Evaluating QE2

On November 3, the Federal Reserve announced some new monetary policy measures that have been popularly (if perhaps inaccurately) referred to as a second round of quantitative easing, or QE2. What effects, if any, does QE2 seem to have had so far?

Measures like those announced by the Fed have the potential to lower long-term interest rates. What we’ve observed since the Fed’s announcement has instead been an increase in the 10-year yield of about 60 basis points.



Yield on 10-year Treasury security, Jan 4 to Dec 8. Vertical line denotes Nov 3. Data source: FRED
treas10yr_dec_10.gif



In my view, the mechanism by which QE2 could potentially have an effect on interest rates is by changing the maturity composition of the outstanding supplies of Treasury securities held by the public. In my research with UCSD Ph.D. candidate Cynthia Wu, we found evidence that changes in the maturity composition have historically been associated with changes in the slope of the yield curve, and that policies like QE2 had the potential to lower long-term rates even when the overnight rate was stuck near zero. The particular policy that we looked at was what would happen if the Fed tried to buy up as much debt as it could at the longest end of the maturity structure (that is, greater than 10 years). We estimated that $400 billion in such purchases might lead to a 13-basis-point drop in the 10-year yield.

QE2 as it’s actually being implemented by the Fed turns out to be something a little different. The Fed is buying very little in the way of bonds of 10 years or longer maturity, and is concentrating its purchases instead on securities between 2-1/2 and 10 years.



Nominal Coupon Securities by Maturity Range

TIPS

1½ -2½
Years

2½-4 Years

4-5½
Years

5½-7
Years

7-10
Years

10-17
Years

17-30
Years

1½-30
Years

5%

20%

20%

23%

23%

2%

4%

3%

Planned distribution of maturities purchased under the Federal Reserve’s new program. Source: Federal Reserve Bank of New York.



Cynthia and I have gone back to our original framework to look at what the effects would be if the Fed were to purchase exclusively 2-1/2 to 10 year securities rather than securities longer than 10 years as we’d originally assumed. Our original estimates are shown in red, whereas the effects of a purchase targeting intermediate securities (in blue) are estimated to be more modest. In fact, whereas our estimated impacts for the first scenario are statistically significantly distinguishable from zero, those for the second scenario are not.



Comparison of effects of purchases targeting different maturities. Horizontal axis: maturity (in weeks). Vertical axis: change in yield for that maturity (in annual percentage points) resulting from proposed change. Red dashed curve: effects of $400 B purchase of securities of 10-year maturity and longer (identical to dashed line in Figure 11 in Hamilton and Wu). Blue solid curve: effects of $400 B purchase of maturities between 2-1/2 and 10 years. Both curves assume the policy is implemented when investors believe that the overnight rate is likely to remain stuck at the zero lower bound for an extended period and that there are no offsetting changes in securities resulting from new Treasury issues.
HW_ZLB_delta2.gif



This is also consistent with the finding by Greenwood and Vayanos that the supply of debt of longer than 10 years maturity is a key summary of what matters for the slope of the yield curve.

Moreover, any actions by the Fed are only one determinant of the maturity composition of publicly held debt. A bigger factor can be what is happening with the debt that is newly issued by the U.S. Treasury. To see what has been happening with this factor, Cynthia and I have updated our detailed data set on the maturity composition of publicly held debt to include observations through November of 2010. The graph below summarizes some of the interesting things that we found. The blue line is the average maturity (in weeks) of debt issued by the U.S. Treasury. The green line is the average maturity of publicly held debt, that is, the green line represents the results of subtracting off the Fed’s holdings of Treasury debt. Historically the green line was above the blue. This is because the Fed preferred to buy the shorter-term debt, as a result of which the average maturity of the remaining debt held by the public (green) was bigger than that for the debt as originally issued (blue). However, since the start of 2008, that relation has been reversed– the Fed has been buying a disproportionate share of the longer-maturity debt, and thus has been a factor in reducing the average maturity.



Blue: average maturity (in weeks) of marketable nominal U.S. Treasury debt outstanding as of the end of the month, 1990:M1-2010:M11. Green: average maturity of debt other than that held by the Federal Reserve.
treas_maturity_dec_10.gif



But note that, despite the fact that the Fed is buying more long-term debt, the average maturity of publicly held debt has still been increasing sharply since 2009. Over the last year and a half, the Treasury has been issuing new long-term debt much faster than the Fed has been buying it.

Average monthly change in non-TIPS marketable Treasury debt by maturity, Nov 2009 to Nov 2010, in billions of dollars.
Maturity Amount

Less than 6 months 10.6

6 months to 2-1/2 years 33.6

2-1/2 to 10 years 71.4

Greater than 10 years 11.7

The table at the right reports the average monthly increase in total outstanding Treasury debt for different maturity categories over the last year. It’s interesting to compare those numbers with the size of the announced QE2. The Fed announced that it intends to buy $600 B in debt over an 8-month period beginning in November, or about $75 B each month. But that turns out to be about the size of new monthly issues of debt in the 2-1/2 to 10 year range. So if the Treasury were to continue to issue debt in the amounts and proportions that it has been over the last year, the Fed would only end up absorbing the new debt in this category over the next 6 months, while the amount that is less than 2-1/2 years or greater than 10 years would continue to grow.

We were interested to look at what would have happened if the Treasury behaved just as it did over the last year but the Fed had implemented its proposed QE2 program a year ago. Specifically, we looked at what difference it would have made over the last 12 months if there had been no growth in the 2-1/2 to 10 year debt (because the Fed had bought it all through a QE effort), but the other debt (less than 2-1/2 years or greater than 10 years) had grown at the observed rate. The effect would be that the average maturity of publicly held debt would still have increased over the last 12 months (from 204 weeks in November 2009 to 221 weeks in November 2010). The fraction of publicly held debt that is of more than 10 years maturity would also have increased (from 7.4% to 8.8%).

In other words, given the modest size, pace, and focus of QE2, and given the size and pace at which the Treasury has been issuing long-term debt, the announced QE2 would have been associated with a move in the maturity structure of the opposite direction from that analyzed in our original research. The effects of the combined actions by the Treasury and the Fed would be to increase rather than decrease long-term interest rates.

President Obama’s new proposal on taxes suggests that future new issues of Treasury debt will also be large. News of this proposal was another factor that likely contributed to the rise in interest rates over the last week.

This is not to say that the President’s proposal, or the rise in interest rates that accompanied its public discussion, is a bad thing. I personally believe that the proposal is a good idea, and will generate more significant stimulus than any action that would be within the Fed’s power. I interpret the interest rate response to this news as an overall favorable indicator. We’re not doing what the Fed originally intended. We’re instead doing something with potentially much more power to move the economy.

In any case, the recent rise in yields makes it clear that any effects of QE2 on long-term interest rates, which even in the most favorable analysis appeared to have modest potential, are easily swamped by other changing factors that also matter for yields.

Does this mean that QE2 has been a failure or irrelevant? My answer is no. The primary mission we should ask and expect from the Fed in the current situation is to prevent a replay of the painful wage and price deflation experienced by Japan in the 1990s and by the U.S. in the 1930s. The policy announced by the Fed has persuaded me and many others that the Fed can and will prevent this from happening. I believe that measures like QE2 can be a useful tool for communicating this intention and carrying it out.

And as I’ve said many times before, more than that we should not ask or expect from the Fed.

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28 thoughts on “Evaluating QE2

  1. W.C. Varones

    It seems to me that this framework holds unless/until the QE causes a big change on the demand side — i.e. China stops buying or domestic investors opt for more equities/commodities/real estate.
    That shift appears to be beginning. I fear it might go a lot further eventually.

  2. MarkS

    “The primary mission we should ask and expect from the Fed in the current situation is to prevent a replay of the painful wage and price deflation experienced by Japan in the 1990s and by the U.S. in the 1930s.”
    From my perspective, US manufacturers must drop real prices on their goods to be competitive in global markets. By extension, US currency can not maintain its value if America can not reverse its chronic trade deficit… Therefore I assume that what you implied (but didn’t clearly communicate), is that the FED is trying to manage the correction by slowly letting the air out of the economy while keeping interest rates low, and subsidizing primary dealer balance sheets with newly created reserves. I’m sorry, but isn’t that exactly what Japan did? Is it better to have the chinese water torture of high unemployment and slow deflation stretched out over several decades, than the fast reckoning and just deserts that would occur without this central bank fiddling?

  3. KevinM

    The confusing part to me is that the biggest portion of what the Fed is buying was issued less than a year ago. Would it not make sense to skip the middle men (primary dealers) and bid directly in the treasury auctions?

  4. Nemesis

    ” . . . Does this mean that QE2 has been a failure or irrelevant? My answer is no. The primary mission we should ask and expect from the Fed in the current situation is to prevent a replay of the painful wage and price deflation experienced by Japan in the 1990s and by the U.S. in the 1930s. The policy announced by the Fed has persuaded me and many others that the Fed can and will prevent this from happening.”
    http://imperialeconomics.blogspot.com/2010/12/it-is-happening-here-but-bernanke-does.html
    See link above.
    The Fed’s primary obligation, communicated or not, is to provide whatever is required to shore up their owner banksters’ balance sheets by printing billions of dollars of digital fiat book-entry debt-money to purchase banksters’ Treasury and MBS holdings, the larger share of the purchases hereafter being of the former variety.
    In fact, the Fed has announced a 100% annualized rate of purchases of Treasuries by spring-summer ’11, increasing the Fed’s holdings of Treasuries from $860 billion to around $1.5 trillion, resulting in a monetary base of some ~$2.5 trillion, which is a tripling of the base since ’08.
    Bank charge-offs and delinquencies are at ~$700 billion, or 6% of bank assets and 7% of private GDP.
    The projected monetary base will be 40% larger than today’s M1, 28-29% of today’s M2, 38% of bank loans, and 26-27% of today’s private GDP.
    Unless the explosion in Treasury-based bank reserves results in a dramatic increase in bank lending and accelerating private GDP (not likely with oil consumption at 6%+ of private GDP), the M1 multiplier and M2 velocity will collapse in the next 6-7 months.
    And even if M1 continues to grow at the 3-mth. annualized 15% rate through next June, the M1 multiplier will fall from ~0.90 to below 0.80. At the 3-mth. M2 rate of 6-7%, the M2 velocity for private GDP will fall below 1.0 by spring-summer ’11.
    M2+ velocity has already fallen below 1.0 for private GDP, suggesting that private debt-money growth is being driven primarily by Fed printing and gov’t borrowing and spending, which is not flowing through to private domestic economic activity.
    Therefore, the QE2, much like the QE2 in Japan in ’00-’03, will circulate virtually exclusively between the Fed, banks, and Treasury, with very little liquidity resulting in increasing growth of bank lending contributing to M1 and M2 growth and private economic activity.
    Gov’t borrowing and spending (11% annualized) through Nov. is running at an annualized deficit of $1.7 trillion, or a jaw-dropping 18% of current private GDP and 11-12% of total nominal GDP. Were this be the size of the deficit for ’11, the US gov’t will have borrowed nearly $4.5 trillion over three fiscal years, which is 47-48% of today’s private GDP!!!
    At this rate, the US gov’t will have borrowed and spent an equivalent of 100% of private GDP by ’15-’16 just to keep US nominal GDP from contracting overall; and total trend nominal gov’t spending will be near 64-65% of private nominal GDP, leaving gov’t spending growth contributing nearly 4% to overall aggregate nominal GDP growth, i.e., any or all growth that occurs, as in Japan since the mid- to late ’90s.
    Moreover, note that total gov’t spending now constitutes 50-51% of nominal disposable income. Total gov’t/disposable income, debt service/disposable income, and oil consumption/disposable income now totals an equivalent of 68% of disposable income, nearly 50% of GDP, and 76% of private GDP!!!
    The more gov’t borrows, spends, and expands as a share of private GDP, the more the Fed prints, and the US$ remains weak against major currencies, the longer the price of oil and commodities prices remain high, increasing US mfg. input costs and dragging on production and on consumer incomes and spending.
    The US private sector cannot grow (must contract by definition) with $80 oil, gov’t spending at 56% of private GDP, and bank lending contracting.
    Thus, there is no organic private sector US economic recovery and expansion after debt service, gov’t spending, and oil consumption; and there can be no private sector growth until debt and debt service contract significantly (30-40%); gov’t/private GDP shrinks; and the price of oil falls below $40.

  5. Anonymous

    The confusing part to me is that the biggest portion of what the Fed is buying was issued less than a year ago. Would it not make sense to skip the middle men (primary dealers) and bid directly in the treasury auctions?
    That is specifically prohibited by law. The Fed cannot buy directly from the Treasury.

  6. flow5

    Any recovery in the economy will present a “catch 22” situation. An upturn in the economy will add increased private demand for loan funds to the insatiable demands of the federal government. The consequent rise in interest rates will effectively abort any recover.

  7. W.C. Varones

    That is specifically prohibited by law. The Fed cannot buy directly from the Treasury.
    Buying subprime assets is specifically prohibited by law, too, but that didn’t stop them from buying Bear Stearns’ toxic waste.

  8. Anonymous

    W.C. Varones: Buying subprime assets is specifically prohibited by law, too, but that didn’t stop them from buying Bear Stearns’ toxic waste.
    No, it isn’t. Do you just make stuff up?

  9. ppcm

    The great depression era was blasted as a “prosperity crash”,as for this contemporary crisis so far, it looks like “greater prosperity for few, without a crash”
    No ideology in this comment,just a mere thought on assets prices rigging s outcome that was the mantra of the years 2005 2007 and still is.
    The social cost of preservation of the imbalances between revenues,incomes and assets prices is yet to be seen.Debts repayment in principal amounts and schedules yet to be addressed.Imbalances between current accounts, countries GDP imbalances between productive work and consumption are preserved.The ongoing transfers of banks liabilities on public accounts for some countries,on central banks for others still a long lasting dynamic process.
    This global state of flux is now officially four years old,the fixed capital formation anemic as financial markets are still the leading components of these economies.
    I find this level of credit and loans and therefore debts unbearable !
    http://sdw.ecb.europa.eu/quickview.do?SERIES_KEY=117.BSI.M.U2.Y.U.AT2.A.1.U2.2000.Z01.E

  10. flow5

    Lending by the shadow banking system (the financial intermediaries), is reflected in the transactions velocity of existing deposits, whereas lending by the member banks, is reflected in the expansion and turnover of newly created money.
    The transactions from both the money creating depository institutions, & the financial intermediaries, all clear thru the commercial banks.
    The magnitude of these transactions is reflected in “The Federal Reserve’s 2010 study of noncash payments has revealed that in 2009 more than three-quarters of all U.S. noncash payments were made electronically”. See 1931 Committee on Bank Reserves Proposal (by the Board’s Division of Research and Statistics), published Feb, 5, 1938, declassified after 45 years on March 23, 1983.
    Contrary to economic theory, & Nobel laureate, Dr. Milton Friedman, monetary lags are not “long & variable”. The lags for monetary flows (our means-of-payment money X’s its TRANSACTIONS rate-of-turnover), i.e., the proxies for (1) real-growth, & for (2) inflation indices, are historically (for the last 97 years), always, fixed in length. However, the FED’s target (?), seems to vary widely.
    I.e., under current policy, the rate-of-change in long-term (MVt) bottoms in JAN (as will be demonstrated by bottoms in core inflation & housing) – when aggregate monetary purchasing power, as measured by the flow of money, will finally reverse.
    Real-gDp – will then (in the 1st qtr), finally, likely exceed the 2nd qtr of 2008’s figure of $13,359T.

  11. Anonymous

    SOMA up $61b since the start of the first reinvestment of principal & interest announcement on August 10, 2010 (@ 2,054T). H.4.1 now showing (@ 2,115T).
    I.e., a 52% increase in the latest reporting week (counting the + 32b purchases from Dec. 1-8). Smokin!
    “On August 10, 2010, the Federal Open Market Committee directed the Open Market Trading Desk (the Desk) at the Federal Reserve Bank of New York to keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities (agency MBS) in longer-term Treasury securities.

  12. Young Economist

    QE policy is totally false policy that Bernanke lies everyone. QE create only problems in every part of the world. First, it make American poorer from higher oil and food price and higher cost of living. American also face lower investment and employment from expectation of lower US dollar. When corporates expect lower US dollar from QE policy, they will decide to shift to invest in abroad and that will lower employment and long-termgrowth. Second, it creates uncontrollable inflation and bubbles. We can see hyperinflaion in China (official numer is more than 5% but real number is nearly 15%) and some emerging markets. Those countries cannot control inflation and bubbles in equities and property prices. Lastly, we will face the bigger crises because of uncontrollable capital movement, liquidity and bubbles.
    I think QE make our world worse.

  13. Ricardo

    JDH wrote:
    Does this mean that QE2 has been a failure or irrelevant? My answer is no. The primary mission we should ask and expect from the Fed in the current situation is to prevent a replay of the painful wage and price deflation experienced by Japan in the 1990s and by the U.S. in the 1930s. The policy announced by the Fed has persuaded me and many others that the Fed can and will prevent this from happening. I believe that measures like QE2 can be a useful tool for communicating this intention and carrying it out.
    And as I’ve said many times before, more than that we should not ask or expect from the Fed.
    There is much revisionist history out there about what Japan has done. In truth the FED and Treasury are following the Japanese model.
    Professor, perhaps we should ask less of the FED – a lot less. Then we might see real recovery rather than simply statistical smoke and mirrors.

  14. Ricardo

    JDH wrote:
    This is not to say that the President’s proposal, or the rise in interest rates that accompanied its public discussion, is a bad thing. I personally believe that the proposal is a good idea, and will generate more significant stimulus than any action that would be within the Fed’s power. I interpret the interest rate response to this news as an overall favorable indicator. We’re not doing what the Fed originally intended. We’re instead doing something with potentially much more power to move the economy.
    On this site I correctly predicted double digit unemployment one year before it happened. About 5 months after my prediction Christina Roemer and the Obama economic team said that if there was not more stimulus the unemployment rate would rise above 8%. We got stimulus and over 8% unemployment.
    If the Republicans and Democrats agree on extending the unemployment payments out to three years unemployment will once again rise above 10%. What too many economists seem to ignore is that you get what you pay for. If you pay for more unemployment, that is what you will get.
    Right now my fears of the ignorance of the Republicans is coming true. My only hope for recovery is that the new members of congress will be able to break through the haze of the old guard and stop the perpetuation of economic stagnation.
    Professor, the Obama/Republican plan is a disaster. They do not even recognize that it is simply more of the same.

  15. Mark A. Sadowski

    I’ve noticed a remarkable tendency for commenters here to conflate the Lost Decade (1991-2002) with the period of QE (2002-2006) in Japan. Do they realize that unemployment rose nearly consistently from 2.1% to 5.3% from 1991-2003 and that it was only after the introduction of QE that unemployment fell (every year from 2004-2007 to 3.9%) and that disinflation ceased? QE in Japan may have not been an unabashed success but to blame the Lost Decade on it is to run history backwards and then claim a weird Dr. Who style causality. It reeks of data free ideology.

  16. ppcm

    It may be a little lengthy,but there is causation and links with the subject of QE.
    May be worth to set up and trade on an exchange bourse,contracts violation,and “future” violation of the same.
    The Maastricht criteria (http://eur-lex.europa.eu/en/treaties/dat/11992M/htm/11992M.html)
    Inflation rates: No more than 1.5 percentage points higher than the average of the three best performing (lowest inflation) member states of the EU.(violated Hungary,Romania,Poland) Violated by all members states during the period 2006 2008
    The ratio of the annual government deficit to gross domestic product (GDP) must not exceed 3% at the end of the preceding fiscal year. If not, it is at least required to reach a level close to 3%. Only exceptional and temporary excesses would be granted for exceptional cases. (no comment)
    Article 104
    1. Overdraft facilities or any other type of credit facility with the ECB or with the central banks of the Member States (hereinafter referred to as “national central banks”) in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments.(no comment)
    The ratio of gross government debt to GDP must not exceed 60% at the end of the preceding fiscal year. Even if the target cannot be achieved due to the specific conditions, the ratio must have sufficiently diminished and must be approaching the reference value at a satisfactory pace.(no comment)
    Article 73f
    Where, in exceptional circumstances, movements of capital to or from third countries cause, or threaten to cause, serious difficulties for the operation of economic and monetary union, the Council, acting by a qualified majority on a proposal from the Commission and after consulting the ECB, may take safeguard measures with regard to third countries for a period not exceeding six months if such measures are strictly necessary.(no comment)
    3. In order to ensure closer coordination of economic policies and sustained convergence of the economic performances of the Member States, the Council shall, on the basis of reports submitted by the Commission, monitor economic developments in each of the Member States and in the Community as well as the consistency of economic policies with the broad guidelines referred to in paragraph 2, and regularly carry out an overall assessment. (no comment)
    For the purpose of this multilateral surveillance, Member States shall forward information to the Commission about important measures taken by them in the field of their economic policy and such other information as they deem necessary.
    NB Every citizen of the Union shall have the right to petition the European Parliament in accordance with Article 138d.

  17. Mark A. Sadowski

    ppcm wrote:
    “Inflation rates: No more than 1.5 percentage points higher than the average of the three best performing (lowest inflation [but not deflation])member states of the EU.(violated Hungary,Romania,Poland) Violated by all members states during the period 2006 2008”
    It was projected in May that in 2010 Cyprus (2.7%), Greece (3.1%), Hungary (4.6%) and Romania (4.3%)would violate the standard (2.7%, as the average of the three lowest positive rates was projected to be 1.2% this year). Nine nations violated the standard in 2007. Thus, thanks to the dramatic and widespread disinflation more member states have come into conformity. It would be impossible for “all member states” to violate the standard for obvious reasons. Thus I fail to comprehend your point.
    The fiscal crisis that the EU is experiencing is a direct consequence of the decline in NGDP and the resulting decline in tax revenues. By raising NGDP QE would help, not hinder. The limitations on this imposed by the Maastricht Treaty underscore the need for greater fiscal union, the next inevitable step towards a true political and economic union in Europe.

  18. Get Rid of the Fed

    “Does this mean that QE2 has been a failure or irrelevant? My answer is no. The primary mission we should ask and expect from the Fed in the current situation is to prevent a replay of the painful wage and price deflation experienced by Japan in the 1990s and by the U.S. in the 1930s. The policy announced by the Fed has persuaded me and many others that the Fed can and will prevent this from happening. I believe that measures like QE2 can be a useful tool for communicating this intention and carrying it out.”

    If you are really serious about that, then you need to able to explain the difference between price inflating with currency and price inflating with debt.

    I also believe you need to be able to explain why all new medium of exchange should be demand deposits created from debt.

  19. flow5

    (1) households” sold over $200 billion corporate equities annualized in Q3.
    (2) “household” sector…was the biggest seller of corporate bonds selling an annualized $541 billion of paper in Q3.
    That’s called tapping your savings. That’s not called hoarding. It is evidence that the transactions velocity of funds has increased, & not decreased (as the liqudity preference curve & the demand for money doctrines would both advise).
    Consumers are about tapped out. I.e., income velocity is a contrived figure. Until the G.6 is brought back, no one will understand money.

  20. ppcm

    Mark
    Debase the inflation rates of all the EEC countries,distort the inflation components,and they are likely to satisfy the constraint:
    1 “Inflation rates: No more than 1.5 percentage points higher than the average of the three best performing (lowest inflation)”
    They still have to meet with constraints:
    2 “The ratio of the annual government deficit to gross domestic product (GDP) must not exceed 3% at the end of the preceding fiscal year.”
    Since inflation has always been driving havoc in the financial industry,constraint (3)is coming to haunt.
    3 “The ratio of gross government debt to GDP must not exceed 60% at the end of the preceding fiscal year.”

  21. Anonymous

    W.C. Varones: The link you provide to support your belief that the Federal Reserve is conducting illegal operations is written by a law professor at a Tier 4 Bible college who states that his area of legal expertise is, I kid you not, amusement and leisure law. It’s like you’re not even trying anymore.

  22. W.C. Varones

    Anonymous,
    I know you ivory tower types care about pedigree over reason or common sense, but it would be helpful if you refuted the argument rather than insult the author.
    I’m still waiting to see anywhere in the Federal Reserve Act where the Fed is authorized to set up Enron-style off-balance-sheet vehicles to buy toxic assets from favored institutions.
    If you can find such authority in the penumbra of the living Federal Reserve Act, we need to repeal the whole thing.

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