"It doesn't matter how beautiful your theory is,
it doesn't matter how smart you are.
If it doesn't agree with experiment, it's wrong."

Richard Feynman

While the financial markets await the latest pronouncement from Fed Chairman Ben Bernanke, we feature a comment from our friend and former colleague at the FRBNY Richard Alford.  He asks whether any of the policy options being considered by the U.S. central bank are meaningful to the American economy. As Paul Krugman said in the New York Times today: "Policy makers are in denial."

It is unclear why proponents of quantitative easing or "QE" inside the Federal Open Market Committee (FOMC) are confident that it will be the answer to our current economic woes. Many of the arguments and models linking QE to improved performance of the real economy are unsatisfactory. The terms of these models are poorly defined and the conclusions drawn from them are at variance with accepted understanding of the function of prices in markets. Prices we should recall act as the signaling and incentive carrying element of market behavior. More importantly, the only available empirical analyses available suggest that QE, when employed in Japan, had little if any effect at all on GDP, inflationary expectations, or measured inflation. Given the definitional problem, the Fed's reliance on QE (targeted expansion of the Fed balance sheet via the purchases of Treasuries) seems questionable. As discussed below, it is far from certain that QE will prove to be an effective policy tool to fight unemployment or real estate price deflation

Definitional Problem

The first hint that the Fed is flying blind is the fact that QE has numerous operational definitions. It is broadly defined as a form of monetary policy used by central banks to stimulate the economy when the policy rate is at or close to zero. "Quantitative" refers to the fact that the central bank is targeting a specific size for its balance sheet while "easing" refers to reducing the pressure on financial markets by increasing the willingness of lenders to lend and the willingness of potential borrowers to take on debt. However, when Chairman Bernanke, a proponent of QE, began the rapid expansion of the Fed balance sheet in 2008, he argued that the Fed was not engaged in QE, but in something distinctly different: credit easing ("CE").

The Federal Reserve's approach to supporting credit markets is conceptually distinct from quantitative easing (QE), the policy approach used by the Bank of Japan from 2001 to 2006. Our approach-which could be described as "credit easing"-resembles quantitative easing in one respect: It involves an expansion of the central bank's balance sheet. However, in a pure QE regime, the focus of policy is the quantity of bank reserves, which are liabilities of the central bank; the composition of loans and securities on the asset side of the central bank's balance sheet is incidental. Indeed, although the Bank of Japan's policy approach during the QE period was quite multifaceted, the overall stance of its policy was gauged primarily in terms of its target for bank reserves. In contrast, the Federal Reserve's credit easing approach focuses on the mix of loans and securities that it holds and on how this composition of assets affects credit conditions for households and businesses. The absence of a general consensus on the operational definition of QE is also reflected in the plethora of "names" attached to the current stance of Fed policy: QE, QE1.1, QE2.0 and QE-lite.

The debate over the proper characterization of the current policy resembles theologians debating how many angels can dance on the head of pin. It is possible that the differences are substantive and have policy implications, but there is little evidence to support this view. Assume that CE worked as Bernanke suggested that it would: it helped repair dysfunctional credit markets. Given that assumption, even if you are convinced that the asset purchases that doubled of the Fed balance sheet between December 2008 and today improved economic performance or at least prevented further deterioration, that success is not evidence that QE (the buying of Treasuries) will enhance future economic performance.

The Problem of Expectations Management

Proponents of QE argue that it can be effective at the zero bound. They believe that QE can still stimulate economic activity by engendering expectations of higher inflation and interest rates in the future. They argue that QE can achieve this if it includes a commitment to maintain QE until a specified rate of inflation is achieved. They also argue that QE can be unwound before it leads to an inflationary spiral. However, discussions of the channels by which some proponents of QE assert that QE will stimulate the real economy are at variance with the standard understanding of the role played by monetary policy and the assumption that the Fed can control inflationary expectations.

The field of microeconomics has many names. While many practitioners call it "Price Theory", none call it "Quantity Theory". There is a very simple reason. It is changes in prices that drive economic agents to change their behavior. Once the price for a good is zero, is there any reason for an increase in the supply of that good to induce economic agents to change their behavior? Apparently the members of the FOMC believe that there is.

The argument in favor of QE has a number of other shortcomings. For one thing, tt assumes that the Fed can control inflationary expectations. However, economic agents are unlikely to credit the Fed with ability to control either inflation or inflationary expectations like water from a faucet. The track record to justify that assumption just isn't there. The Fed did not see the housing bubble. The Fed did not forecast the recent (assuming we are out of it) recession until we were in it.

In 2002, Bernanke set the goal for US monetary policy: avoid a Japan-like experience, but Bernanke and the FOMC caused a real estate bubble and the near destruction of the financial system. Given this performance, why should economic agents already troubled by debt levels and/or over capacity increase their debt load in response to an assertion by the Fed that will generate inflation or growth in the near future? QE relies on inflationary expectations as the transmission mechanism. This suggests also that if the expansion of the balance sheet does not have an immediate effect on aggregate demand, the chances are that it never will have an effect. Economic agents will learn that QE is of no consequence.

Evidence from the Japanese Experience

Outside of stabilizing financial institutions and markets, the evidence that QE changed macroeconomic variables in Japan is mixed at best. In 2006, the Bank of Japan (BOJ) published a working paper titled "Effects of the Quantitative Easing Policy: A Survey of Empirical Analyses." The paper broke "QEP" down into 3 separate components:

1. A commitment to maintain zero interest rates until the policy goal of sustained inflation was achieved;

2. Setting the policy with an aim of achieving a targeted range for the size of Bank of Japan's balance sheet; and

3. A change in the composition of the Bank's balance sheet.

The paper surveyed the results of a number of efforts to identify and quantify the effects of QEP. The effects of QEP on financial institutions, financial markets, the real economy and inflation are presented in the Executive summary. First, the effects on financial markets and institutions:

"Looking at the contents of the macroeconomic impact … these macroeconomic analyses verify that because of the QEP the premiums on market funds raised by financial institutions carrying substantial nonperforming loans shrank to the extent that they no longer reflected credit rating differentials. This observation implies that the QEP was effective in maintaining financial system stability and an accommodative monetary environment by removing financial institutions funding uncertainties, and by preventing further deterioration of economic and price developments resulting from corporation's uncertainty about future funding."

The effect of QEP on macroeconomic variables:

"Granted the positive above effects of preventing further deterioration of the economy reviewed above, many other macroeconomic analyses included that the QEP's effects in raising aggregate demand and prices were limited. In particular, when verified empirically taking into account the fact that the monetary policy regime change under the zero bound constraint of interest rates, the effects from increasing the monetary base were not detected or smaller, if anything, then during periods when there was no zero bound constraint. The studies generally show that the QEP, had a greater monetary easing effect than that stemming from merely lowering the uncollateralized overnight call rate to 0%, while the effects in raising aggregate demand and prices nevertheless turned out to be limited, Many of these analyses present analytical results and interpretations indicating that in addition to the zero bound constraint of the interest rate, the substantial decline in responsiveness to monetary easing on the part of corporations and financial institutions resulting from the deteriorated core capital due to a plunge in asset prices played a major role."

Most relevant to the current US situation is the BOJ finding that while QEP (especially the commitment to maintain zero interest rates) had "strong effects" on the expected path of short-term interest rates and help stabilize financial markets, the effects Of QEP on aggregate demand as well as on expectations of economy recovery and inflationary expectations were "uncertain/small." One of the studies cited in the working paper concluded that "the QEP did not have the effect of reversing the financial markets expectations that deflation would persist."

In short, the research summarized in the BOJ working paper suggests that the Fed, by using near zero interest rates (ZIRP), the commitment to ZIRP until deflation fears abates, and steps (CE) that it has already taken to restore the functioning of the financial market, has already taken the steps that achieved most of if not all the benefits Japan enjoyed as a result of QEP.

Richard Koo has characterized the failure of QE to promote recovery in Japan as "the greatest monetary non-event." Koo has also emphasized the unwillingness of policymakers to concede that QE might be ineffective:

"Even though QE failed to produce the expected results, the belief that monetary policy is always effective persists among economists in Japan and elsewhere. To these economists, QE did not fail: it simply was not tried hard enough. According to this view, if boosting excess reserves of commercial banks to 25 trillion yen has no effect, then we should try injecting 50 trillion, or 100 trillion yen."

The Fed on the Japanese Experience with QE

In 2006, the Federal Reserve Bank of San Francisco published a "Pacific Basin Note" titled: Did Quantitative Easing by the Bank of Japan "Work"? While it discussed the effect of QEP on interest rates, financial institutions and markets, there was no discussion whatsoever of any effect on the real economy or inflation. In 2008, the Federal Reserve Bank of Cleveland published a short survey piece which also attempted to assess the effectiveness of the BOJ's QEP. The piece offered the following observation regarding the effect of OEP on real economic activity and inflation:

"... Most observers believe that because the quantitative easing policy aided the banking sector, economic activity at least did not deteriorate further. The pace of economic activity did pick up, with contributions from consumer spending and investment, but exports, which benefited from growth among Japan's trading partners, spurred much of the improvement. Although deflation ended in 2006, along with the quantitative easing policy, it returned after a very short hiatus in 2007, and continued until the recent commodity price boom."

Recently, the former Fed Vice Chairman Alan Blinder opined in the Wall Street Journal:

"Chairman Ben Bernanke has told the world that the Fed is not out of ammunition…The good news is that he's right. The bad news is that the Fed has already spent its most powerful ammunition; only the weak stuff is left."

Blinder, it seems has reached the conclusions that the Fed is approaching the limits of the effectiveness of monetary policy. He has also concluded that it would be best for the Fed to go out guns blazing no matter how small the effect. There was no mention of any empirical analyses of the effectiveness of QE, although he stated that he thought that a return to CE would be preferable to adopting QE. There was no discussion of whether the expected return from QE had erode so much that it would fail a risk return test even if it passed in the past.

Should the Fed Further Expand Its Balance Sheet?

The Fed, either by design or chance, has already implemented those aspects of QE which the analyses cited in the BOJ study indicated had "strong effects" on interest rates and financial institutions. The Fed is now faced with signs that the economy is slowing and the fact that QE had uncertain/small effects on output and inflation in Japan. Hence, the size of the potential upside benefit to QE or renewed CE is probably rather small. This raises the question: What is the downside, if any to QE? It might, given the commitments to both low interest rates and inflation) precipitate s dollar crisis which would be very costly for the US and the world. It could further damage the reputation and standing of the Fed which has suffered as a result the housing bubble, its failure to exercise its regulatory responsibilities, it role in the AIG fiasco, etc. This would in turn further erode the Fed's future ability to use "talk as policy." QE will also increase financial institutions incentives to leverage up and run large maturity mismatches.

However, many proponents of QE appear to be highly confidence in its effectiveness despite the absence of supporting evidence. It is likely that many supporters of QE do so because to do otherwise would be to admit that we have reached or are very near the limits of monetary policy. Unfortunately, while QE may enable the Fed to finesse the zero "bound", the only existing evidence strongly suggests the effectiveness of unconventional monetary policy is waning. It should not be surprising, if we have reached the limit of monetary policy. It has been the go to policy to stimulate growth. US tax policy is best explained as an effort to garner campaign contribution despite deleterious effects on growth, fairness and efficiency. It has also encouraged the buildup of debt and leverage, while discouraged saving and equity financed investment. The expenditure side of fiscal policy has been reduced to partisan-seniority-determined allocations of pork. Regulatory policy has become a means of placating valued constituencies and expanding moral hazard incentives. Trade policy is non-existent. Energy policy is non-existent. Perhaps it is time to expect less from monetary policy and demand more from other policies and policy makers.

Link to BOJ piece

http://www.boj.or.jp/en/type/ronbun/ron/wps/data/wp06e10.pdf

Link to FRB SF piece

http://www.frbsf.org/publications/economics/letter/2006/el2006-28.pdf

Link to FRB Cleveland piece

http://www.clevelandfed.org/research/trends/2008/1208/ET_dec08.pdf

Link to Bernanke speech of 2002

http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm

Link to Blinder WSJ piece

http://online.wsj.com/article/SB10001424052748703846604575448022122679194.html?mod=rss_opinion_main

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