Wednesday, November 17, 2010

On why QE2 may not be effective

On different occasions I have come across the argument that, through quantitative easing (QE), the Fed will definitely be able to increase nominal spending, thereby lifting prices, macroeconomic growth, etc., etc. The Fed’s task is nothing but easy, either because the channels through which monetary policy operates are clogged, or because counter-acting forces are offsetting QE at present.

Suppose that the Fed buys your ten-year Treasury bond, paying cash for it. What do you do with the cash? You buy the closest substitute that you can find to that bond. For example: another ten-year Treasury, a AAA-rated ten-year corporate bond, a ten-year certificate of deposit, a seven-year Treasury note, etc. The Fed’s asset purchases do not change your choice between spending and saving directly, and therefore they do not affect nominal aggregate demand (AD) directly.

By purchasing long-term bonds, however, the Fed lowers their yield, as well as the yields on other assets that the market views as substitutes. The ten-year Treasury currently trades around 2.8%, so there is room to push down nominal rates at the long end of the curve. The lower nominal rates translate into lower real rates and lower user cost of capital, which in turn stimulate current consumption, versus future consumption, and increase investment spending: this is the interest rate channel of monetary policy. Business spending has been doing relatively well in the US. But households have been de-leveraging even as interest rates fell. Going forward, given the large amount of consumer credit outstanding, the prospect of meager income growth and higher taxes, and the job insecurity that comes with high unemployment, I would say that we are unlikely to see households increasing their borrowing.

Another monetary transmission mechanism, the credit channel, tells us that a purchase of Treasurys increases the amount of excess reserves of the banking system. Those reserves are eventually used by the banks to give loans, which at some point turn into spending, cash in circulation, and higher inflation. (Lower interest rates also prop asset prices, which can be used as collateral for additional loans.) The problem here is: there exist already excess bank reserves worth about $1 trillion, created during QE1. Why would an additional $600 billion jumpstart the credit channel all of a sudden?

There is also the wealth channel: a reduction in the long-term interest rate increases the value of long-lived assets (stocks, bonds, and real estate, for example), increasing resources available for spending and leading to an increase in consumption. The tricky part here is “leading to an increase in consumption.” If the increase in prices in the equity and bond markets spurred by QE is seen for what it is, i.e. a temporary, small asset bubble, not supported by meaningful rises in earnings or government creditworthiness, respectively, it is unlikely that the public responds to it with higher spending. And when it comes to real estate, well, the overhang of available or soon-to-be-foreclosed American houses is so large that lower interest rates are not even enough to prevent prices from falling further, let alone lift them. Additionally, the positive wealth effect of QE2 is presently being offset by a negative wealth effect: the lower expected growth in households’ personal income stemming from lower macroeconomic growth and higher unemployment.

Then there is the exchange-rate channel. The decrease in domestic interest rates, the theory goes, should lead to a weaker dollar (via the uncovered interest-rate parity condition) and an increase in net exports and the overall level of AD. The problem with this channel is twofold. First, there is the empirical question of the elasticity of the US trade balance to the trade-weighted exchange rate of the dollar. Short answer: it takes about a 10% depreciation of the dollar to reduce the trade deficit by one percentage point, in the long run. Second, the dollar value vis-à-vis the currencies of the euro zone and China, two of the US’s main trading partners, is currently affected by events and policies outside the Fed’s domain. The value of the euro will swing along with the tribulations of Ireland, Greece, and Portugal (and the posturing of Germany), but the final outcome, in my view, will be a strengthening of the dollar. China is under pressure to let the yuan appreciate, but wary of doing so quickly.


Before letting you go, a heuristic comment (or a question for you): if QE made it so easy to lift spending and nominal prices, how come the Bank of Japan failed? If it were so easy to stoke inflation through QE, how come Japan has experienced deflation for years? (Warning: Arguments such as “the BoJ is incompetent” are unacceptable.)

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