Is There Any Sense in Which Quantitative Easing Might Increase Financial Instability?: The Honest Broker for the Week of March 22, 2014: Friday Focus

Let us start with Gabriel Chodorow-Reich:

Gabriel Chodorow-Reich: Effects of Unconventional Monetary Policy on Financial Institutions: “Abstract: Unconventional monetary policy affects financial institutions through their exposure to real project risk,

the value of their legacy assets, their temptation to reach for yield, and their choice of leverage…. High-frequency event studies… show the introduction of UMP in the winter of 2008-09 had a strong, beneficial impact on banks and especially on life insurance companies…. Subsequent policy announcements had minor effects…. The interaction of low nominal interest rates and administrative costs led money-market funds to waive fees, producing a possible incentive to reach for higher returns…. I find some evidence of high-cost money-market funds reaching for yield in 2009-11, but little thereafter. Private defined-benefit pension funds with worse funding status or shorter liability duration also seem to have reached for higher returns beginning in 2009, but again the evidence suggests such behavior dissipated by 2012. Overall, in the present environment there does not seem to be a trade-off between expansionary policy and the health or stability of the financial institutions studied.

As I have said before–over and over and over again–when the Federal Reserve engages in quantitative easing it buys up assets that have duration risk in exchange for securities that have no nominal risk at all. Either it holds those securities until maturity–in which case that risk is extinguished, as throughout the period those securities are live losses on the Federal Reserve’s marked-to-market portfolio are exactly offset by increases in expected future capital gains–or should it unwind that transaction it simply returns the amount of risk the private sector must bear to its previous value. How then can quantitative easing possibly increase risk?

It remains a mystery to me. The fullest explanation I can find from a regional Federal Reserve Bank President who fears that quantitative easing raises risk is this from Richard Fisher:

Richard Fisher: Beer Goggles, Monetary Camels, the Eye of the Needle and the First Law of Holes: “Peter Boockvar, who is among the plethora of analysts offering different viewpoints

that I regularly read to get a sense of how we are being viewed in the marketplace. Here is a rather pungent quote from a note he sent out on Jan. 2:

…QE [quantitative easing] puts beer goggles on investors by creating a line of sight where everything looks good…

For those of you unfamiliar with the term “beer goggles,” the Urban Dictionary defines it as “the effect that alcohol … has in rendering a person who one would ordinarily regard as unattractive as … alluring.” This audience might substitute “wine” or “martini” or “margarita” for “beer” to make it more age-appropriate, but the effect is the same: Things often look better when one is under the influence of free-flowing liquidity…. Today, I want to muse aloud about whether QE has indeed put beer goggles on investors and whether we, the Fed, can pass the camel of massive quantitative easing through the eye of the needle of normalizing monetary policy without creating havoc.

Boockvar is right. When money available to investors is close to free and is widely available, and there is a presumption that the central bank will keep it that way indefinitely, discount rates applied to assessing the value of future cash flows shift downward, making for lower hurdle rates for valuations. A bull market for stocks and other claims on tradable companies ensues; the financial world looks rather comely.

Market operators donning beer goggles and even some sober economists consider analysts like Boockvar party poopers. But I have found myself making arguments similar to his and to those of other skeptics at recent FOMC meetings, pointing to some developments that signal we have made for an intoxicating brew…. Share buybacks financed by debt issuance that after tax treatment and inflation incur minimal, and in some cases negative, cost…. Dividend payouts financed by cheap debt that bolster share prices…. Stock market metrics such as price-to-sales ratios and market capitalization as a percentage of gross domestic product at eye-popping levels not seen since the dot-com boom of the late 1990s. Margin debt that is pushing up against all-time records. In the bond market, investment-grade yield spreads over “risk free” government bonds becoming abnormally tight. “Covenant lite” lending becoming robust and the spread between CCC credit and investment-grade credit or the risk-free rate historically narrow.

I will note here that I am all for helping businesses get back on their feet…. But I worry when “junk” companies that should borrow at a premium reflecting their risk of failure are able to borrow (or have their shares priced) at rates that defy the odds of that risk…. And then there are the knock-on effects of all of the above…. During the financial debacle of 2007–09, I was able to buy for a song volumes I have long coveted (including a mint-condition first printing from 1841 of Mackay’s Memoirs of Extraordinary Popular Delusions, which every one of you should read and re-read, certainly if you are contemplating seeing the movie The Wolf of Wall Street). Today, I could not afford them. First editions, like paintings, sculptures, fine wines, Bugattis and homes in Highland Park or River Oaks, have become the by-product of what I am sure Bill Martin would consider a party well underway….

Here is the point as to the market’s beer goggles. Were a stock market correction to ensue while I have the vote, I would not flinch from supporting continued reductions in the size of our asset purchases as long as the real economy is growing, cyclical unemployment is declining and demand-driven deflation remains a small tail risk; I would vote for continued reductions in our asset purchases, with an eye toward eliminating them entirely at the earliest practicable date.

Let’s turn to the camel, by which I mean the size of the Fed’s balance sheet…. On Sept. 10, 2008, the amount of Reserve Bank credit outstanding was $867 billion…. On March 18, 2009… our balance sheet was marked at $2 trillion…. I considered a balance sheet of $2-plus trillion and a base lending rate of 0-to-1/4 of 1 percent more than sufficient to stimulate not just the housing market but the stock market, too…. We have since doubled our balance sheet to $4 trillion. This has resulted not only in saltatory housing, bond and stock markets, but a real economy that is on the mend, with cyclical unemployment declining and inflation thus far held at bay.

Here is the rub. We have accomplished the last $2 trillion of balance-sheet expansion by purchasing unprecedented amounts of longer-maturity assets…. We hold nearly 40 percent of outstanding eligible MBS and of Treasuries with more than five years to maturity. Selling that concentrated an amount of even the most presumably liquid assets would be a heck of lot more complicated than accumulating it. Currently, this is not an issue. But as the economy grows, the massive amount of money sitting on the sidelines will be activated; the “velocity” of money will accelerate. If it does so too quickly, we might create inflation or financial market instability or both….

To prevent excess reserves from fueling a too-rapid expansion of bank lending in an expanding economy, the Fed will need to either drain reserves on a large scale by selling longer-term assets at a loss or provide inducements to banks to keep reserves idle, by offering interest on excess reserves at a rate competitive with what banks might earn on loans to businesses and consumers…. Such inducements to control the velocity of the monetary base might expose the Fed to intense scrutiny and criticism. The big banks that park the lion’s share of excess reserves with us are hardly the darlings of public sentiment. Raising interest payments to them while scaling back our remittances to the Treasury might raise a few congressional eyebrows….

Of greatest concern to me is that the risk of scrutiny and criticism might hinder policymakers from acting quickly enough to remove or dampen the dry inflationary tinder that is inherent in the massive, but currently fallow, monetary base…. How do we pass a camel fattened by trillions of dollars of longer-term, less-liquid purchases through the eye of the needle of getting back to a “normalized” balance sheet so as to keep inflation under wraps and yet provide the right amount of monetary impetus for the economy to keep growing and expanding?

Richard Fisher’s fear appears to be that acting to control inflation while the Federal Reserve’s balance sheet is at $4 trillion might “expose the Fed to intense scrutiny and criticism” from members of Congress and from the press. But I had always thought that the point of having a technocratic, independent central bank was precisely because it could take steps in the long-run economic interest of the nation without having to worry about its immediate popularity among those who get their news from soundbites and chyrons. To the extent that monetary policy is constrained by short-run congressional sentiments, monetary policy should be made not in FOMC meetings but by congressional vote so that voters can clearly see where the responsibility and accountability lives.

And the fullest explanation I can find from an academic economic point of view comes from the very sharp Federal Reserve Governor Jeremy Stein–and why on December 11, 2012, Barack Obama decided that what the Federal Reserve needed was two new governors, Jeremy Stein and Jerome Powell, both of whom were considerably more hawkish on monetary policy than Chair Ben Bernanke is one of many, many things about the Obama administration that are completely beyond me.

Let’s get into Jeremy Stein’s thinking via a critique by Ryan Avent:

Ryan Avent: Financial stability: Leaning, then toppling: “IF YOU want to know why the Federal Reserve is undershooting both its inflation target and its maximum employment mandate,

cast your eye toward Jeremy Stein… [who] has led the intellectual charge within the Federal Open Market Committee to place more emphasis on financial stability as a monetary policy goal. For a glimpse… have a look at his most recent speech….

I am going to try to make the case that, all else being equal, monetary policy should be less accommodative–by which I mean that it should be willing to tolerate a larger forecast shortfall of the path of the unemployment rate from its full-employment level–when estimates of risk premiums in the bond market are abnormally low. These risk premiums include the term premium on Treasury securities… expected returns to investors… bearing the credit risk on… corporate bonds and asset-backed securities…. Consider the period in the spring of 2013 when the 10-year Treasury yield was in the neighborhood of 1.60 percent and estimates of the term premium were around negative 80 basis points…

Mr Stein is effectively taking ownership of the Fed’s move toward tapering. Long-term unemployed Americans should address their letters accordingly. Why not laud the governor for his efforts? Who could be against financial stability, particularly given disastrous recent experience? Well, financial stability is a fine goal…. But Mr Stein’s particular approach… strikes me as… very likely to prove counterproductive…. Consider the way Mr Stein opens the speech….

The easier question is, should financial stability concerns, in principle, influence monetary policy decisions?… This question is about theory, not empirical magnitudes, and, in my view, the theoretical answer is a clear “yes.”

Hold on. Mr Stein… takes for granted that excess unemployment is the price to be paid for stability rather than excess inflation. Why? Where does that view come from? Naturally, it is assumed:

[T]he argument assumes that there is some variable summarizing financial market vulnerability–I will be abstract for the moment and just call it FMV–which is influenced by monetary policy. That is, easier monetary policy leads to increased vulnerability… there is a greater probability of an adverse event–some kind of financial market shock–that, if it were to occur, would push up the unemployment rate, all else being equal….

Once one assumes that, showing that tighter policy might be justified even when unemployment is above desired levels is mathematically trivial. Everything is built on the assumption that easy policy = financial danger…. It’s not hard to see how Mr Stein has arrived at this point. Much of his academic work focused on exploring the “lending channel” of monetary policy transmission: tighter policy affects the economy by reducing bank lending…. What is most remarkable about all of this is how swiftly and silently the FOMC is moving in Mr Stein’s direction. The governor is drawing some hugely significant conclusions from rather tenuous beginnings, and the FOMC is following his lead with scarcely any public debate…. Here is where Janet Yellen explains why the Fed gestured toward tapering last summer:

Well, I think there were quite a number of things happening at that time. I think it’s probably true that monetary policy may have played a role in touching off that market reaction, but I think the market reaction was exacerbated by the fact that we had a very significant unwinding of carry trades and other leveraged positions that investors had taken, perhaps thinking that the level of volatility was exceptionally low and perhaps lower than was safe for them to have assumed. But we certainly saw–now, in some ways, the fact that term premium in interest rates have come up somewhat, although it has had a negative effect on the recovery and that’s evident in housing, in the slowdown in housing, perhaps it’s diminished some financial instability risk that may have been associated with these carry trades and speculative activities that were unwinding during that time. A lesson is that we will try, and we were trying then, but we will continue to try to communicate as clearly as we possibly can about how we will conduct monetary policy and to be as steady and determined and as transparent as we can, to provide as much clarity as is reasonably certain–given that the economic developments in the economy are themselves uncertain–but we will try as hard as we can not to be a source of instability here.

That’s corroboration for the idea that the Fed was taking its tapering cues from Mr Stein. But Ms Yellen provides no information on how the Fed decided to risk an economic slowdown for the sake of a shift in the term premium, or whether it judges the trade-off to have been worth it, or under what circumstances it might try something similar, or whether anyone within the FOMC thought to ask whether this makes any sense at all with the unemployment rate at 6.7% and inflation at 1.2%.

That, to some extent, is the most boggling aspect of this whole mess. Whatever the source of an economic shock, one can be certain that its effect on the macroeconomy will be substantially more painful when the central bank’s response is limited by the zero lower bound. Mr Stein has himself acknowledged this; in his first speech as a governor he commented that:

If the federal funds rate were at, say, 3 percent, we would have, in my view, an open-and-shut case for reducing it.

Moving to tighten when the federal funds rate is near zero and inflation is well below target is a good way to make sure the Fed’s main interest rate never again approaches 3%. I’ll put it differently. Mr Stein has been working to take one monetary policy tool after another off the table—by warning against the riskiness of quantitative easing, by fretting over the financial dangers of a prolonged period of low interest rates, and by urging tightening well before the economy is ready for higher rates, all but guaranteeing that the zero lower bound is a constraint when the next recession strikes. He has been doing this, ostensibly, because doing so reduces the risk of a nasty financial shock.

What he doesn’t seem to appreciate is that it magnificently raises the economy’s vulnerability to shocks generally—including financial instability unwittingly triggered by the decision to lean against the wind. And the most sinister aspect of this shift is that it plays directly into the FOMC’s natural bias toward hawkishness. The economy kept refusing to give the Fed a reason to tighten, but thankfully there was Mr Stein, ready to provide. Unfortunately but perhaps unsurprisingly, the FOMC has seized the opportunity to write off millions of American workers.

I remember back in 1999 attending a Federal Reserve Bank of Boston Conference on “Monetary Policy in a Low-Inflation Environment”, at which I found myself thinking over and over again of something my great uncle Phil from Marblehead Massachusetts used to say. He once took a sailing safety examination. One question was: “What should you do if you are caught on a lee shore in a hurricane?” His answer was: “You never get caught on a lee shore in a hurricane!” He was correct. If you want to minimize financial, monetary, and economic instability, you work very very hard indeed to make sure that you are never in a position where short-term safe nominal interest rates are constrained by the zero lower bound. Yet Stein seems to Ryan Avent (and to me) to be seeking a world in which central banks are often so constrained. And the consequences of such constraint are such that back in 1902 Larry Summers and I were very enthusiastic about reducing inflation from 10%/year to 5%/year we were very wary of reducing it from 5%/year to 0:

Lawrence Summers and J. Bradford DeLong (1992): Macroeconomic Pollicy and Long-Run Growth: “Even leaving dramatic instances of policy failure like the Depression aside,

we suspect it would be a mistake to extrapolate the results on the benefits…. On almost any theory of why inflation is costly, reducing inflation from 10 percent to 5 percent is likely to be much more beneficial than reducing it from 5 percent to zero…. And there are potentially important benefits of a policy of low positive inflation…. A large easing of monetary policy, as measured by interest rates, moderated but did not fully counteract the forces generating the recession that began in 1990. The relaxation of monetary policy seen over the past three years in the United States would have been arithmetically impossible had inflation and nominal interest rates both been three percentage points lower in 1989. Thus a more vigorous policy of reducing inflation to zero in the mid-1980s might have led to a recent recession much more severe than we have in fact seen…

So what are the risks from an expanded Federal Reserve balance sheet, really? I discount the risk that members of congress might object to Federal Reserve policy: the Federal Reserve is designed precisely because we live in a world in which such objections are at times raised. I point out that, arithmetically, quantitative easing reduces rather than increases the total amount of duration risk that must be borne by the private sector, and that the reduced risk premiums observed by Fisher (and Stein) are not signs that too much risk is being borne but merely that demand curves slope up. If there is a danger to financial stability from quantitative easing, it must be that some particular financial institutions that are not backed by a government guarantee are induced to gamble for resurrection on a dangerously large scale as a result of quantitative easing. What is the evidence on that?

As the Brookings Institution’s conference organizers summarize Chodorow-Reich’s paper:

: Effects of Unconventional Monetary Policy on Financial Institutions: “As then Fed Chairman Ben Bernanke noted in May 2013 Congressional testimony:

The Fed’s policy-making Federal Open Market Committee takes”

very seriously… the possibility that very low interest rates, if maintained too long, could undermine financial stability. For example, investors or portfolio managers dissatisfied with low returns may reach for yield by taking on more credit risk, duration risk or leverage. 

But Chodorow-Reich notes that those same Fed policies also make the overall economy stronger, boosting the value of financial institutions’ portfolios and making them less risky…. [His] bottom line is:

In the present environment, there does not seem to be a trade-off between expansionary [monetary] policy and the health or stability of the financial institutions studied….

Life insurers and commercial banks: Sustained low interest rates may cause life insurers to engage in riskier behavior…. On the other hand, Fed policies raise the value of mortgages, bonds, and other assets held by life insurers, reducing their riskiness…. Chodorow-Reich… notes that the initial round of quantitative easing in 2008–09 had “a clear beneficial impact” on bank holding companies and especially on life insurers, and reduced perceptions of their riskiness…. On March 18, 2009, for instance, when the Fed announced a $1.15-trillion expansion of its planned purchases of government and agency bonds and mortgages… the price of insuring the debt of four big insurers (Allstate, MetLife, Lincoln National and Prudential) fell; the same was true for seven of eight large banks, the exception being Citigroup… financial markets see unconventional monetary policy as making life insurers and banks less risky…. Fed moves after 2009 had a more muted effect, but ranged from positive to neutral….

Money market funds: Very low interest rates pose a challenge for money market mutual funds…. Chodorow-Reich finds that money market mutual funds with higher costs did buy riskier, higher yield securities in 2009–2011, but not thereafter….

Defined-benefit pension plans: Chodorow-Reich finds that private-sector defined-benefit pension plans with larger unfunded liabilities or with a large number of current beneficiaries relative to total plan participants did reach for yield in 2009 and the following couple of years, but he finds little evidence of that in 2012. As with banks and life insurers, the favorable effects of unconventional monetary policy on the stock market have improved the solvency positions of pension funds and therefore reduced the temptation…

The particular framework in which Chodorow-Reich is working leads to the conclusion that there are highly-leveraged financial institutions with demand curves slope the wrong way when they are nearly insolvent and when interest rates are very low. Thus the worries of Stein and Fisher would possibly have systemic consequences if the economy were to worsen so much that our too-big-to-fail institutions would once again wind up in the insolvency range, but not otherwise. And even then the beneficial effects of quantitative easing on solvency do more good for financial stability and the reach-for-yield does harm.

The day after Gabriel Chodorow-Reich presented his paper at Brookings, David Wessel of Brookings’s brand-new Hutchins Center brought some economists together to talk about it:

Emily Parker, Pari Sastry, and David Wessel: Is Today’s Fed Policy Sowing Seeds of Future Financial Turmoil?: “Here are five takeaways from the lively 75-minute conversation.

1. Unconventional Monetary Policy:… Berkeley’s Annette Vissing-Jorgenson questioned whether institutions not studied by Chodorow-Reich paper, such as hedge funds, could be increasing their risk-taking behavior. MIT’s Deborah Lucas noted that the Fed’s unconventional policies were implemented during the Great Recession, and wondered if financial markets might respond in unpredictable and unconventional ways when the economy – and monetary policy – returns to normal. Princeton’s Alan Blinder argued that excess risk-taking is most worrisome if it is concentrated in highly-leveraged financial intermediaries; at the moment, it isn’t.
2. Macro-Prudential Policies: John Williams… expressed the importance of creating micro- and macro-prudential policies that the Fed can use to preserve financial stability in…. Frederick Mishkin… noted that the Fed would face strong political opposition if it chose to employ macroprudential tools….
3. Stress Tests: Brookings’ Don Kohn… said… measuring financial stability involves… a) identifying excesses… b) seeing the links between that market and other markets, and c) seeing the links between that market and highly leveraged financial intermediaries….
4. Bubbles: Mishkin explained that it can be difficult for central banks to predict and identify asset bubbles…. James Bullard… contrasted the tech bubble… which led to mild recession and left behind substantial technological innovation, with the collapse of the housing bubble in 2007… because it involved so much leverage….
5. The Mortgage Market: For MIT’s Deborah Lucas, the mortgage market is still a cause for concern and one that isn’t getting enough attention. The federal government basically has controlled the market, and she expressed concern about the risks it is taking–including by lowering Federal Housing Administration lending standards.

I think that Annette Vissing-Jorgenson is looking in the wrong place as far as hedge funds are concerned: they are not leveraged enough to be a serious source of systemic risk. And I do not understand Deborah Lucas’s fears that the government is taking on too much mortgage risk in the context of this discussion. I understand the belief that the government is not charging financial intermediaries enough for bearing their mortgage risk, And as a result is wasting taxpayers money on a mortgage banking subsidy. But I do not understand any belief that the government is raising the risk of financial crisis by doing so. Government-guarantees of domestic currency-denominated debts do not cause financial crises.

And Megan McArdle has a smart take on Chodorow-Reich:

Megan McArdle: Pension Funds’ Risky Business: “Where regulators were extremely focused on keeping firms from reaching for yield, they didn’t.

In areas where they weren’t so focused, notably pensions, you saw investors sexing up their portfolios to try to make up for the losses of 2008 and miserly interest rates on safer investments. That suggests that pension regulators should be paying a lot more attention to pension fund portfolios in times of market stress.

Although I would note that we do have mechanisms in place for resolving pension-fund insolvency without triggering any runs of any sort.

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