Progress report on QE2

We’re now 3 months into the Fed’s new asset purchase program that has been popularly described as a second round of quantitative easing, or QE2. I thought it would be useful to take a look at what has actually changed during the first 3 months of QE2.

The essence of QE2 is that the Fed buys some longer-term Treasury debt and pays for it by creating reserves on which the Fed pays an overnight interest rate. In my view, in the current environment, interest-bearing reserves are for all practical purposes the same kind of security as a very short-term Treasury bill. The net effect of such a Fed operation is to lower the average maturity of the combined outstanding debt of the Federal Reserve and Treasury. One view of how such an operation might affect the economy is that a big enough drop in the net supply of long-term debt might result in a decline in long-term yields. In a research paper with Cynthia Wu, we found that historical changes in the maturity structure were associated with changes in the slope of the yield curve, and that those historical correlations were consistent with the claim that massive Fed operations of this type might have a modest ability to lower long-term interest rates in the current environment. A number of other researchers have also obtained similar results using a variety of methods.

I noted in December that QE2 as actually implemented by the Fed differed from the particular scenarios that we and other researchers had looked at in two key respects. First, the Fed has primarily been buying debt of intermediate maturity (2-1/2 to 10 years) rather than the longest term debt outstanding. Second, the Fed spread these purchases out over a period of 8 months, during which time we could anticipate significant changes in the composition of debt issued by the Treasury which could potentially offset any effects of QE2.

The graph below provides our calculations of the average maturity of publicly-held debt both before and after the Fed’s operations, updated to include the first 3 months of QE2. 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:M1-2011:M1. Green: average maturity of debt other than that held by the Federal Reserve.

But also since 2008, the Treasury has been issuing more long-term debt faster than the Fed has been buying it, so that the green line continues to rise over time. What we find in the latest data is that this trend has continued over the last 3 months, even with QE2. The graphs below highlight details of the last year. The top panel is the average maturity of publicly-held Treasury debt inclusive of all Fed operations, that is, it corresponds to the green line in the preceding figure. Although the average maturity in the second and third months of QE2 (December and January) fell a little below that for the first month (November), the average maturity in every one of these three months was bigger than in every month of the two years prior to QE2. The second panel shows the fraction of publicly-held Treasury debt (again, after netting out the Fed’s operations) that is of 10 years or longer maturity. This has gone on to make new highs in both December and January.

Top panel: average maturity of Treasury debt other than that held by the Federal Reserve, 2010:M1-2011:M1. Bottom panel: fraction of outstanding Treasury debt not held by the Federal Reserve that is of 10 years or longer maturity, 2010:M1-2011:M1.

Our conclusion is that if QE2 made a positive contribution to the improving economic indicators since the program began, it could not have been through the mechanism of shortening the maturity of publicly-held Treasury debt.

This does not rule out the possibility that QE2 had an effect through some other channels. Another possible mechanism is that, by announcing QE2, the Fed successfully communicated that it had a higher inflation target than some observers had assumed, and successfully communicated that the Fed had both the tools and the will to prevent outright deflation. It appears to be quite an accurate characterization that QE2 did have an effect on many people’s expectations. Indeed, some observers had quite a passionate response that I find hard to reconcile with the fundamentally modest nature of what the Fed has been doing. Using the tool of QE2 as a device for helping to manage expectations is in fact the main argument I can see for having the Fed rather than the Treasury be the agent responsible for announcing and carrying out the plan. Even so, I doubt that it can make much sense for the Treasury to pull so hard in one direction that it completely undoes any real effects of QE2.

But whether it makes sense or not, that’s what’s been happening so far.

36 thoughts on “Progress report on QE2

  1. KevinM

    Closing sentence unclear to me.
    You mean the treasury is undoing QE2, or the Fed’s is defeating inflation expectations?

  2. 2slugbaits

    JDH From your Oct 2010 post:
    If the Federal Reserve decided to increase the degree of policy accommodation today, two avenues could be: 1) additional large-scale asset purchases, and 2) a communication that policy rates will remain at zero for longer than “an extended period.” A third and complementary policy tool would be to announce that, given the current liquidity trap conditions, monetary policy would seek to target a path for the price level.
    You’ve shown that option #1 is being frustrated by the Treasury. My question is whether option #3 makes sense without at the same time implicitly accepting option #2. In other words, how will the Fed effectively target to a price level if they don’t also pursue, at least to some extent, option #2? And here the signals, or at least the interpretations of the signals from the Fed seem to be at odds with one another. A lot of folks believe the Fed is signaling an end to a zero interest rate policy by the end of the year. But if they end ZIRP, how will they affect a higher price level target? Or does the Fed think the economy is starting to gather enough momentum of its own that prices will begin to rise due to increased economic activity and a reduced output gap?

  3. Scott Sumner

    Good post. I’ve argued from the beginning that the mechanical aspects of QE2 were relatively unimportant, and that it was basically a way of boosting inflation expectations by shifting expectations of future monetary policy (in a more expansionary direction.) I also did a recent “QE2 after 3 months” post suggesting that QE2 looks modestly successful so far, mostly based on rising TIPS spreads in response to rumors of QE2 in September and October, and also some promising economic data in recent months.

  4. flow5

    QE2 was backwards economics. You have to create REAL-investment to create REAL-jobs. Now you have set up another time bomb – an explosion in the interest paid on the federal debt.

  5. David Beckworth

    QE2 was a modest monetary stimulus program that was implemented in an non-optimal fashion. It would have been far more effective had the Fed announced an explicit price level target (or in my dream world a NGDP level target) and committed to buying as many assets as needed to hit the target. Had it done so and successfully reshaped nominal expectations, the market would have done the heavy lifting and thus required less spending by the Fed. Instead, the Fed did it backward: it committed up front to an explicit dollar amount with the vague goal of hitting its dual mandate.
    With that said, one can make the case for some modest QE2 success as done here.

  6. Ricardo

    Thank you professor. This is a great article.
    I have been in a debate with a friend over the relationship of the debt ceiling extension to QE2. If everything worked just as Bernanke hoped then his purchases of Treasury securities would raise the prices resulting in lower effective interest rates. But that is only true if the Treasury does not issue securities to thwart what Bernanke is doing.
    It appears that the Treasury has been doing just that. Could this be why the Treasury needs to have the debt ceiling raised? Shouldn’t FED purchases of Treasury securities actually lower the need for the debt ceiling to be raised since the interest on the FED held securities is actually paid to Treasury then simply returned to the FED?
    Think about it.

  7. JDH

    Ricardo: When the Fed buys Treasury debt, it doesn’t help avoid the debt ceiling. The debt ceiling applies to the blue curve (plus some other stuff), not the green.

    The reason the debt ceiling must be raised is because Congress has instructed the Treasury to spend more than it takes in as taxes.

  8. David Beckworth

    I may have asked this before, but did you find in your research with Cynthia Wu any insights on the famous interest rate “conundrum” of 2004-2006? It would seem the sharp fall in average maturing structure would be part of the story.

  9. davepowers

    In searching for the impact of QE2, what is the impact of the vastly increased ‘reserves,’ which the FED creates by keystroke to pay for its Treasury paper purchases?
    The argument is that these reserves are sterilized because they just sit there, the only economic impact being the relatively small ‘interest’ earned thereon.
    But are the reserves held at the FED as a result of QE truly sterilized?
    Does the fed funds market, for example, where banks can lend and borrow bank reserves on an overnight basis, allow access to the trillion dollars or so of ‘excess reserves’ and effectively make them fuel in a fractional reserve lending scheme that thereby fuel commodity and stock speculation?
    If there are mechanisms whereby the apparently passive, held at the Fed ‘excess reserves’ can provide ammo for speculation, it would work hand in hand with the ‘animal spirits’ unleashed by the expectation management impact of QE mentioned at the end of this article.

  10. JDH

    David Beckworth: That episode is included in our database, so the correlation you mention is implicitly part of the evidence on which our estimates and those of other researchers has been based. See also Warnock and Warnock.

  11. flow5

    IORs are idle & unused. Remuneration is based the average, aggregate, end-of-day balances, held during a 7 day maintenance period (interest which is paid to the excess balance accounts 15 days later).
    IORs aren’t the floor envisioned. The overnight FFR trades below the risk-free overnight remuneration rate – so selling inter-bank funds isn’t as profitable – as holding bank earning assets (as sterile reserves). Thus the BOG’s monetary transmission mechanism is via IORs.
    By comparison, if the BOG raised the average reserve ratios on deposit liabilities, the volume of required reserves would increase (which if large enough, could induce bank credit contraction), ceteris paribus.
    This process is the same as if the BOG raised the remuneration rate on excess & required reserves, vis a’ vis other competitive instruments and yields. It would also increase the volume of legal reserves, ceteris paribus (which likewise, absorbs the commercial bank’s lending capacity).
    Thus from that perspective, IORs are the functional equivalent of required reserves.
    As of JAN 2011 month-end, the BOG’s remuneration rate @ .25% on excess reserves (IBDDs), exceeded the “Daily Treasury Yield Curve” out to one full year. But the maturity distribution covered under the level of the remuneration rate’s umbrella, has been rapidly shifting towards the shorter-end of the yield curve in the last 2 weeks.
    One year rates have gone up 20%. Two year rates have gone up 46%. Three year rates have gone up 40%. I.e., long-term monetary flows have bottomed as predicted. And in effect, monetary policy has eased.
    Traders will soon be enlightened. If there was a doubt, the liquidity preference curve is a false doctrine. The money supply can never be managed by any attempt to control the cost of credit.

  12. Spry

    If you consider the treasury’s actions as exogenous from the fed’s perspective then can you say that QE2 did help to lower long term rates? That is to say that long term interest rates would have been higher if the fed had not done QE2.

  13. don

    To echo Spry at 5:57p, before you can argue that the Treasury has been undoing QE2, you need to know what the Treasury would have done absent the QE strategy. If Treasury bases the maturities of its issues on the rate structure (which would seem to be a very reasonable assumption), then they may automatically act to offset the effects of the QE strategy, but if this hypothesis has been tested, I missed it.
    I wonder if the Fed may not be giving some rather bad price targetting signals. Namely, by loading up on longer term debt, they may inadvertantly signal an inability to reverse course should inflationary expectations suddenly appear. Like the case of a driver using the accelerator to spin his car wheels when stuck on ice, if traction finally comes, it may yield a sudden and unpleasant result, one worse than accepting the stalled position. And given the tack record of our Fed going back to Greenspan’s tenure (whose policies Ben never questionned), I don’t have much faith in the Fed’s abilities. In particular, I think their time horizon is too short and they are too fixated on maintaining overvalued asset prices.

  14. Bryce

    Good post. Said another way, Quantitative borrowing is overwhelming Quantitative easing [or in more honest language, massive creation of fiat money.]

  15. Nexus

    Voodoo economics – moving the deckchairs on the Titanic give the impression they know what they are doing with negligible impact on the real economy. More like keeping the illusion going longer so the big banksters can extract even more immoral profits.

  16. anon

    “Our conclusion is that if QE2 made a positive contribution to the improving economic indicators since the program began, it could not have been through the mechanism of shortening the maturity of publicly-held Treasury debt.”
    If shortening of the maturity of publicly-held Treasury debt is a reasonable enough hypothesis to be considered and rejected, why wouldn’t comparative shortening (actual versus counterfactual) be reasonable enough to be considered and accepted?

  17. flow5

    No, long-term interest rates rose, in part, because IORs induced disintermediation (an outflow of funds from, or a negative cash flow within, the financial intermediaries). I.e., IORs absorb savings. Monetary savings are impounded within the commercial banking system. I.e., savings held within the monetary system have a velocity of zero and are a leakage in the Keynesian national income concept of savings. I.e., Keynes was a moron.
    When the CBs lend or invest, they expand both the volume & velocity of new money & credit. Lending by the CBs is inflationary. However, lending by the non-banks simply activates existing money, & all of these savings originate outside of the intermediary lending institutions. Lending by the non-banks is not inflationary. Such lending serves to match savings with investment.
    I.e., rates rose in part, because the supply of loan-funds decreased – just when the demand for loan-funds was increasing. Based on the Z.1 release, the non-banks represented 82% of the lending market before it collapsed during the Great Recession.
    I.e., redirect savings to the non-banks, and velocity (consumption & investment), will be activated and rebound, without unnecessarily forcing prices (stagflation), higher (just like the 1966 paradigm). I.e., money flowing to the non-banks (or the shadow banking system), actually never leaves the commercial banking system, as anyone who has ever applied double entry bookkeeping on a national scale would know.
    When the rubber meets the road, you have to realize Bernanke (has with QE2), actually acted to shift the economy into reverse.

  18. Ricardo

    Thanks for the reply.
    My questions were both serious and some what rhetorical. Much of the money owed by the Treasury is owed to the government. Essentially, the government is paying interest to itself.
    The FED is engaged in a little slight of hand. They say that they have increased their mid to long term purchases but they are keeping their purchases of Treasery securities steady at 35%. But that is actually an increase. When it is expressed as a percentage then increasing total purchases means increasing the purchase of Treasury debt if the 35% ratio is maintained.

  19. Ricardo

    I wrote:
    The FED is engaged in a little slight of hand. They say that they have increased their mid to long term purchases but they are keeping their purchases of Treasery securities steady at 35%. But that is actually an increase. When it is expressed as a percentage then increasing total purchases means increasing the purchase of Treasury debt if the 35% ratio is maintained.
    The reason I posted this is because it means that not only is the Treasury undoing QE2 but the FED itself is undoing QE2 with increased Treasury purchases.

  20. Nemesis
    Despite the many self-serving interpretations by Wall St. shills and Fed propagandists, the intent of QE is the same as in the 1930s and in Japan since the late ’90s: to bail out banksters’ balance sheets of bad assets.
    Bank charge-offs and delinquencies are currently about $725B, which is 10% of loans and 6-7% of assets and twice banks’ net interest margin. Then there is the estimated $2T in toxic assets not being marked to market.
    The Fed “managing” inflation expectations and asset prices is secondary, albeit critical (Bernanke and others argue that this is where the BOJ failed, which is silliness, as Japan experienced a secular demographic drag, which we are now facing), to running interference for banks’ attempts to avoid shutting the doors and turning out the lights.
    Naturally, the Bernanke Fedsters want to discourage a debt- and asset-deflationary mentality and, instead, encourage a benignly inflationary mentality.
    Unfortunately, the Fed is ultimately only succeeding in pushing equity valuations to levels from which investors will be guaranteed 0% to negative 3-, 5-, 10-, and even 20-yr. returns hereafter, with the increasing risk of yet another stock market crash, global recession, and larger financial crisis.
    The best gift one can realize from the Bernanke Fed’s fiat digital debt-money pumping is to sell stocks NOW and take the gains before the bottom drops out and Goldman and their ilk short the bloody hell out of the equit and corporate bond markets from offshore.
    By this summer, the Fed will have tripled the monetary base from ’08, and the US gov’t will have borrowed and spent during the same period an equivalent of nearly 50% of private GDP with little benefit to the underlying private organic economy.
    The debt held by the public is now 100% of private GDP, having grown 20%/yr. since early ’08.
    At the trend rate since ’08, the US gov’t will have borrowed and spent 100% of today’s private GDP by ’14-’15, tripling the debt held by the public, with the net interest on the public debt exceeding 15-16% of federal receipts, and the net interest on total debt outstanding reaching 30% or more of receipts.
    By no later than ’20-’21, the total US public debt outstanding will approach, or exceed, 200% of GDP (as in Japan today), and net interest on the public debt will reach and exceed the critical 25% of receipts, whereas the net interest on the outstanding public debt will exceed 40% of receipts.
    Thus, Fed printing and hyper-Keynesian borrowing and spending to avoid the inevitable (necessary) debt-deflationary contraction only ensures that we will experience one or more massive stock market crashes AND US fiscal insolvency simultaneously or in succession.
    There is simply no way out of this debt overhang apart from private and eventual public default on at least half of the outstanding debts (loss of value of assets and total US net wealth) that cannot be repaid with interest from the secular trend rate of incomes, profits, and gov’t receipts.
    Until we face this overarching structural reality, including the forces bearing down on us from the unprecedented Boomer demographic drag, Peak Oil, and population overshoot, all else is magical thinking and misplaced emphasis.
    Sell stocks and junk debt, buy Treasuries (for now), and accumulate gold at lower prices over the next 2-3 to 8-10 years. Bernanke will be the banksters’ scapegoat for the next collapse in the years ahead.

  21. markg

    JDH, you begin the post by stating “interest-bearing reserves are for all practical purposes the same kind of security as a very short-term Treasury bill”. I could not agree more. Is there a limit to the amount the FED can buy and why? If the Fed bought all outstanding govt debt would we not have in effect a flat yield curve at the rate set by the FED? How would this effect the economy verse having a positive sloping yield curve?

  22. MarkS

    “…the liquidity preference curve is a false doctrine. The money supply can never be managed by any attempt to control the cost of credit.”
    Thanks Flow5 for voicing the obvious… The money supply is controlled by the volume of credit (the effective reserve ratio), not the interest rate. The PBoC got that message a long time ago.
    IORs is just a convoluted method for the FED to re-liquify over-extended commercial banks while mitigating the effects of real estate deflation. QE is a similar game to unload non-performing RE securities out of the commercial banking system while supplying free reserves to pump up distressed reserve ratios. In both cases we have public subsidy of private banking.

  23. ppcm

    The TIC report is showing the variation of the US treasury debt holders. The US government debt is to a lesser extent hold by third party (percentage wise) courtesy of Q1 Q2 and additional primary deficit funded autonomously through banks and accrued banks reserves.
    Assumptions Carabbean and the UK are tax brass plates territories reshuffling the US TBs among US domestic interest.This strategy provides for a more stable debt market and is aiming at providing a shelter from exogenous chock.
    Additional benefits of QE have been covered through many Econbrowser posts and comments.
    A comparative analysis of the great depression and actual

  24. Nemesis

    ppcm, et al., the Fed is now the largest holder of US Treasuries, surpassing China and Japan since last fall.
    Further, the Fed, banks, insurers, and pensions are larger holders of US debt than China, Japan, the UK, and oil-producing nations combined.
    The Fed returns most of the interest received from its $2T+ balance sheet of Treasury, agecny, and MBS paper back to the Treasury (after Fed expenses).
    As in the case of Japan since the late ’90s to date, we are now our biggest creditor; that is, when the time comes to default, we will default on foreign creditors first, of course, but we will also have to renege on our promises to ourselves eventually, and on a large scale.
    Note that the US debt held by the public per capita is now equivalent to the median hourly annual wage of the typical US worker of $31,000.
    Total debt outstanding per capita is now $48,000, which is approximately the median US household income.
    Further, total public and private debt outstanding per capita is now nearly $170,000, which is the avg. household income of the 2-3% of households below the top 1-2%, and 3 1/2 times the median household income.
    There is no mathematical possibility that we can grow our way out of the overarching public and private debt burden; nor can we continue to print, borrow, and spend our way out of the debt without destroying the currency, financial system, legitimacy of the central bank and gov’t, and eventually witnessing a complete collapse.

  25. Anonymous

    “The money supply is controlled by the volume of credit (the effective reserve ratio), not the interest rate”
    Reserve requirements are no longer binding — increasing levels of vault cash (larger ATM networks), retail deposit sweep programs, fewer applicable deposit classifications, & lower reserve ratios, have combined to remove most reserve, & reserve ratio, restrictions.
    The member banks are unencumbered in their lending operations (except for bank capital adequacy ratios, credit worthy customers, & high quality investments).
    Targeting interest rates has been the FED’s achilles heel since 1965 when the operations at the “trading desk” started pegging the FFR. The demand for money, liquidity preference curve, liquidity trap theories, etc. are all so much nonsense.
    Otherwise, your observations haven’t received enough emphasis in the press.

  26. flow5

    “rubber hits the road” I can’t identify the inflection point yet. But we know:
    Long-term money flows bottomed in JAN. So inflation will just accelerate. It’s no accident that rates began to rise quickly at the beginning of FEB.
    Short-term money flows show that real-output should spike at record millenia levels during the 1st & 2nd qtrs. Real-money and real-output are both growing faster than inflation.
    But when QE2 ends, the FED’s informal mandate (supporting the Treasury market), will become much more difficult. That’s where we should look for skid marks.

  27. MarkS

    We’re in perfect agreement. Notice that I said effective reserve ratios? The real culprit was the FED’s (AKA the BLS’) removal of EuroDollar accounts from reserve requirements. The fantasy that credit and interest rate derivatives would mediate risk in the payments system has been shown to be hollow in the absence of effective regulation and collateral to cover counter party risk.
    The rot is systemic, the oligarchy desperately continues to expand the credit bubble in the blind hope that they can cash-out before gravity overcomes the last back-fire of their jet packs.

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