The Power of the Fed
QE: The economic story of our time
Frontline recently aired on PBS a documentary called “The Power of the Fed”. The documentary discusses the “great experiment’ of Quantitative Easing (QE), which it characterizes as “the economic story of our time”. I highly recommend this documentary to all of you, and I plan to make this required viewing for future students in my Financial Services class. You can find the documentary here.
I don’t teach macro-economics nor I do consider myself an expert on monetary policy or the operations of the Fed. But as a student, teacher and practitioner of finance I think it is important to stay generally informed about the Fed, the most important and powerful financial institution in the world. And I would agree that QE is indeed the economic story of our time. I can think of very little in the world of finance today that has not been impacted significantly by QE, for better or worse (or both). If you work in finance today, or will soon be interviewing for a job, you had better understand at least the basics of QE. Seriously, this is a BIG DEAL!
In the interests of getting us all on the same page, and providing readers with some food for thought and further discussion, I will attempt to answer below a few basic questions about QE. I don’t have all the answers to these questions, and there may be some important things I have not addressed, but I encourage you all to let me know what I have left out and/or gotten wrong.
So here goes:
What exactly is QE? Quantitative Easing is a form of unconventional (non-traditional) monetary policy involving the large scale purchase by central banks of government bonds and other securities funded with newly created money. QE has generally been adopted by central banks at a time of zero or near-zero short-term interest rates, when the standard tools of Traditional Monetary Policy (TMP) have been found to be less effective. QE has been used to stabilize financial markets and also to provide stimulus to the real economy. QE is considered by some to be a complement to expansionary fiscal policy, with the central bank effectively (if indirectly) monetizing government deficit spending through its purchase of government bonds with newly created money. (On this last point, see below: “Why is QE so controversial?”). For a more nuanced and thoughtful definition and discussion of QE, read here. )
What is the origin of QE? The adoption of Quantitative Easing as we currently understand it is generally attributed to the Bank of Japan (BOJ) in the early 2000’s, The implementation of QE in Japan was a reversal of longstanding BOJ policy, adopted in a bold effort to fight persistent deflation in the Japanese economy. In the US, the first round of contemporary QE began during 2008 in response to the global financial crisis and the latest round was implemented during the Covid pandemic in 2020. (The Fed also experimented with QE back in the 1930’s. You can read about this here.) Other major central banks across the world have also adopted QE during the same time period and for the same reasons. These QE programs all remain in place today.
How does QE differ from Traditional Monetary Policy? Both Quantitative Easing and Traditional Monetary Policy (TMP) operate by manipulating the money supply (specifically the level of bank reserves) to influence the market level of interest rates and thereby stimulate (or contract) credit and the level of real economic activity. The tools of TMP generally work well in a world with positive interest rates, but they lose much of their effectiveness when interest rates approach zero, as is currently the case in many of the developed world economies. QE differs from TMP in several respects, most notably in size (the amount of securities purchased), in scope (the range of securities purchased), and in mode of operation (outright purchases vs repo). TMP focuses primarily on the market level of short-term interest rates (eg the Fed Funds rate), whereas QE focuses on the interest rate (yield) on longer-term securities, including government, mortgage and corporate debt. When the Fed purchases or sells UST bills through open market operations (or engages in overnight or term repo or reverse repo) for the purpose of manipulating the level of bank reserves and short-term interest rates, this is TMP. When the Fed purchases and holds large quantities of longer-maturity UST, agency MBS and corporate bonds for the purpose of reducing long-term interest rates, flattening the yield curve and tightening credit spreads, this is QE. For more on how the Fed creates “money” and the relationship between QE and the money supply, read here and here.)
Tell me more about the history of the Fed’s QE program. In the US, the Fed has recently undertaken several rounds of QE, five by my count. The first round (QE1) of about $1.25tn occurred in the fall of 2008, during the depths of the financial crisis. This was followed by subsequent rounds of varying sizes in 2010, 2012, 2014, 2019 and 2020. Since the onset of the financial crisis, the Fed has grown the size of its balance sheet (total assets) from around $1tn in mid-2007 to $8tn today. (At the end of June 2021, the Fed had about $1tn of cash parked with it in the form of reverse repo, which offsets some of the liquidity created as a result of QE. See my prior post on the subject of “Reverse Repo Explodes”, found here.) Of the $7.6tn of securities currently held outright on the Fed balance sheet, the vast majority (68%) consists of UST securities (mostly longer-maturity notes and bonds) and agency-backed MBS (32%). For more data on the growth and composition of the Fed’s balance sheet over time, see here and here.)
How does the Fed’s QE activity compare with that of other central banks? As noted, the size of the Fed’s balance sheet (total assets) is now about $8tn. This is roughly 35% of the current level of US GDP ($22tn). By contrast, the ECB balance sheet now stands at Euro 8tn (USD 9.5tn), which is roughly 60% of Euro-zone GDP (Euro 13tn). But the world’s largest QE program in relative terms is in Japan, at Yen 720tn (USD 6.5tn), or about 120% of Japanese GDP (USD 5bn). (Japan’s QE holdings are also very large relative to the outstanding supply of government debt, which is very high in Japan compared to other countries.) Japan’s QE program is noteworthy not only for its relative size, but also because the assets purchased by the BOJ include publicly traded equities as well as Japanese government bonds and other debt securities. In fact the BOJ is now Japan’s largest holder of equity securities, larger in fact than the Government Pension Investment Fund, with over USD 400bn of equity securities owned by the BOJ at the end of November 2020. By contrast, the Fed does not own any equities and its holdings of credit instruments is small relative to the overall size of its QE holdings, about $150bn, mostly consisting of Covid related credit (eg PPP and Main Street Lending facilities) For more data on the ECB’s QE program, see here. And for more data on the BOJ program, see here.
To put these national QE numbers into a global context, the total size of developed country central bank balance sheets is now estimated at $28tn (USD equivalent), over 40% of which has been acquired in response to Covid during 2020-21. (These estimates provided by JP Morgan, and sourced in The Economist here.) By comparison, the size of the global bond market is estimated at roughly $120tn, of which approximately 68% consists of sovereign and sovereign agency debt and 40% (of the total) consists of US issued debt (of all types). For more data on the global bond market, see here.
Has QE been successful? The answer to this question depends on how you define “success” and what you consider to be the most likely counter-factual scenario in a world without QE (or with much less QE). Unfortunately (or fortunately perhaps), we do not know what the global economy would look like today had central banks not implemented massive QE programs in response to the financial crisis and then subsequent Covid pandemic. If you believe that without QE the global economy would have suffered economic devastation on a scale to make the 1930’s look like boom times, then I think you would have to say “yes, QE has been successful” almost regardless of what you think the longer-term consequences might be. Personally, I think this counter-factual is too extreme and I believe it is far too early to express a definitive view on the overall merits of QE, which is still playing out in real time. Even if one believes that QE has been largely successful so far, we still do not know how this story ends or what the long-term impacts will be.
Why is QE so controversial? By all accounts, Quantitative Easing has been and remains very controversial. This is true in Washington DC, on Wall Street and in the capital cities and financial centers of most of the major countries across the world. QE was and is a great experiment, the results of which are still not fully known to any of us. But why is QE so controversial? This question is explored in great detail in the Frontline documentary, The Power of the Fed, which I again encourage all of you to watch (link here).
It seems to me that QE is controversial for a number of related reasons. One, by reducing to near-zero the yield on risk-free assets (UST securities), QE has forced return-seeking investors to take on much more risk than they would generally like to. They payoff to investors has been good so far (the bond and stock markets are both up significantly) but there may a high price to pay in the future if/when this situation reverses.
Second, by increasing the price (value) of financial assets (stocks and bonds) held disproportionately by well-to-do individuals, QE may have contributed significantly to the already problematic inequality of wealth in this country. And this in turn may generate increased interest in some sort of windfall wealth tax.
Third, some people believe that QE is little more than a thinly disguised (and possibly illegal) attempt by the Fed to monetize runaway federal deficit spending through its purchase of government bonds with newly created money. In the US, this view is heavily influenced by partisan politics, which I won’t get into here. But I will note that by law the Fed is not allowed to purchase securities directly from the US Treasury, which is not what it is doing with QE. (You can read more about this here.). QE is also controversial in Europe, in part for this same reason. You can read more about German legal challenges to the ECB’s QE program here.
Fourth, critics of QE have been for years predicting runaway inflation as a result of the quantum of new money creation by the Fed. QE has indeed resulted in a massive expansion of the US money supply since 2007 (pre-financial crisis) and particularly since the advent of Covid in early 2020. (See the FRED M2 money stock data here. And for an explanation of the relationship between QE and the money supply, read here). But until very recently there has been little sign of a sustained pick-up in inflation in the US. (See the FRED data on “sticky” CPI here.) Of course the US inflation rate did jump dramatically in May and June this year (read here), which has the inflation hawks shouting “told you so”. But it is far from clear (as of now) to what extent the recent increase in inflation is due to factors which will turn out to be “transitory” rather than permanent (eg used and new car prices, airfare, hotel rates…). Said another way, it is far from clear to what extent recent price increases are the result of loose monetary policy as opposed to other more transitory factors, perhaps relating to the disruption of supply chains and changing business and consumer behavior during Covid. (For more on this topic, read my recent post, “Inflation Expectations and Monetary Policy”, found here. And better yet, read the recent testimony of Fed chair Powell in his semiannual Monetary Policy Report to Congress, found here. )
And finally, a number of people (including me) are concerned about the “moral hazard” aspects of QE. In the Frontline documentary, these views were probably best expressed by former FDIC chair Sheila Bair, a longtime critic of the Fed and financial regulators for accommodating and even incentivizing “bad behavior” among banks, investors and consumers going back to the years preceding the financial crisis. Viewed from this perspective, it seems like we keep getting ourselves into economic difficulties as a result of overly aggressive financial behavior and yet the Fed and other government agencies keep bailing us out, with no real penalties imposed on those who got us all into trouble in the first place. In the words of Oaktree Capital’s Howard Marks, our financial system seems to have become like a “no lose casino…with no downside to risky behavior”. “Is it really acceptable”, asks Neel Kashkari, “that we have had two gigantic government bailouts of our financial system in the past 12 years?” Many think not, and put some of the blame on the perverse incentives created by government support programs like QE.
What is the future of QE? This of course is what everyone wants to know. What will the major central banks do with their QE programs over the next few years and when and how will they do it? More specifically, when will the central banks begin “tapering” their asset purchases and at what pace and over what time frame? At what point in this process might central banks also consider raising short-term interest rates? How will the capital markets react to these developments? What will be the impacts on the real economy? How does the unclear and ever changing Covid picture complicate this analysis?
The Economist recently published an excellent article addressing some of these questions, “The Quest to Quit QE”, which I will not attempt to summarize here but will recommend to those of you behind The Economist paywall. You can find the article here.
Today the Fed issued a statement from the FOMC following the conclusion of its July meeting, which you can find here. And if you have an hour or so, you can also watch Fed Chair Powell answering journalist questions in the post-release press conference, found here. And finally, you can read the WSJ’s quick take on the FOMC release and Chair Powell’s comments, found here.
Central bank policy statements are very carefully worded documents and they do not always contain clear answers to many of the questions we might have, often because the central banks simply do not yet have the answers and they prefer not to speculate about possible future actions in the face of uncertain and changing economic conditions. The statements of central banks and central bankers can move markets, and so they are very careful about what they say publicly and privately. And while Chair Powell is generally regarded as being fairly transparent and intelligible by central banker standards, he knows well not to diverge from the published FOMC statement or to say anything which might mislead the markets or restrict the Committee’s freedom of action in the future. Neither Chair Powell nor anyone else wants a repeat of the 2013 taper tantrum (see above), which followed some seemingly innocuous but ill-considered comments from then Chair Bernanke.
But I do think a few things are now clear about Fed policy:
The Fed’s monetary policy will remain “accommodative” and short-term interest rates will remain low for an extended period of time. The Fed is highly unlikely to change its policy rate (Fed Funds @ 0-0.25%) until after it has wound down its QE asset purchases (see below). The increase in policy rates after a long period of no change is often referred to as “lift-off”. Do not expect this from the Fed anytime soon.
The Fed plans to continue with its QE asset purchases on the schedule outlined in its December 2020 statement. This means monthly purchases of “at least” $80bn of UST securities and $40bn of agency-MBS, which is the current rate. Absent a significant turn of events (positive or negative), the QE purchases will likely continue at this pace for another few months, while the Fed continues “in coming meetings” to monitor the progress of the economy towards it dual goals of “full employment” and “inflation moderately above 2% for some time…with long term inflation expectations anchored at 2%”. (Note that the FOMC meets eight times a year, and the next meeting is in late September, just prior to the central bankers’ conference in Jackson Hole, and it meets after that again in November and December.) The Fed is paying particular attention to Covid related developments, including the vaccination rate and the spread of the Delta virus, although it expects the economic impacts of Covid to continue declining with time.
The Fed’s monthly asset purchases will continue until the FOMC determines that the economy has made “substantial further progress” toward its dual employment and inflation goals. The current FOMC view is that the economy is making “progress” but not “substantial progress”. The US economy is still operating with about 9mm fewer people employed than prior to the onset of Covid, and while there are also about 9mm job openings posted currently, it may take some time for labor markets to clear and for employment to reach the Fed’s target. Inflation is now running well above 2% (see the May report), but the FOMC view is that much of this is “transitory”. Recent price increases will not necessarily reverse (although some have, like lumber prices), but the Fed expects the rate of price increases to decline markedly. (Inflation measures the rate of change in the level of prices, not the price level per se.) Having said that, Chair Powell seemed to concede that the risk to inflation was now on the upside, meaning future inflation is more likely to overshoot than undershoot the Fed’s target. But he largely dodged the question of how the FOMC might react if the Fed’s inflation target is reached or exceeded well before we hit full employment, saying that this discussion “was not yet timely”.
In the press conference Chair Powell strongly defended QE against some of the criticisms noted in this post above (see “Why is QE Controversial”), saying that QE had been “critical” in stabilizing financial markets and providing much needed monetary accommodation to the real economy. He let pass a question about the impact of QE on wealth inequality, a big topic discussed in the Frontline documentary. He largely dismissed the suggestion that QE had caused big increases in house prices, saying also that there was “little support” on the FOMC for tapering the purchase of MBS before that of USTs (which was specifically suggested in The Economist article cited above).
This has been a very long post, for you and for me, and I congratulate and thank those of you who have read it all the way through. As noted several times, QE is truly the economic story of our time and I think it is important that we all understand it. I encourage you to re-read this post, and click through to some of the supporting material provided, when you have the time.
The QE story is far from over, so expect more news flow and further posts from me.