So Many QE-Bashers, So Little Time

Both the Financial Times and the Wall Street Journal have been full of articles and blog posts warning of the ill-effects of QE3. In my previous post, I discussed the most substantial of the recent anti-QE discussions. I was going to do a survey of some of the others that I have seen, but today all I can manage is a comment on one of them.

In the Wall Street Journal, Benn Steil, director of international economics at the Council of Foreign Relations, winner of the 2010 Hayek Book Award for his book Money, Markets, and Sovereignty (co-authored with Manuel Hinds), and Dinah Walker, an analyst at the CFR, complain that since 2000, the Fed has stopped following the Taylor Rule, to which it supposedly adhered from 1987 to 1999 during a period of exceptional monetary stability, and, from 2000 to the present, the Fed supposedly abandoned the rule. This is a familiar argument endlessly repeated by none other than John Taylor, himself. But as I recently pointed out, Taylor has implicitly at least, conceded that the supposedly non-discretionary, uncertainty-minimizing, Taylor rule comes in multiple versions, and, notwithstanding Taylor’s current claim that he prefers the version that he originally proposed in 1993, he is unable to provide any compelling reason – other than his own exercise of discretion — why that version is entitled to any greater deference than alternative versions of the rule.

Despite the inability of the Taylor rule to specify a unique value, or even a narrow range of values, of the target for the Fed Funds rate, Steil and Walker, presumably taking Taylor’s preferred version as canonical, make the following assertion about the difference between how the Fed Funds rate was set in the 1987-99 period compared how it was set in the 2000-08 period.

Between 1987, when Alan Greenspan became Fed chairman, and 1999 a neat approximation of how the Fed responded to market signals was captured by the Taylor Rule. Named for John Taylor, the Stanford economist who introduced the rule in 1993, it stipulated that the fed-funds rate, which banks use to set interest rates, should be nudged up or down proportionally to changes in inflation and economic output. By our calculations, the Taylor Rule explained 69% of the variation in the fed-funds rate over that period. (In the language of statistics, the relationship between the rule and the rate had an R-squared of .69.)

Then came a dramatic change. Between 2000 and 2008, when the Fed cut the fed-funds target rate to near zero, the R-squared collapsed to .35. The Taylor Rule was clearly no longer guiding U.S. monetary policy.

This is a pretty extravagant claim. The 1987-99 period was marked by a single recession, a recession triggered largely by a tightening of monetary policy when inflation was rising above the 3.5 to 4 percent range that was considered acceptable after the Volcker disinflation in the early 1980s. So the 1992 recession was triggered by the application of Taylor rule, and the recession triggered a response that was consistent with the Taylor rule. The 2000-08 period was marked by two recessions, both of which were triggered by financial stresses, not rising inflation.  To say that the Fed abandoned a rule that it was following in the earlier period is simply to say that circumstances that the Fed did not have to face in the 1987-99 period confronted the Fed in the 2000-08 period. The difference in the R-squared found by Steil and Watson may indicate no more than the more variable economic environment in the latter period than the former.

As I pointed out in my recent post (hyper-linked above) on the multiple Taylor rules, following the Taylor rule in 2008 would have meant targeting the Fed Funds rate for most of 2008 at an even higher level than the disastrously high rate that the Fed was targeting in 2008 while the economy was already in recession and entering, even before the Lehman debacle, one of the sharpest contractions since World War II. Indeed, Taylor’s preferred version implied that the Fed should have increased (!) the Fed Funds rate in the spring of 2008.

Steil and Watkins attribute the Fed’s deviation from the Taylor rule to an implicit strategy of targeting asset prices.

In a now-famous speech invoking the analogy of a “helicopter drop of money,” [Bernanke] argued that monetary interventions that boosted asset values could help combat deflation risk by lowering the cost of capital and improving the balance sheets of potential borrowers.

Mr. Bernanke has since repeatedly highlighted asset-price movements as a measure of policy success. In 2003 he argued that “unanticipated changes in monetary policy affect stock prices . . . by affecting the perceived riskiness of stocks,” suggesting an explicit reason for using monetary policy to affect the public’s appetite for stocks. And this past February he noted that “equity prices [had] risen significantly” since the Fed began reinvesting maturing securities.

This is a tendentious misreading of Bernanke’s statements. He is not targeting stock prices, but he is arguing that movements in stock prices are correlated with expectations about the future performance of the economy, so that rising stock prices in response to a policy decision of the Fed provide some evidence that the policy has improved economic conditions. Why should that be controversial?

Steil and Watkins then offer a strange statistical “test” of their theory that the Fed is targeting stock prices.

Between 2000 and 2008, the level of household risk aversion—which we define as the ratio of household currency holdings, bank deposits and money-market funds to total household financial assets—explained a remarkable 77% of the variation in the fed-funds rate (an R-squared of .77). In other words, the Fed was behaving as if it were targeting “risk on, risk off,” moving interest rates to push investors toward or away from risky assets.

What Steil and Watkins are measuring by their “ratio of household risk aversion” is liquidity preference or the demand for money. They seem to have a problem with the Fed acting to accommodate the public’s demand for liquidity. The alternative to the Fed’s accommodating a demand for liquidity is to have that demand manifested in deflation. That’s what happened in 1929-33, when the Fed deliberately set out to combat stock-market speculation by raising interest rates until the stock market crashed, and only then reduced rates to 2%, which, in an environment of rapidly falling prices, was still a ferociously tight monetary policy. The .77 R-squared that Steil and Watkins find reflects the fact, for which we can all be thankful, that the Fed has at least prevented a deflationary catastrophe from overtaking the US economy.

The fact is that what mainly governs the level of stock prices is expectations about the future performance of the economy. If the Fed takes seriously its dual mandate, then it is necessarily affecting the level of stock prices. That is something very different from the creation of a “Bernanke put” in which the Fed is committed to “ease monetary policy whenever there is a stock market correction.” I don’t know why some people have a problem understanding the difference.  But they do, or at least act as if they do.

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10 Responses to “So Many QE-Bashers, So Little Time”


  1. 1 Luis H September 21, 2012 at 11:27 am

    I agre in general with You, but because I Don’t believe in permanent rules. Neither Taylor rule nor NGDP rule…
    Rules are perhaps profitable in normal times. Some flexible rule, as the dual mandate, make easier to monitor the FED decisions. More than in any rule I Believe in “risk management” of Greenspan. Now, I’d like to see a little more inflation to make easier the deleveraging process. But I cannot think that te FED is omnipotent to control NGDP (growth) against all events.

  2. 2 Marcus Nunes September 21, 2012 at 11:58 am

    David, “Lord,forgive them for they don´t know what they are saying! In a recent post I put up the Mankiw rule. Qualitatively it gives out the same information as the T-R. Indeed, in 2007-08 it required an even higher FF rate.

    http://thefaintofheart.wordpress.com/2012/09/18/50-years-of-us-growth-and-inflation-history-from-a-market-monetarist-perspective/

  3. 3 Bob Athay September 21, 2012 at 1:33 pm

    Mathematically, the Taylor rule is just a linear interpolating function that happens to give a reasonably good fit to the Fed’s observed behavior over one particular 12-year period. But that’s no reason think that it’s at all useful in a different time, under different conditions. These guys need some fairly rigorous exposure to modeling nonlinear systems…

  4. 4 Benjamin Cole September 22, 2012 at 4:07 am

    Since we are now enduring the hyperinflation created by QE1 and QE2, I guess I am against QE3.

  5. 5 maynardGkeynes September 23, 2012 at 7:25 am

    I believe that Bernanke has specifically noted the supposed “wealth effect” of a higher stock market, which means the stock market is not being used as an indicator, but as a transmission mechanism. Anyone who follows the stock market knows that it is not a good indicator of anything. It is bunch of day traders and robots, and if Bernanke is using it as an indicator, I am REALLY worried.

  6. 6 Ravi September 24, 2012 at 9:58 am

    outstanding last paragraph, david.

  7. 7 Mark Stamatakos September 24, 2012 at 10:40 pm

    I’ve got a few questions here David.

    The announcement of QE 3 boosted the stock market quite a bit. I invest in stocks so I am not displeased from this perspective. I wonder though if this recent run is creating another equity bubble built on a house of cards.

    Long term, has QE 1 and QE 2 (plus from what I understand an unlimited QE 3) addressed unemployment, the collapsing labor participation rate, GDP growth, payroll income levels, government deficit spending, a huge $16 trillion government debt, US bond rating downgrades and new business growth??? Would you argue that the QE stimulus plans have prevented some of these figures from being even worse?

    To me, the stock market and how the U.S. is doing are totally detached from each other. How can the stock market be pushing back to its historic highs when virtually every other figure on the economy is trending in the opposite direction? Is everyone smoking something?

    Are we seeing another stock market Bubble? Seems reasonable to me. I am not saying the Fed is orchestrating anything here, and I have no evidence that politics are at play, but if Romney got elected is it reasonable to say he is going to fire Bernacke (or ask him to step down)? Could QE 3 be a play to save his job? Is this reasonable or ridiculous?

  8. 8 David Glasner October 5, 2012 at 9:17 am

    Luis, And I agree, in general, with you.

    Marcus, As usual, you are so right. Thanks.

    Bob, Well said.

    Benjamin, Sometimes we do have to yield to the weight of the evidence despite our preconceived biases, don’t we?

    maynardGkeynes, Well Paul Samuelson, who I am sure you admire greatly, once said that the stock market has predicted nine out of the last five recessions. Bernanke has said a lot of things, and I have criticized him numerous times for what he has said. I don’t think that you can necessarily infer what the underpinnings of QE by quoting particular statements that he has made.

    Ravi, Thanks.

    Mark, For the stock market to be 5 to 10% below the level it reached 5 years ago does not strike me as being at all disconnected from reality. I don’t think that Bernanke has any particular personal interest in keeping his job at the Fed. His pecuniary income and possibly his psychic income would both increase if he took a new job in academia or in the private sector.


  1. 1 Self-contradictory Fed Bashing - NYTimes.com Trackback on September 22, 2012 at 8:27 am
  2. 2 One Rule to Ring Them All? | FavStocks Trackback on September 26, 2012 at 1:20 am

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About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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