Tuesday, February 4, 2014

The Marginal Impact of the Three Trillion Dollar Experiment

A recent paper "Measuring the Macroeconomic Impact of Monetary Policy at the Zero Lower Bound" by Jing Cynthia Wu and Fan Dora Zia uses a mathematical model to measure the impact of the Federal Reserve's long-term experiment with zero interest rates on the economy, particularly whether unconventional monetary policy has achieved the Fed's goal of lowering the unemployment rate.  While the paper itself leans strongly toward the academic community, its conclusion is rather stunning.

Historically, the Federal Reserve has used its ability to manipulate the Fed Funds Rate as its primary instrument of monetary policy.  Through the raising of this rate to control inflation and slow down an overheated economy and the lowering of this rate to stimulate a slowing economy, the Fed has been able to steer the American economy from one recession to the next.  Here is a graph showing the Fed Funds Rate since the 1950s:

If we zoom in to the period between the beginning of the Great Recession in December 2007 and the present, this is what the curve looks like:

Since December 2008, the Fed Funds rate has varied between 0.07 percent (its current level) and 0.22 percent, a far cry from the average of 2.14 percent since 2000.  Prior to 2009, economists could use movements in the Fed Funds Rate to get information about the state of the American economy, however, since the rate has been stuck at the zero lower bound since 2009, movements in the Fed Funds rate no longer provide information about the health of the economy.

Since December 2008, the Fed has not been able to lower the rate any further to stimulate the economy.  This got the creative minds at the Federal Reserve speculating that they could use what they term as "non-conventional policy tools" to stimulate the economy; using massive asset purchases and forward guidance to try to affect interest rates and influence the economy.  Here is one of the results of their newfound wisdom:

The Fed's balance sheet has risen from $869 billion on August 2007 to its current level of $4.072 trillion, an increase of 369 percent and a new high that will be breached as long as the Fed keeps on entering the bond market.

The paper by Wu and Zia assesses the effects of all of the Fed's monetary "fun and games" on the economy, particularly its impact on unemployment as I noted above, using the shadow rate term structure model (SRTSM) that "...posits the existence of a shadow interest rate that is linear in Gaussian factors with the actual short-term interest rate, the maximum of the shadow rate and zero.".  The model is used to describe and quantify the recent behaviour of interest rates and measure the effect of the Fed's monetary policy under the zero lower bound environment.

Let's get to the meat of the matter.  Using a series of mathematical formulas that look like this:

...the authors have calculated the impact of over $3 trillion worth of monetary experimentation on the American economy:

Unemployment (May 2013):

With QE: 7.6 percent
Without QE: 7.83 percent
Difference with QE: Net decrease of 0.23 percentage points

Industrial Production Index:

With QE: 98.7
Without QE: 96.7
Difference with QE: Net increase of 2.1 percent

Housing Starts:

With QE: 914,000
Without QE: 880,000
Difference with QE: Net increase of 34,000 housing starts

One could hardly say that these economic "improvements" are statistically significant.

From my perspective, the risks of the Bernanke experiment far outweigh the economic rewards that have been experienced by the American economy since the end of the Great Recession.  The fact that the Fed continues to paint itself into a policy corner with its Grand Three Trillion Dollar Experiment despite the fact that their asset purchases have had relatively minimal impact on Main Street America speaks to the level of desperation that central bankers are feeling.


  1. Great post, I thank you for your work!

    What I'm seeing develop is an "almost surreal" feeling of indifference towards reality. Companies have already ushered saving from interest paid on debt into the earning column and a major reason inflation remains low is they are sitting on a hoard of cash this has lowered the velocity of money. We must remember the artificially low FED controlled interest rates are a massive one-off or onetime tailwind that is mainly behind us. When they stop going lower or reverse the positive effect will ebb and become a major headwind. With massive government debt in many countries and the economy still weak this headwind has the potential to become devastating. The collision of MMT, social unrest over inequality, and other destabilizing factors have the potential to create the perfect storm. More about how we have grown far to complacent to the risk before us in the post below,


  2. Um, anyone can design variables to give just about result one wants. How on earth can anyone "predict" with any degree of certainty what the economy "would have looked like" without QE stimulus? There are simply too many variables, and too many assumptions, to assume any validity whatsoever to this "study". The author's biases (economic, social, expectational, etc.) are the only result we see in this study.

  3. I'd like to check their math but my calculators batteries are dead.