“The problem with QE is that it works in practice, but it doesn’t work in theory.”
—Ben Bernanke, at his last remarks as Federal Reserve Chairman in January 2014
Did Quantitative Easing work?
We spent some time talking about the powers and actions of the Federal Reserve in our February 2012 article, “Recent Changes at the Federal Reserve.” Specifically, we discussed their abilities to adjust monetary policy through manipulation of key interest rates, adjusting bank reserve requirements, and so on. The unique recent actions of the Federal Reserve, prompted by the severity of the financial crisis, are best exemplified by the Quantitative Easing (QE) programs which were described in our February 2012 article
As expected, the Federal Reserve stuck to their plan to end the asset purchasing program in October. Even without QE, monetary policy is still incredibly accommodative: the Fed funds rate is essentially zero and not expected to rise to high levels. The end of the controversial program raises the question, “did it work?” The QE program was an experiment into uncharted waters, especially for an economy as large and complex as our own; evaluating the efficacy of the QE program, even in hindsight, is not a trivial task.
Playing the game
Think of managing the economy as a game. The government has resources to spend to attempt to reach the best possible outcome. If managing the economy is a game, what is a winning state and what is the losing state for the QE experiment? Were the fears of QE justified? Were the benefits of the program worth the cost? Did QE work?
First, we should define our terms in this game. What are the Federal Reserve goals? What is a loss? What moves does the Federal Reserve make and what resources are spent?
Without rehashing our February 2012 article, when the recession started, liquidity was a deep problem in the financial system. Initially, the Federal Reserve bought up bonds and other assets to inject petty cash into the system and maintain the prices of mortgage bonds which could have fallen into a death spiral. Today, the bond market has enjoyed years of amble liquidity and prices have not suffered the downward shocks so prevalent in the early days of the financial crisis.
Other QE programs, like Operation Twist, existed to lower the cost of long term mortgages and bolster the housing sector. Today, housing sector data is mixed. First time home-buyers are at record lows, but this is due to consumer cautious rather than inherent financial hurdles. Indeed, mortgage rates are still near their all time lows and home prices are still trading at a 10-20% discount to their 2006 era highs.
Economists generally assert that the QE programs have had some positive effects to the economy, but what was the cost? Since the Treasury, which funds the QE program, can essentially print money out of thin air, what resources are being spent anyway? For individuals like you and I, money is a concrete resource: you either have it or you don’t. For governments in charge of their own currency, credibility is the resource. Governments can print an infinite amount of dollars, but an infinite amount of dollars chasing after a finite amount of resources is a sure-fire way to lose price stability and generate massive inflation: the antithesis of the Federal Reserve’s mandate.
So, the Federal Reserve balance sheet expanded to $4.5 trillion dollars (from less than $1 trillion at the start of the crisis) from money that was essentially printed out of thin air. Did all of the additional dollars cripple the purchasing power of the dollar? Not on a relative basis, no. Rather, the US economy’s growth rate has lately been the envy of other developed markets which have problems of their own. Despite printing billions of dollars to support asset prices, our currency has not suffered any weakness.
The results of QE
The only scientific way to determine if QE worked would be both irresponsible and unfeasible: creating an identical economy both with and without QE. If you could reverse time and see what happened in a parallel universe where QE never happened, then you’d be able to measure and compare the two outcomes. Obviously, since we can’t reverse time, we should instead consider the best judgments and analysis of economists. For instance, the International Monetary Fund’s opinion is that QE has eased some of the worse effects of the financial crisis.
The IMF has the benefit of acting in hindsight and not having to risk anything with this judgment. Therefore, a more compelling argument for the net benefits of QE is the behavior of other counties on the world stage. Consider that the US economy is growing, albeit slowly, and is fundamentally strengthening while other parts of the developed world are nearly stagnant. It seems that the benefits of the US QE experiment have sufficiently impressed our peers – the Bank of Japan and the European Central Bank – to enact similar asset purchase programs. The ECB will purchase asset-backed securities in November, however direct purchases of sovereign debt is difficult given restraints on the ECB relative to a national bank. ECB chairman Mario Draghi declared their commitment to broad monetary easing, even through “unconventional” policies (i.e. asset purchases) to counter the weakening growth momentum in the Eurozone. Moreover, on October 31st, the BOJ announced huge expansion of their monetary stimulus, tripling their annual real estate purchases and ETF purchases.
Critics of Japan assert that the monetary expansion is only masking the issue, buying time perhaps for the government to resolve issues, but not fixing the fundamental problems with the Japanese economy. In other words, Japanese monetary stimulus may not actually “fix” anything, but it can extend real economic damage from hitting all at once into longer, shallower cuts which may be borne without a full panic. Critics of the European economic situation put forward similar challenges to the ECB: monetary easing is only a temporary fix to a permanent problem. Monetary policy can mask or defer fiscal or economic weakness and the entangled Eurozone needs more meaningful solutions. Still these central banks are open to any relief they can get and, through deferring hard choices, the opportunity to enact bigger fixes.
The central government has accrued some moral hazard with the policy. Investors have fewer incentives to be careful and avoid bad investments if they believe the Federal government will buy suffering asset classes wholesale in times of stress. However, investors – both corporate and individuals – seem genuinely chastened by the events of the financial crisis. Investor sentiment and consumer confidence numbers do not suggest euphoria, but wariness. Investors may have been shielded from the worst consequences by QE and other accommodative policies, but most market participants were impacted by the 2008 recession.
Moreover, behavioral finance suggests that we overemphasize the feeling of losses. In other words, it feels worse to lose a dollar than it feels good to earn a dollar through investments. Thus, the shared economic damage felt throughout the economy is sufficient to counteract the modest protection investors received given occasional government support during times of deep stress. Investors are still pretty cautious, despite a multi-year bull run and some assistance from the Federal Reserve. In other words, even temporary monetary policy band-aids can offset the irrationality and fear endemic to crises of confidence.
Critics of QE correctly assert that there may still be problems from Fed policy that we do not yet know about. For instance, penalizing savers with low rates may hamper future growth. Forcing money into riskier assets may produce unsustainable asset price bubbles; we may not know the extent of this damage until the manipulation of monetary policy has been eliminated. Indeed, some critics have suggested that the stock market and real estate rallies are the byproduct of policies which are designed to force savers out of money markets and bank accounts into the riskier asset classes. However, these potential problems are a function of Fed rate targets. The key determinant of QE success – or failure – is price stability and inflation. Based upon that criteria, inflation has been stable, contained, and honestly less that the implied target of 2%. In the future, the Federal Reserve may have difficulty unwinding its trillions of dollars in treasury and mortgages, either by selling them into the marketplace or allowing the bonds to mature and fall off their balance sheet, without cheapening prices. However, for now, the current evidence on suggests Quantitative Easing has been a success for the Federal Reserve. We will be watching closely to see if bond and equity markets can maintain their high levels without the Federal Reserve sopping up the excess and squeezing cash into riskier ventures.