US Economic growth slows to 1,6% – Does Quantitative Easing Really Matter?

The economy in the US grew at a much slower pace this spring than previously estimated, mostly due to the largest surge in imports in 26 years and a slowdown in companies’ restocking of goods. The revision follows a week of disappointing economic reports. Former NY FED, Richard Alford, now raise the question if another round of quantitative easing are going to have any effect at all?

“Perhaps it is time to expect less from monetary policy and demand more from other policies and policy makers.”

Richard Alford

“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,” Richard Alford writes in a commentary.

The US gross domestic product – the broadest measure of the economy’s output – grew at a 1,6 percent annual rate in the April to June, the Commerce Department said Friday.

That’s down from an initial estimate of 2.4 percent last month and much slower than the first quarter’s 3.7 percent pace.

Investors will now turn their attention to a speech by Federal Reserve Chairman Ben Bernanke, scheduled for 10 a.m., that will address what the FED may do in response to the weakening economy.

Economists expect many other supports for economic growth to fade.

Federal government spending and the housing sector bolstered the economy last quarter, but housing has slumped again and will likely drag growth down in the third quarter.

The impact of the federal government’s $862 billion stimulus package is also projected to taper off this year.

The big question is if the US Federal Reserve will launch another round of massive quantitative easing to get the US economy going again.

The second biggest question is: Will it work?

Do They Even Know What They’re Talking About?

Former NY FED official Richard Alford have just published a commentary at the Institutional Risk Analysts website, in where he raises several critical question about the monetary policy, currently ruling the world, known as quantitative easing. (A derivative of traditional Keynesian theory).

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,” Alford points out.

“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),” Alford writes.

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.”

US money supply (M2)

The Calibration Problem

“The absence of any basis upon which to calibrate or chose the target size for the FED balance sheet is another revealing issue that supports questions about the efficacy of QE,” the former NY FED official continues.

“Monetarism employs estimates of the money multiplier and the income velocity of money to determine desired reserve levels and stance of monetary policy. Keynesians employ estimates of the Keynesian multiplier to choose the size of fiscal stimulus packages. What will drive and limit the scale of QE? If doubling the size of the FED balance sheet again doesn’t result in trend or better economic growth should the FED just keep doubling the balance sheet until it does?”

(The BOJ’s balance sheet target increased more than six-fold during the QE episode in Japan.)

“How can economists assess the effectiveness of QE in the absence of some defined and quantified link to the ultimate policy targets?” Alford rightfully asks.

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,” Alford writes.

“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: to avoid a Japan-like lost decade 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 analysis verify that because of the QEP the premiums on market funds raised by financial institutions carrying substantial non-performing 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,” Alford says.

On the effect of QEP on macroeconomic variables:

“Granted the positive above effects of preventing further deterioration of the economy reviewed above, many other macroeconomic analysis 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 analysis 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,” Mr. Koo concludes. Adding; “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 (1) 25 trillion has no effect, then we should try injecting (2) 50 trillion, or (3)100 trillion.”

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,” Mr. Alford points out, and refers:

“… 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,” Alford writes.

Should the FED Further Expand Its Balance Sheet?

“The FED, either by design or chance, has already implemented those aspects of QE which the analysis 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,” Richard Alford replies.

“Perhaps it is time to expect less from monetary policy and demand more from other policies and policy makers,” he concludes.

Original post at the IRA homepage here.

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Full transcript of Mr. Bernanke’s speech at Jackson Hole, August 27th.

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