QE, We Hardly Knew Thee


Yesterday, the Federal Reserve announced that it was halting the bond-buying program known as “quantitative easing”, the third round of which had begun in September 2012. While the Fed won’t divest itself of the more than $4 trillion in bonds it has accumulated, and has no immediate plans to raise interest rates, it won’t buy any more. Matt O’Brien fears that the Fed is sending the wrong signals as the economy remains lethargic:

The fact that it’s ending QE3 despite still-low inflation and still-high, though declining, unemployment, signals that the Fed is eager to return to normalcy. So does changing its statement from saying there’s a “significant underutilization of labor resources” to it “gradually diminishing.” The Fed, in short,  looks much more hawkish. And that’s not good, because, as Chicago Fed President Charles Evans explains, the “biggest risk” to the economy right now is that the Fed raises rates too soon.

QE isn’t magic — far from it — but it is, as Boston Fed President Eric Rosengren told me, “quite effective.” Especially at convincing markets that the Fed won’t raise rates for awhile, which is all it should be saying right now. Because the only thing worse than having to do QE is having to do QE again. The Fed, in other words, should do everything it can to make sure the economy lifts off from its zero interest rate trap before it pulls anything back. Otherwise, we might find ourselves back in the same place a few years from now.

Justin Wolfers stresses that this isn’t really “the end” of QE, since the assets the Fed holds will continue to have a stimulative effect:

Of course, the aspect of Wednesday’s Federal Reserve decision that has captured the most attention is its decision to stop purchasing further long-term securities. But don’t confuse this with a monetary tightening. It’s hanging on to the stock of securities it currently holds, and the Fed’s preferred “stock view” says that this is what matters for keeping longer-term interest rates low. By this view, the Fed’s decision to end its bond-buying program does not mark the end of its efforts to stimulate the economy. Rather, it is no longer going to keep shifting the monetary dial to yet another more stimulative notch at each meeting. The level of monetary accommodation will remain at a historical high, even if it is no longer expanding.

Over recent years, policy makers have also worked to lower long-term interest rates by shaping expectations about future monetary policy decisions, in a process known as forward guidance. Today’s statement continues this policy, repeating recent guidance that the Fed expects interest rates to remain low for “a considerable time.”

But Ylan Mui suggests that higher rates may not be as far off as promised:

The debate over when to raise rates, which has already begun, will prove tricky for the Fed — and likely the biggest challenge of Janet Yellen’s tenure since she took over as head of the central bank early this year. Fed officials, who have suggested that the move could come in the middle of next year, hope that it causes little disruption. But achieving that delicate balance is the most basic dilemma of central banking. If the Fed moves too soon, it could undermine the recovery. If it waits too long, it could breed the next financial bubble as investors take too many risks backed by the belief the Fed will always be stimulating the economy.

When Fed officials suggested in the past that they may withdraw stimulus from the economy faster than anticipated, markets have swooned and interest rates have popped up. That’s one reason central bank officials have been preaching patience in responding to the strengthening recovery — but some investors believe they will not be able to wait much longer.

The Bloomberg View editors revisit the debate over whether QE worked. They maintain that it was the right call:

Exactly how much QE has helped the economy remains a matter of debate. Former Fed Chairman Ben Bernanke said in 2012 that the Fed’s first two rounds may have boosted output by 3 percent and added more than 2 million jobs. In a more recent paper, San Francisco Fed President John Williams said such estimates were uncertain; he also noted the risks to the financial system posed by so large an intervention. Some believe QE has gradually diminishing effects; others that it has no positive effect at all.

Regardless, the gamble was justified. After the crash a persistent slump in demand hobbled the recovery and drove up long-term unemployment, threatening great and lasting economic damage. With inflation low, the risks of QE were small in relation to the possible gains. The benefits weren’t confined to the direct effects of the Fed’s purchases: Even more important, QE bolstered confidence that the central bank was willing to do everything in its power to revive the economy.

Danielle Kurtzleben also defends the program:

One key thing to consider with QE3 is the counterfactual — what would the economy have looked like had it never been put into place? One of the big benefits of QE3 was that it counteracted a Congress that insisted on holding back spending, even while the economy was sluggish. As Fed Chair, Bernanke was constantly chiding Congress for dragging on the economy, encouraging them to save deep spending cuts like those under sequestration for later.

So though 2013’s economic growth wasn’t exactly stellar compared to 2012’s, it’s important to consider how bad it could have been, says [economist Paul] Edelstein. “I mean, 2012 GDP growth was two and a quarter percent. 2013 comes, we have all the sequester-related spending cuts, and we have QE3. The result: GDP growth of two and a quarter percent,” he says. “Is two and a quarter percent good? Not really. But clearly again it could be a lot worse if we didn’t have fiscal drag.”

The Fed Is Getting Back To Normal

Ylan Mui has the details of yesterday’s Federal Open Market Committee meeting, in which Federal Reserve Chair Janet Yellen laid out a plan to draw down the Fed’s massive stimulus program in light of the economic recovery and the upward trajectory of the job market:

The improving outlook means that the recovery no longer needs as much support from the nation’s central bank.

Since the start of this year, the Fed has been slowly reducing the amount of money it is pumping into the economy. The central bank said Wednesday it will reduce its purchases of Treasuries and mortgage-backed securities to $15 billion in October, down from $85 billion a month last year. The Fed expects to end the program altogether when it meets next month.

Still, the Fed said it will maintain the size of its balance sheet for now –which stands at $4.4 trillion — by reinvesting maturing securities. The Fed holds more than four times as many assets as it did before the 2008 financial crisis. Though the central bank said Wednesday it is committed to shrinking the balance sheet to a more normal size, it formally announced it does not plan to sell any of its assets, a reversal of the plan laid out three years ago. Instead, the Fed said it will eventually stop reinvesting maturing securities and let them run off. However, the central bank said Wednesday that process will not start until after it has successfully raised its benchmark interest rate.

Neil Irwin rejoices at the prospect of a return to boring monetary policy:

For the last six years, Federal Reserve policy has been sexy, or at least as sexy as monetary policy can ever be. Leaders of the central bank have had to improvise answers to tremendously consequential questions. What should the Fed do to combat a severe financial crisis? (Pretty much anything they could think of, and then some, was the answer.) What should the Fed do to stimulate a depressed economy when interest rates are already near zero? (Buy trillions of dollars in securities and pledge to keep interest rates at zero for a really long time.) Should it consider more radical measures like lifting its target for inflation? (No.)

But now, the big questions of Fed policy have mostly been answered, all the more so after this week’s meeting of the Federal Open Market Committee and the news conference on Wednesday by Janet L. Yellen, its chairwoman. And that is terrific news.

Michael Grunwald is on the same page:

It’s true that our recovery from the Great Recession has been slower than previous recoveries from ordinary recessions. But it has been much stronger than previous recoveries in nations that endured major financial crises—and much stronger than Europe’s current recovery. The euro zone’s output has not yet reached pre-crisis levels; it’s still struggling with 12% unemployment and a risk of deflation.

We’re doing a lot better than that. We had more effective bank bailouts, more generous fiscal stimulus—until Republicans took over the House after the 2010 midterms and began demanding austerity—and much more accommodative monetary policy. It’s all worked remarkably well. We’ve faced some headwinds—the contagion from the near-collapse of Greece in 2010, the turmoil after we nearly defaulted on our debt in 2011—but the economy has continued its path of slow but steady growth. That’s why Yellen was able to discuss those mind-numbing “policy normalization principles,” the guidelines the Fed will follow as it starts raising rates and reining in its bloated balance sheet in 2015. We’re approaching normal. And the Fed’s forecast for the next few years also looks pretty decent.

But the Bloomberg View editors oppose ending the Fed’s extraordinary measures:

[T]he Fed has better tools than monetary policy to mitigate financial threats to the broader economy. It can require banks to fund themselves with more loss-absorbing equity, and it can pressure them to steer clear of obvious trouble spots. As a member of the Financial Stability Oversight Council, it can also push for better monitoring of risks that might be building outside the regulated banking system. For monetary policy, the biggest question is whether the Fed can get employment back to pre-recession levels without generating too much inflation. The concern is that structural changes such as shrinking labor-force participation and decelerating productivity might have made that goal impossible. If so, and without government action to combat stagnation, central bankers might have to write off the livelihoods of millions of people as a permanent loss.

So far, there’s little evidence that the Fed has reached the limit of what it can do. Giving up too soon would be a tragedy, even if inflation temporarily overshoots the Fed’s target. Hence, the central bank would do well to maintain room for maneuver.

And Andrew Flowers notes that the debate over the effectiveness of the third round of “quantitative easing” is not settled:

The latest Survey of Consumer Finances showed that the typical household’s income fell by 5 percent (after adjusting for inflation) from 2010 to 2013 — which covers all of QE2 and the bulk of QE3. And economic inequality rose. Because the rich tend to hold a greater percentage of their assets in stocks, and stock prices rose, 2013 saw a widening disparity in wealth.

Critics of QE3 have also worried about inflation. With the Fed effectively printing money to buy $1.6 trillion in bonds, and all this money sloshing around, the prices of all sorts of goods and services could increase, and nullify whatever stimulative effect the program was supposed to have. However, inflation rates have barely budged and remain below the Fed’s 2 percent target, and inflation expectations are stable. This “inflation hysteria” has not materialized, QE3 supporters say; not yet, say the critics.

He also observes that the Fed’s long-term growth projections are pessimistic:

Specifically, the midpoint forecast for real gross domestic product growth in the longer run was lowered to 2.15 percent, down from 2.20 percent in June. In early 2009, when the Fed first began releasing projections, the longer-run midpoint forecast was 2.60 percent. That’s a huge drop. … This “longer run” growth projection is equivalent to potential growth — defined as the economy’s growth rate when using all available resources but without leading to debilitating inflation. And the Fed is not alone in revising down its views of long-run growth: The nonpartisan Congressional Budget Office also revised down potential GDP this year.