UPDATE: In response to a comment, I have revised slightly the third paragraph of this post to remove an unnecessarily harsh rhetorical attack on Mr. Bernanke.
Ben Bernanke gave his commentary about US monetary policy at the annual late summer monetary conference at Jackson Hole, Wyoming sponsored by the Federal Reserve Bank of Kansas City. At the 2010 meeting, just after the stock market had fallen by nearly in the month of August as fears of potential deflation were rapidly gathering strength, Bernanke signaled that the FOMC would undertake its second round of quantitative easing, prompting a quick turnaround in both inflation expectations and the stock market. The rally in inflation expectations and the stock market continued impressively from September through February when a series of adverse supply shocks, the loss of Libyan oil supplies after the uprising against Colonel Gaddafi’s regime, the earthquake, tsunami, and nuclear meltdowin in Japan, put a damper on the modest expansion that was getting underway. A similar downward drift of inflation expectations this spring led to a substantial drop in stock prices from their early 2012 highs, prompting Bernanke and the FOMC to emit faint signals that a third round of quantitative easing just might be in the offing at some future time if it seemed warranted. Those signals were enough to reverse a months long downward trend in inflation expectations producing a rebound in stock prices back close to their highs for 2012.
So the good news from Bernanke’s speech is that he argued that, contrary to those who deny that monetary policy can be effective at the zero lower bound, there is empirical evidence showing that the previous rounds of quantitative easing had a modest stimulative effect. Bernanke maintains that quantitative easing has increased GDP by 3% and private payroll employment by 2 million jobs compared to a scenario with no QE. That Bernanke went to the trouble of making the case that previous rounds of QE have been effective suggests strongly that Bernanke has decided that the time has come to try one more round of QE, notwithstanding the opposition of some members of the FOMC, like Richard Fisher of the Dallas Fed, and among the other regional Federal Reserve Bank Presidents, notably Jeffrey Lacker of the Richmond Fed and Charles Plosser of the Philadelphia Fed. That’s the good news.
Now for the bad news — the very bad news – which is that the arguments he makes for the effectiveness of QE show that Bernanke is totally clueless about how QE could be effective. If Bernanke thinks that QE can only work through the channels he discusses in his speech, then that gives us a very acute insight into why the Fed, under Bernanke’s watch, has failed so completely to bring about a decent recovery from the Little Depression in which we have been stuck since 2008. Consider how Bernanke explains the way that the composition of the Fed’s balance sheet can affect economic activity.
In using the Federal Reserve’s balance sheet as a tool for achieving its mandated objectives of maximum employment and price stability, the FOMC has focused on the acquisition of longer-term securities–specifically, Treasury and agency securities, which are the principal types of securities that the Federal Reserve is permitted to buy under the Federal Reserve Act. One mechanism through which such purchases are believed to affect the economy is the so-called portfolio balance channel, which is based on the ideas of a number of well-known monetary economists, including James Tobin, Milton Friedman, Franco Modigliani, Karl Brunner, and Allan Meltzer. The key premise underlying this channel is that, for a variety of reasons, different classes of financial assets are not perfect substitutes in investors’ portfolios. For example, some institutional investors face regulatory restrictions on the types of securities they can hold, retail investors may be reluctant to hold certain types of assets because of high transactions or information costs, and some assets have risk characteristics that are difficult or costly to hedge.
Imperfect substitutability of assets implies that changes in the supplies of various assets available to private investors may affect the prices and yields of those assets. Thus, Federal Reserve purchases of mortgage-backed securities (MBS), for example, should raise the prices and lower the yields of those securities; moreover, as investors rebalance their portfolios by replacing the MBS sold to the Federal Reserve with other assets, the prices of the assets they buy should rise and their yields decline as well. Declining yields and rising asset prices ease overall financial conditions and stimulate economic activity through channels similar to those for conventional monetary policy.
Bernanke seems to think that changing the amount of MBSs available to the public can alter their prices and change the shape of the yield curve. That is absurd. The long-term assets whose supply the Fed is controlling are but a tiny sliver of the overall stock of assets whose prices adjust to maintain overall capital market equilibrium Affecting the market for a particular group of assets in which it is trading actively cannot force all the other asset markets to adjust accordingly unless the Fed is able to affect either expectations of future real rates or future inflation rates. If the Fed has succeeded in driving down the yields on long term assets, it is because the Fed has driven down expectations of future inflation or has caused expectations of future real rates to fall. The balance-sheet effect can at most affect the premium or discount of particular securities relative to other similar securities. If I am in a position to change the price of crude oil at Cushing Oklahoma, it does not mean that I can control the price of crude throughout the entire world. Bernanke continues:
Large-scale asset purchases can influence financial conditions and the broader economy through other channels as well. For instance, they can signal that the central bank intends to pursue a persistently more accommodative policy stance than previously thought, thereby lowering investors’ expectations for the future path of the federal funds rate and putting additional downward pressure on long-term interest rates, particularly in real terms. Such signaling can also increase household and business confidence by helping to diminish concerns about “tail” risks such as deflation.
Bernanke is on to something here, but he is still not making sense. What does Bernanke mean by “a more accommodative policy stance?” The policy stance of the central bank does not exist in isolation, it exists in relation to and in the context of the state of the real economy. Thus, any signal by the central bank about the future path of the federal funds rate is ambiguous insofar as it reflects both a signal about the central bank’s assessment of the public’s demand for accommodation and the central bank’s supply of accommodation conditional on that assessment. When the central bank announces that its lending rate will remain close to zero for another year, that doesn’t mean that the central bank is planning to adopt a more accommodative policy stance unless the central bank provides other signals about what its assessment of, or target for, the economy is. The only way to provide such a signal would be to announce a higher target for inflation or for NGDP, thus providing a context within which its lending rate can be meaningfully interpreted. And a signal that increases household and business confidence by diminishing concerns about deflation should not be associated with falling nominal interest rates and falling inflation expectations — precisely the result that Bernanke feels that earlier rounds of QE have accomplished. Actually, the initial success of QE2 was associated with rising long-term rates and rising inflation expectations. It was only when the program petered out, after adverse supply shocks caused a temporary blip in commodity prices and CPI inflation in the spring of 2011, that real interest rates and inflation expectations began to drift downwards again.
Because he completely misunderstands how QE might have provided a stimulus to economic activity, Bernanke completely misreads the evidence on the effects of QE.
[S]tudies have found that the $1.7 trillion in purchases of Treasury and agency securities under the first LSAP [large-scale asset purchases] program reduced the yield on 10-year Treasury securities by between 40 and 110 basis points. The $600 billion in Treasury purchases under the second LSAP program has been credited with lowering 10-year yields by an additional 15 to 45 basis points. Three studies considering the cumulative influence of all the Federal Reserve’s asset purchases, including those made under the MEP, found total effects between 80 and 120 basis points on the 10-year Treasury yield. These effects are economically meaningful.
The reductions in long-term interest rates reflect not the success of QE, but its failure. Why was QE a failure? Because the only way in which QE could have provided an economic stimulus was by increasing total spending (nominal GDP) which would have meant rising prices that would have called forth an increase in output. The combination of rising prices and rising output would have caused expected real yields and expected inflation to rise, thereby driving nominal interest rates up, not down. The success of QE would have been measured by the extent to which it would have produced rising, not falling, interest rates.
Bernanke makes this fatal misunderstanding explicit later on in his speech.
A second potential cost of additional securities purchases is that substantial further expansions of the balance sheet could reduce public confidence in the Fed’s ability to exit smoothly from its accommodative policies at the appropriate time. Even if unjustified, such a reduction in confidence might increase the risk of a costly unanchoring of inflation expectations, leading in turn to financial and economic instability. It is noteworthy, however, that the expansion of the balance sheet to date has not materially affected inflation expectations, likely in part because of the great emphasis the Federal Reserve has placed on developing tools to ensure that we can normalize monetary policy when appropriate, even if our securities holdings remain large. In particular, the FOMC will be able to put upward pressure on short-term interest rates by raising the interest rate it pays banks for reserves they hold at the Fed. Upward pressure on rates can also be achieved by using reserve-draining tools or by selling securities from the Federal Reserve’s portfolio, thus reversing the effects achieved by LSAPs. The FOMC has spent considerable effort planning and testing our exit strategy and will act decisively to execute it at the appropriate time.
Bernanke views the risk of an unanchoring of inflation expectations as a major cost of undertaking QE. Nevertheless, he exudes self-satisfaction that the expansion of the Fed’s balance sheet over which he has presided “has not materially affected inflation expectations.” OMG! The only possible way by which QE could have provided any stimulus to the economy was precisely what Bernanke was trying to stop from happening. Has there ever been a more blatant admission of self-inflicted failure?