Tuesday, October 24, 2017

The Effectiveness of Quantitative Easing - Not as Advertised

As we are well aware, since the near-collapse of the economy during the Great Recession, the Federal Reserve has implemented a program of unconventional monetary policies, most particularly, quantitative easing.  A recent publication by Stephen W. Williamson at the Federal Reserve Bank of St. Louis takes an interesting look at how effective QE has been, a subject of interest particularly given that the world's central banks are likely to fall back on the use of asset purchases to influence the economy in the next recession.

Let start by looking at what quantitative easing is, how it is a part of unconventional monetary policy and how QE works by comparing it to conventional monetary policy.  Conventional monetary policy is achieved through direct manipulation of short-term interest rates as changes in economic performance occur, in the case of the Fed, the target is the federal funds rate.  According to the Taylor rule, central bank's nominal interest rate targets should rise if inflation exceeds the central bank's target and fall if aggregate output (i.e. GDP) falls below the economy's potential.  In most cases, there is a limit to how low short-term nominal interest rates can go, the effective lower bound.  In the case of the Fed, this lower bound is essentially zero but, as we've seen in the case of Europe, the lower bound is negative.

At the end of 2008, the Federal Reserve faced a unique "perfect economic storm".  The federal funds rate was at zero percent, however, inflation remained stubbornly below the Fed's 2 percent target and the American economy was performing poorly.  This resulted in the Fed implementing unconventional monetary policies, particularly multiple programs of quantitative easing and the Twist, in an effort to kick-start the economy.  Here is a summary of the Fed's monetary manipulations between December 2008 and October 2014:

1.) Quantitative Easing 1 - December 2008 to March 2010 - Purchases of $175 billion in agency securities and $1.25 trillion in mortgage-backed securities.

2.) Reinvestment Policy - August 2010 to present - Replacement of maturing securities to maintain the balance sheet at a constant nominal size if there is no QE program underway.

3.) Quantitative Easing 2 - November 2010 to June 2011 - Purchases of $600 billion in long-maturity Treasury securities.

4.) Operation Twist - September 2011 to December 2012 - Swap of more than $600 billion involving purchases of Treasury securities with maturities of six to 30 years and sales of Treasury securities with maturities of three years or less.

5.) Quantitative Easing 3 - September 2012 to October 2014 - Purchases of mortgage-backed securities and long-maturity Treasury securities, initially set at $40 billion per month for mortgage-backed securities and $45 billion per month for long-maturity Treasury securities.

As a result, this is what happened to the Fed's balance sheet:

Overall the Fed's assets increased from 6.0 percent of U.S. GDP in Q4 2007 to 23.5 percent of GDP in Q1 2017.  As well, by May 2017, all of the Fed's Treasury Bills had matured, leaving them with a massive inventory of long-maturity Treasury Notes and Bonds and Mortgage-backed Securities.

While we may think that, at 23.5 percent of GDP, the Fed's balance sheet is at uncomfortable levels, in fact, other central banks/nations are in worse shape.  In December 2016, the European Central Bank's balance sheet was 34 percent of Europe's GDP, the Bank of Japan's balance sheet was 88 percent of GDP and the Swiss National Bank's balance sheet was 115 percent of Switzerland's GDP.

So, how did central bankers justify this massive and unprecedented bloating of their balance sheets?  Central bankers believe that purchases of long-maturity assets will flatten the yield curve; with interest rates at or near zero, the purchase of long-term Treasuries will narrow the difference between short- and long-term interest rates.  As well, even if there are no direct effects of asset purchases, the commitment to a course of action (i.e. that of QE) by a central bank signals that the bank is likely to use the same monetary policies in the future when economic conditions (i.e. a recession) warrant their use.

So, with all of this action by the world's most influential central banks, how effective was QE at beating low inflation and promoting real economic growth?  Here are two examples:

1.) The Bank of Japan (BOJ) and QE in Japan after January 2013:  In January 2013, the Bank of Japan announced that it would pursue a 2 percent inflation target, a lofty goal for an economy that had suffered from deflationary pressures for many years as shown here:

In April 2013, it announced the launching of the Quantitative and Qualitative Monetary Easing Program which was designed to achieve a 2 percent inflation target within two years.  The BOJ's overnight nominal interest rate was close to zero and has been negative since early 2016.  In addition, the monetary base in Japan increased by nearly 300 percent from the beginning of 2013 to May 2017.

Here is a graphic showing the growth of Japan's monetary base and CPI inflation since 2013:

As you can see, despite the BOJ's massive actions, inflation has remained just around zero percent since early- to mid-2015, nowhere near the 2 percent goal set in 2013.  It is also important to note that the 3.5 to 4 percent peak in CPI inflation in 2014 was due to the imposition of a 3 percentage point increase in Japan's consumption tax.

2.) Real GDP Growth in Canada vs. the United States: Unlike its American counterpart, the Bank of Canada did not engage in any asset purchases over the period since the Great Recession and only moved to lower its key interest rate close to but slightly above zero percent.  In sharp contrast to the situation in the United States where the Fed's balance sheet is 23.6 percent of GDP, the Bank of Canada's balance sheet is only 5.1 percent of Canada's GDP.

Here is a graphic comparing the real growth in GDP for both Canada and the United States over the decade since 2007 (scaled to 100 in 2007):

As you can see, Canada's real GDP growth is quite comparable to that of the United States.  In fact, Canada's real GDP in the fourth quarter of 2016 was 2 percent higher than the real GDP in the United States, reflecting higher cumulative growth despite the use of no asset purchases.

Let's look at the author's conclusion:

"Evaluating the effects of monetary policy is difficult, even in the case of conventional interest rate policy. With unconventional monetary policy, the difficulty is magnified, as the economic theory can be lacking, and there is a small amount of data available for empirical evaluation. With respect to QE, there are good reasons to be skeptical that it works as advertised, and some economists have made a good case that QE is actually detrimental." (my bold)

As the Federal Reserve moves to unwind its $4 trillion plus balance sheet, it will be interesting to see what impact this unprecedented move will have on the economy.  From the author's analysis and keeping in mind that he is a representative of the Federal Reserve system, the value of quantitative easing as a panacea for economic weakness is, at best, doubtful and, in the worst case, it make actually be detrimental to the long-term health of the economy.


  1. Recently articles have surfaced exploring how the central banks and governments have controlled markets making a strong case that it was nothing more than a new model of nationalization. The premise holds great moral hazard in that the entity that owns the stocks can control perceived valuations by being the market maker that sets prices.

    When true price discovery vanishes we must question what is real. The article below explores how Japan is leading the world in this experiment and why it may backfire leaving us in a world of hurt.


  2. The one point that is bothering me is the high debt we are accumulating on a monthly basis that seems to be ign0red by the media and the market.The
    Central banks lowering interest rates and injecting money into the market artificially lifted the market to presence heights while debt continued to grow.Nine years of a bull market buoyed by these two factors have led us to a point of an overvalued stock market that could see a substantial fall due to overbought conditions and data that was overstated to the general public.