  “these lending programs were aimed at broader economic stabilization… offering bank-dependent borrowers the same access to credit as borrowers with access to securities markets... Most …evidence on these programs suggests that they lowered bank funding costs, promoted lending, and improved monetary policy passthrough…However, the efficacy of these programs seems likely to depend in a complicated way on the health of the banking system: If banks are well-capitalized, then their need for cheap liquidity from the central bank may be limited. Conversely, if banks are short of capital, their lending may be constrained or their incentives to make good loans distorted, notwithstanding the availability of low-cost funding”.

c.       Negative rates.  He says they might cause switching into cash and affect Bank’s profits, but aginst that help overall economic conditions.

d.       Yield curve control. He believes this works in Japan, but might not in the US. “…if long-term yields were pegged, and market participants came to believe that the future path of policy rates was likely higher than the targeted yield, the Fed might need to buy a large share of the outstanding bonds to try to enforce the peg. Those purchases in turn would flood the banking system with reserves and expose the central bank to large capital losses.  However, pegging Treasury yields at a shorter horizon, say two years, would likely be feasible”.

3.       What are the costs of risks of these various tools?  He believes all, bar the last, on financial instability, are small

a.       “Impairment of market functioning….Asset purchases likely improved market functioning “

b.       “High inflation. … Fed policymakers and staff understood that, with short-term interest rates near zero, the demand for bank reserves would be highly elastic and the velocity of base money could be expected to fall sharply  [i.e. that money and bonds would be near perfect substitutes]…. However, some FOMC participants did express concern about the possibility that [QE] could un-anchor inflationary expectations”

c.       Managing exit

d.       Distribution “the research literature is close to unanimous in its finding that the distributional effects of expansionary monetary policies… may even work in a progressive direction, for example by promoting a “hot” labor market”.

e.       Capital losses “The large, unhedged holdings of longer-term securities associated with asset purchase programs risked substantial capital losses if interest rates had risen unexpectedly, losses which in turn could have ultimately reduced the Federal Reserve’s remittances of profits to the Treasury”. 

Finally he discusses “. Financial instability….including but not limited to the creation of asset bubbles; incentivizing “reach for yield” and excessive risk-taking by investors; the promotion of excessive leverage or maturity transformation; and the destabilization of the business models of insurance companies and pension funds, which rely on receiving adequate long-run returns, and of banks, whose profits depend in part on their ability to earn positive net interest margins. U.S. central bankers also heard frequently from their foreign counterparts, especially in emerging markets, about the “spillover effects” of Fed policies on financial conditions abroad (Rey, 2013).”  He makes a number of points.

                                                               i.      “Increased risk-taking is by no means always a bad thing, of course: Encouraging banks, borrowers, and investors to take reasonable risks, rather than hoarding cash and hunkering down, is a desirable goal for policies aimed at ending a recession or crisis and restoring normal growth. However, risk-taking may become excessive…”

                                                             ii.      “Most participants in that debate agree that that the first line of defense against financial instability risks should be targeted regulatory and macroprudential policies..”

                                                           iii.      “…the portfolio balance effect of QE involves pushing some investors out of longer-term Treasuries into other, possibly riskier assets; but in general equilibrium, by removing duration risk from the system, QE reduces the riskiness of private-sector portfolios in aggregate, increases the supply of safe and liquid assets, and helps compensate for reduced private risk-bearing capacity during periods of high uncertainty”. 

Teaching Link: Imperial college student webinar, Current economic prospects, 12 May 2020

Imperial college student webinar, Current economic prospects, 12 May 2020

Some of our Imperial College students organised a webinar last night on our current economic prospects. They kindly invited David Shepherd, David Miles, James Sefton and me to participate. Here are some notes on the questions that they set us in advance and a few notes on what was said. Thanks to our talented and interested students for organising this and participating.

Q. How does the current climate compare to previous periods of economic turbulence e.g. Spanish flu of 1918, WW I&II, the great depression? In your opinion what is the optimal fiscal/monetary policy mix to confront the liquidity crunch due to COVID? 

The BBC showed on its website the following graph saying that this was the sharpest annual downturn since 1706. So this is clearly an gigantic recession; historically unparalleled, at least since 1706m and rolling together The Great Depression, the 2008 Financial Crisis and the flu pandemic all in one go. 

Optimal mix.

The optimal mix of money in fiscal policy is a nice question. Perhaps the best way to think about it is the benchmark economics competitive model. In that model economic systems are self-correcting. If there’s a shock to a market, say to the demand for PPE, it becomes more expensive: demand is choked off and supply is increased, as firms rush to enter a more lucrative market. The two forces of falling demand and rising supply raise prices and bring the market back to equilibrium.

The second feature of the benchmark competitive economics model, is that markets are not only self correcting, but they are what economists call complete. By complete this means that goods can be transacted for. And, in particular, future goods can be transacted for via future contracts.  Of course that's exactly what we see in the real world if we're thinking about let us say oil or aluminium. Airlines buy the oil forward . And that's part of prudent business management. But when economists think of a complete market they mean that all items can be traded forward. As John Kay is pointed out, in his book “The Truth About Markets” that would mean that you could buy a futures contract in let us say 1960 for the appearance of an iPad in 1990. The fact is of course that nobody even knew what an iPad was in 1960, let alone were able to sign a contract for it. But had they done so, it would have meant that the contract could have been traded and the forces of supply and demand mentioned above would have equilibrated the market.

Now in an economy where neither of those two conditions hold then we potentially have a room for policy. Let's take the first one. Many markets especially financial markets, seemed to be complete opposite of self equilibrating, especially in periods when market participants are panicking. That is to say uncertainty over the future, which induces panic, often makes sellers of financial assets sell, without demanders coming in to pull up the price (Think of somebody who are forced into crisis to sell some asset, a so called fire sale , even when the market is very depressed). The price of the asset falls and falls, thereby amplifying the original shock.

As for the second condition, nobody knew what COVID19 was and nobody signed a contract on it: in this case nobody insured themselves against its possibility. So we've had a very large adverse shock against which nobody took out insurance.

So the role of the state in this case , is to (1) step in if the market is in chaos and (2) to provide insurance because of the incompleteness in that market.

One important role for monetary policy is to step in when financial markets are in chaos and are dysfunctional. The Monetary Policy Committee did this in the financial crisis.

As for insurance, that is commonly the right role for fiscal policy. The benefit system ensures that workers have unemployment benefits if they were unlucky enough to be unemployed, and the progressivity of the tax system is such that when incomes go down taxes are effectively cut, so-called automatic stabilisers. That provisioning of insurance of course involves borrowing and involves perhaps paying out large amounts of unemployment benefit now, to be funded by the state, but then paid back by future taxing and borrowing once the economy has been restored.  

The right mix of monetary and fiscal policy depends upon institutions that we currently have in place.  The burden of insurance provision should lie with the fiscal authorities. Note however that as part of inflation targeting an independent central bank might want to undertake more expansionary monetary policy than would otherwise be the case if it wanted to avoid scarring; that is to say, if its inflation target would be imperilled if a prolonged recession lowered the potential output in the economy.   See Powell’s speech today (https://www.federalreserve.gov/newsevents/pressreleases/other20200228a.htm).

·         Do you expect a mild recession with a V shape recovery, a greater recession with a U shaped recovery or an L shaped deep depression? What are 'the city' thinking and how are they modelling excess risk/uncertainty into long-term economic models/predictions?

In our most recent monthly policy report The Bank of England have felt that the situation is so uncertain, and the historical parallels so difficult to discern, that it is unable to have a definitive forecast . Instead it produced a scenario, being an outlook based on the series of what at the time seem reasonable judgments. That scenario in Chart 1.3 below has a very sharp fall in GDP and then a slow recovery.  So overall UK GDP falls by 14% in 2020. Activity then picks up in the latter part of 2020 and into 2021 as social distancing measures are relaxed. That said GDP doesn't reach the pre covid level until the second half of 2021. So in 2020 GDP falls by 14%, in 2021 it rises by 15% and in 2022 it rises by 3%.

. 

The chart below shows what other forecasters expect for 2020 Q 2. The bank is somewhere in the middle of these averages. 

The report notes a number of downside risks to this scenario. One of course is the position of the world which is currently extremely difficult. A second which other commentators have looked at is the possibility of further waves of the pandemic. This is obviously a matter for epidemiologists but it is of interest to look at the chart below, put together by some London Business School economists pointing out that belief the death rate from Spanish flu came in three waves.  It is perhaps also worth pointing out do we don't yet have a vaccine for AIDS, thus the question of whether we will eventually have a vaccine is still open one .  Still another important point came out in the discussion last night. It is that it's very difficult to know how to interpret the recent fall and death rates because we are so uncertain as to what the level of infection in the community might be. The range of estimates seems to be from 5 to 65%. Of course, if the level of infection is very high, this is potentially extremely good and important news, because it means that the lockdown can be released. We urgently need to know what this number is. Perhaps the proliferation of tracing apps, the national launch of the NHS app, and Professor Tim Spector’s app from Kings College might help us.

Finally, the other sets of sensitivities would be around scarring. As mentioned above this is the possibility that the long-term supply potential of the economy is so damaged that it is difficult for the economy to come back again consistent with low inflation.  A number of scarring mechanisms exist. One is obviously the idea that if there was an extended period of unemployment workers would lose their skills and motivation. The second is that there may be a permanent structural change in the economy such that a number of capital assets (think airports) are simply as not usable and productive in the current economy as before. Of course capital can be reallocated but if that takes a time then the supplies potentially the economy can potentially be disrupted.  And of course it does look like they're going to be need to be some capital assets which will have to be increased: say, hospitals, delivery equipment and social distancing infrastructure.

·         What will be the long term impact of QE/Debt monetisation on interest rates and inflation post-COVID?  How will we pay-off the debt: taxation, austerity, growth, or a combination of the three? How does this marry-up with political decision-making and public opinion?

This raises a number of key questions. Let's go through them one by one .

The first point is what will happen to R*. To recap R*is the neutral rate of interest , that is to say the rate of interest at which resources completely utilised, and  unemployment and inflation are stable. It is indeed the case that central banks can influence short term interest rates but the long term interest rate is something typically beyond their control. So for example the large increase in demographic ageing in the last 30 years and the associated high demand for savings for a longer old age, is widely held to have depressed the equilibrium interest rate. Equally there appears to have been a fall in the demand for capital, perhaps caused by the increase of use of intangible assets which likewise pressed down on the equilibrium long term interest rate. So the key question is what happens to that future interest rate after this crisis?

One possibility is that it will increase as the demand for capital and demand for debt rises in the face of large borrowing by central banks and governments. Against that if there were an outbreak of precautionary savings in the face of the uncertainty around this shock , then there will be strong pressure for the rate to fall even further. We don't know what the balance of these forces is going to be. At least in the short run the amount of saving is strongly correlated with unemployment and the fear of unemployment. If unemployment rises and stays high that would typically drive saving up comma and if that were, common throughout the world that would drive the equilibrium real rate of return down.

So if the equilibrium interest rate falls further or at least stays low, that of course is very good news for what will of course be highly indebted governments. That said, we will need to boost growth in order that even at very low interest rates the economy can grow sufficiently to pay off what will be almost certainly a greatly increased debt burden.  And indeed was a bit of discussion at the session as to what his oral experience can tell us. The debt to GDP ratio was extremely high After World War One World War Two and rather earlier the Napoleonic wars. In the case of the Napoleonic wars in World War One the debt was reduced essentially via growth and low interest rates. That was also the case after World War 2, although inflation did play a role. So there is historical precedent for having high debt burdens and there is historical precedent for their being reduced by the joint forces of economic growth and interest rates.

In that respect QE is a minor player.  

Q. The Fed was quick and effective to launch stimulus programmes to contain the freefall in markets by providing mass scale liquidity. Warren Buffet recently commented that due to Fed intervention asset prices haven't bottomed out, making investment opportunities less attractive. Do you think the market has bottomed out? What are the asset price implications if lockdowns continue, albeit intermittently, until 2021? i.e. returns on stocks, bond yields, ETFs, safe haven assets such as gold.  Given the flight to safety we're seeing in capital outflows, what are the implications for FX rates between strong currencies (e.g. dollar, euro) and EM currencies? Could the massive scale QE cause the dollar to depreciate?

The session finished with some discussion of the above couple of questions. The difficulty of forecasting interest rates exchange rates made most people rather non-committal, beyond the observation that the US dollar always seems to stay strong in periods of panic , as people seek refuge in the world’s reserve currency. Finally, the future of the housing market. The interesting issue here is whether our experience of working from home, and the possible worries about taking public transport , might get us to a situation in which there is simply much less demand for both offices in general, but also office space,. That fall in demand may well have important effects reducing prices and rendering housing more affordable.  Another example of an equilibrating market?