Must-Read: Michael Woodford: Quantitative Easing and Financial Stability

Must-Read: The extremely sharp Michael Woodford makes the obvious point about quantitative easing and financial stability: by increasing the supply and thus reducing the premium on safe liquid assets, it should–if demand and supply curves slope the normal way–not increase but reduce the risks of the banking sector.

It is very, very nice indeed to see Mike doing the work to demonstrate that I was not stupid when I made this argument in partial equilibrium:

J. Bradford DeLong (January 17, 2014): “Beer Goggles”, Forward Guidance, Quantitative Easing, and the Risks from Expansionary Monetary Policy: When the Federal Reserve undertakes quantitative easing, it enters the market and takes some risk off the table, buying up some of the risky assets issued by the U.S. government and its tame mortgage GSEs and selling safe assets in exchange. The demand curve for risk-bearing capacity seen by the private market thus shifts inward, to the left: a bunch of risky Treasuries and GSEs are no longer out there, as the government is no longer in the business of soaking-up as much of the private-sector’s risk-bearing capacity:


And this leftward shift in the net demand to the rest of the market for risk-bearing capacity causes the price of risk to fall, and the quantity of risk-bearing capacity supplied to fall as well. Yes, financial intermediaries that had held Treasuries and thus carried duration risk take some of the cash they received by selling their risky long-term Treasuries to the Fed and go out and buy other risky stuff. But the net effect of quantitative easing is to leave investors and financial intermediaries holding less risky portfolios because they are supplying less risk-bearing capacity…

It is reassuring that I was not stupid–that there is nothing important in general equilibrium that I had missed:

Michael Woodford: Quantitative Easing and Financial Stability: “Conventional interest-rate policy, increases in the central bank’s supply of safe (monetary) liabilities, and macroprudential policy…

…are logically independent dimensions of variation in policy… [that] jointly determine financial conditions, aggregate demand, and the severity of the risks associated with a funding crisis in the banking sector…. If one thinks that the [risk] premia that exist when market pricing is not “distorted” by the central bank’s intervention provide an important signal of the degree of risk that exists in the marketplace, one might fear that central-bank actions that suppress this signal–not by actually reducing the underlying risks, but only by preventing them from being reflected so fully in market prices–run the danger of distorting perceptions of risk in a way that will encourage excessive risk-taking. The present paper… argues… that the concerns just raised are of little merit….

Quantitative easing policies can indeed effectively relax financial conditions…. Risks to financial stability are an appropriate concern of monetary policy deliberations…. Nonetheless… quantitative easing policies should not increase risks to financial stability, and should instead tend to reduce them…. Investors are attracted to the short-term safe liabilities created by banks or other financial intermediaries because assets with a value that is completely certain are more widely accepted as a means of payment. If an insufficient quantity of such safe assets are supplied by the government (through means that we discuss further below), investors will pay a “money premium” for privately-issued short-term safe instruments with this feature, as documented by Greenwood et al. (2010), Krishnamurthy and Vissing-Jorgensen (2012), and Carlson et al. (2014). This provides banks with an incentive to obtain a larger fraction of their financing in this way… choose an excessive amount of this kind of financing… because each individual bank fails to internalize the effects of their collective financing decisions on the degree to which asset prices will be depressed in the event of a “fire sale.” This gives rise to a pecuniary externality, as a result of which excessive risk is taken in equilibrium (Lorenzoni, 2008; Jeanne and Korinek, 2010; Stein, 2012)….

Cut[ting] short-term nominal interest rates in response to an aggregate demand shortfall can arguably exacerbate this problem, as low market yields on short-term safe instruments will further increase the incentive for private issuance of liabilities of this kind (Adrian and Shin, 2010; Giavazzi and Giovannini, 2012)…. Quantitative easing policies lower the equilibrium real yield on longer-term and risky government liabilities, just as a cut in the central bank’s target for the short-term riskless rate will, and this relaxation of financial conditions has a similar expansionary effect on aggregate demand in both cases. Nonetheless, the consequences for financial stability are not the same…. Conventional monetary policy[‘s] reduction in the riskless rate lowers the equilibrium yield on risky assets… [by] provid[ing] an increased incentive for maturity and liquidity transformation on the part of banks…. In the case of quantitative easing, instead, the equilibrium return on risky assets is reduced… through a reduction rather than an increase in the spread…. The idea that quantitative easing policies, when pursued as an additional means of stimulus when the risk-free rate is at the zero lower bound, should increase risks to financial stability because they are analogous to an expansionary policy that relaxes reserve requirements on private issuers of money-like liabilities is also based on a flawed analogy…. In the model presented here, quantitative easing is effective at the zero lower bound… because an increase in the supply of safe assets… reduces the equilibrium “money premium”… [which reduces] banks’ issuance of short-term safe liabilities… so that financial stability risk should if anything be reduced….

[This] paper develops these points in the context of an explicit intertemporal monetary equilibrium model, in which it is possible to clearly trace the general-equilibrium determinants of risk premia, the way in which they are affected by both interest-rate policy and the central bank’s balance sheet, and the consequences for the endogenous capital structure decisions of banks…

Must-read: Peter Praet: Interview with La Repubblica

Must-Read: SOCIAL CREDIT!! The helicopters are not in the air, not on the runway with rotors spinning, not on the tarmac, but they are in the hangar undergoing maintenance checks…

Peter Praet: Interview with La Repubblica: “External shocks can easily trigger a vicious circle, with further downward pressure on inflation…

…We wanted to ensure that this did not happen, in line with our mandate. It was decided by the vast majority in the Governing Council, that we had to act very forcefully to ensure an even more accommodative monetary policy stance…. We decided in favour of a package which still made use of changes in the ECB interest rates but increased the weight of measures aimed at credit easing…. The measures we took should bring us close to the 2 per cent target at the end of 2018. But don’t forget, the measures we take like the APP are supposed to remain in place as long as inflation has not reached a sustainable adjustment….

There has been a lot of skepticism recently about monetary policy, not only in delivering but in saying ‘your toolbox is empty’. We say, ‘no it’s not true’. There are many things you can do. The question is what is appropriate, and at what time. I think for the time being we have what we have, and it is not appropriate to discuss the next set of measures…. [But] you can issue currency and you distribute it to people. That’s helicopter money. Helicopter money is giving to the people part of the net present value of your future seigniorage…. The question is, if and when is it opportune to make recourse to that sort of instrument…

Must-read: Draghi Day

Must-Read: FastFT: Draghi Day: “Rabobank describes the wild market moves that followed the European Central Bank rates decision and press conference as ‘carnage’…

…Whether that’s the ECB’s fault or the markets’ depends on who you speak to. Here’s a taste…. Jim Reid at Deutsche Bank sees signs of a strop in the market…. “Imagine you were expecting a trip during school holidays in a caravan around the country but instead you can take 2 weeks off school, fly first class to Disneyworld, have a go in the cockpit on the way, stay at a hotel made of chocolate, and then be able to go on every ride every day without queuing and have a private play session with the real Mickey Mouse as each day draws to a close. However if the market was the same kid its reaction yesterday was ‘do I not get unlimited spending money, and where are we going for our summer holidays then?’”…

Frederik Ducrozet at Pictet says ‘don’t fight the ECB’: “Such a policy package designed to boost bank lending and to improve QE implementation should lead to a significant easing of monetary and financial conditions. We are positive on the net impact….” Peter Schaffrik at RBC: “We do not share the negativity and could well imagine that the initiative to engage in risky assets will find more coverage going forward.”… And the economics team at BNP Paribas….

Now for the critics…. Lutz Karpowitz from Commerzbank says the central bank is ‘firing blanks’. He has issues with TLTRO 2, where the banks can effectively fund their lending at negative rates from the ECB…. Grant Lewis from Daiwa…. “The cost of finance is only one consideration for banks when deciding whether to lend or not – of at least equal importance is how the underlying economy, and hence the loan itself, is expected to perform. And on that measure it’s far from certain that today’s announcements will prove transformative to the economic outlook. Indeed, the ECB’s own forecast for 2017 sees growth of just 1.7% and inflation well below target at just 1.3%.” Rabobank’s Piotr Matys says ECB can forget about talking the euro down: “The damage to bearish bets against the euro, however, has been done. Those market participants, including yours truly, who went into the ECB meeting with a bearish view on the euro ended Thursday’s session calculating their losses instead of celebrating profits… after such a massive blow as on Thursday Draghi and other ECB officials may find it even more difficult, if they choose to do so, to talk the euro down.”

Citi‘s rates team says Draghi’s bazooka has ‘backfired’: “The bazooka backfired because the ECB is taking rate cuts off the table. We expect easing to be priced out. The measures do little to convince us that realised inflation will move higher any time soon.” That said, the same bank’s emerging-markets team says ‘the ECB delivered’: “There is now an incentive to move away from a policy fully centered on negative rates, to a toolset centered on further relief of financing in the banking sector. The markets should be cheering that, rather than reacting in a negative way.”

Quantitative easing: Walking the walk without talking the talk?

The extremely sharp Joe Gagnon is approaching the edge of shrillness: He seeks to praise the Bank of Japan for what it has done, and yet stress and stress again that what it has done is far too little than it should and needs to do:

Joe Gagnon: The Bank of Japan Is Moving Too Slowly in the Right Direction: “Bank of Japan Governor Haruhiko Kuroda’s bold program…

…has made enormous progress, but it has fallen well short of its goal of 2 percent inflation within two years. Now is the time for a final big push… The government of Prime Minister Shinzo Abe could help by raising the salaries of public workers and taking other measures to increase wages…. But the BOJ should not make inaction by the government an excuse for its own passivity…. The BOJ needs to make a convincingly bold move now… lowering its deposit rate to -0.75 percent… step up purchases of equities to 50 trillion yen…. The paradox of quantitative easing… is that central banks that were slowest to engage in it at first (the BOJ and the European Central Bank) are being forced to do more of it later…. If the BOJ does not move boldly now, it will have to do even more later.

Those of us who are, like me, broadly in Joe Gagnon’s camp are now having to grapple with an unexpected intellectual shock. When 2010 came around and when the “Recovery Summers” and “V-Shaped Recoveries” that had been confidently predicted by others refused to arrive, we once again reached back to the 1930s. We remembered the reflationary policies of Neville Chamberlain, Franklin Delano Roosevelt, Takahashi Korekiyo, and Hjalmar Horace Greeley Schacht gave us considerable confidence that quantitative easing supported by promises that reflation was the goal of policy would be effective. They had been ineffective in the major catastrophe of the Great Depression. They should, we thought, also be effective in the less-major catastrophe that we started by calling the “Great Recession”, but should now have shifted to calling the “Lesser Depression”, and in all likelihood will soon be calling the “Longer Depression”.

Narayana Kocherlakota’s view, if I grasp it correctly, is that in the United States the Federal Reserve has walked the quantitative-easing walk but not talked the quantitative-easing talk. Increases in interest rates to start the normalization process have always been promised a couple of years in the future. Federal Reserve policymakers have avoided even casual flirtation with the ideas of seeking a reversal of any of the fall of nominal GDP or the price level vis-a-vis its pre-2008 trend. Federal Reserve policymakers have consistently adopted a rhetorical posture that tells observers that an overshoot of inflation above 2%/year on the PCE would be cause for action, while an undershoot is… well, as often as not, cause for wait-and-see because the situation will probably normalize to 2%/year on its own.

By contrast, Neville Chamberlain was very clear that it was the policy of H.M. Government to raise the price level in order to raise the nominal tax take in order to support the burden of amortizing Britain’s WWI debt. Franklin Delano Roosevelt was not at all clear about what he was doing in total, but he was very clear that raising commodity prices so that American producers could earn more money was a key piece of it. Takahashi Korekiyo. And all had supportive rather than austere and oppositional fiscal authorities behind them.

But, we thought, monetary policy has really powerful tools expectations-management and asset-supply management tools at its disposal. They should be able to make not just a difference but a big difference. And yet…

There are three possible positions for us to take now:

  1. In a liquidity trap, monetary policy is not or will rarely be sufficient to have any substantial effect—active fiscal expansionary support on a large scale is essential for good macroeconomic policy.
  2. In a liquidity trap, monetary policy can have substantial effects, but only if the central bank and government are willing to talk the talk by aggressive and consistent promises of inflation—backed up, if necessary, by régime change.
  3. We are barking up the wrong tree: there is something we have missed, and the models that we think are good first-order approximations to reality are not, in fact, so.

I still favor a mixture of (2) and (1), with (2) still having the heavier weight in it. Larry Summers is, I think, all the way at (1) now. But the failure of the Abenomics situation to have developed fully to Japan’s advantage as I had expected makes me wonder: under what circumstances should I being opening my mind to and placing positive probability on (3)?

(AP Photo/Koji Sasahara)

Must-read: Joe Gagnon: “The Bank of Japan Is Moving Too Slowly in the Right Direction”

Must-Read: Joe Gagnon: The Bank of Japan Is Moving Too Slowly in the Right Direction: “Bank of Japan Governor Haruhiko Kuroda’s bold program…

…has made enormous progress, but it has fallen well short of its goal of 2 percent inflation within two years. Now is the time for a final big push…. On January 29, the Bank of Japan (BOJ) announced a complicated program to pay different rates of interest on tranches of deposits that banks hold with the BOJ…. Financial markets quickly reacted positively: Real bond yields fell, the yen fell, and stock prices rose. But much of these gains were erased in subsequent days, probably because markets came to believe the effects of the new policy would be small…. Ten-year inflation compensation is now only 0.5 percent, a clear message that markets expect the BOJ to fail to deliver 2 percent inflation….

A shift from 0.1 to -0.1 percent on a small fraction of BOJ deposits is a tiny move…. The BOJ should move to -0.75 percent on future increases in deposits, while paying 0 percent on the current stock of deposits. The BOJ’s program of asset purchases since 2013 moved the best measure of core inflation (consumer prices excluding energy and fresh food) from nearly -1 percent to more than 1 percent. This is about two-thirds of the way to its goal…. But the BOJ cannot afford to make only tiny adjustments to its policies at this time…. The government of Prime Minister Shinzo Abe could help by raising the salaries of public workers and taking other measures to increase wages recently recommended by Olivier Blanchard and Adam Posen in the Nikkei Asian Review. But the BOJ should not make inaction by the government an excuse for its own passivity…. The BOJ needs to make a convincingly bold move now… lowering its deposit rate to -0.75 percent… step up purchases of equities to 50 trillion yen….

The paradox of quantitative easing in the past seven years is that central banks that were slowest to engage in it at first (the BOJ and the European Central Bank) are being forced to do more of it later than those central banks that embraced it earlier (the Bank of England and the Federal Reserve). If the BOJ does not move boldly now, it will have to do even more later.

Must-Read: Gauti Eggertson and Michael Woodford: The Zero Bound on Interest Rates and Optimal Monetary Policy

Must-Read: The reality-based piece of the macroeconomic world is right now divided between those who think (1) that Bernanke shot himself in the foot and robbed himself of all traction by refusing to embrace monetary régime change and a higher inflation target, and thus neutered his own quantitative-easing policy; and (2) that at least under current conditions markets need to be shown the money in the form of higher spending right now before they will give any credit to factors that make suggest they should raise their expectation of future inflation. What pieces of information could we seek out that would help us decide whether (1) or (2) is correct?

Gauti Eggertson and Michael Woodford (2003): The Zero Bound on Interest Rates and Optimal Monetary Policy: “Our dynamic analysis also allows us to further clarify the several ways…

…in which the central bank’s management of private sector expectations can be expected to mitigate the effects of the zero bound. Krugman emphasizes the fact that increased expectations of inflation can lower the real interest rate implied by a zero nominal interest rate. This might suggest, however, that the central bank can affect the economy only insofar as it affects expectations regarding a variable that it cannot influence except quite indirectly; it might also suggest that the only expectations that should matter are those regarding inflation over the relatively short horizon corresponding to the term of the nominal interest rate that has fallen to zero. Such interpretations easily lead to skepticism about the practical effectiveness of the expectations channel, especially if inflation is regarded as being relatively “sticky” in the short run.

Our model is instead one in which expectations affect aggregate demand through several channels…. Inflation expectations, even… [more than] a year into the future… [are] highly relevant… the expected future path of nominal interest rates matters, and not just their current level… any failure of… credib[ility] will not be due to skepticism about whether the central bank is able to follow through on its commitment…

Must-Read: Joseph E. Gagnon: Is QE Bad for Business Investment? No Way!

Must-Read: Also Larry Summers.

The important thing here, I think, is to have Bernanke’s back. Bernanke is right: QE was worth trying ex ante, and ex post it looks as though it was worth doing–and I would say it was worth doing more of it than he did. If there are arguments that Bernanke’s QE policy is wrong, they need to be arguments–not mere expressive word-salad.

Spence and Warsh are attacking Bernanke’s monetary policy. Why? It’s not clear–they claim that business investment is low because Bernanke’s QE policies have retarded it. But they do not present anything that I would count as an argument or evidence to that effect. As I see it, they are supplying a demand coming from Republican political masters, who decided that since Obama renominated Bernanke the fact that Bernanke was a Republican following sensible Republican policies was neither here nor there: that they had to oppose him–DEBAUCHING THE CURRENCY!!

And Warsh and Spence are meeting that demand, and meeting it when a more sensible Republican Party–and more sensible Republican economists–would be taking victory laps on how the George W. Bush-appointed Republican Fed Chair Ben Bernanke produced the best recovery in the North Atlantic.

I don’t know why Warsh is in this business, lining up with the Randites against Bernanke, other than hoping for future high federal office. And I am with Krugman on Spence: I have no idea why Spence is lining up with Warsh here–he is very sharp, even if he did give me one of my two B+s ever. What’s the model?

Joseph E. Gagnon: Is QE Bad for Business Investment? No Way!: “There is no logical or factual basis for their claim…

…It is the reluctance of businesses and consumers to spend in the wake of a historic recession that is forcing the Fed and other central banks around the world to keep interest rates unusually low–not the other way around…. Economies in which central banks were most aggressive in conducting QE early in the recovery (the United Kingdom and the United States) have been growing more strongly than economies that were slow to adopt QE (the euro area and Japan). At the top of their piece, the authors pull a classic bait and switch, noting ‘gross private investment’ has grown slightly less than GDP since late 2007. Yet the shortfall in private investment derives entirely from housing. No one believes that Fed purchases of mortgage bonds tanked the housing market. The whole premise of the article, that business investment is excessively weak, is simply false….

But the piece also fails a basic test of common sense. Spence and Warsh posit that ‘QE has redirected capital from the real domestic economy to financial assets at home and abroad.’ This statement reveals a fundamental misunderstanding of what financial assets are. They are claims on real assets. It is not possible to redirect capital from financial assets to real assets, since the two always are matched perfectly. Equities and bonds are (financial) claims on the future earnings of (real) businesses. Spence and Warsh accept that QE raised the prices of equities and bonds. Yet they seem ignorant of the effect this has on incentives to invest…. True, some businesses have used rising profits to buy back their own stock. But that is a business prerogative that points to lackluster investment prospects and cannot be laid at the feet of easy Fed policy…. [If] QE has raised stock prices, it discourages businesses from buying back stock because it makes that stock more costly to buy…

Department of “Huh!?!?”: QE Has Retarded Business Investment!?

Kevin Warsh and Michael Spence attack Ben Bernanke and his policy of quantitative easing, which they claim “has hurt business investment.”

2015 10 06 for 2015 10 07 DeLong ULI key

I score this for Bernanke: 6-0, 6-0, 6-0.

In fact, I do not even think that Spence and Warsh understand that one is supposed to have a racket in hand when one tries to play tennis. As I see it, the Fed’s open-market operations have produced more spending–hence higher capacity utilization–and lower interest rates–has more advantageous costs of finance–and we are supposed to believe that its policies “have hurt business investment”?!?!

Michael Spence and Kevin Warsh: The Fed Has Hurt Business Investment: “Bernanke[‘s view]… may well be true according to economic textbooks…

…But textbooks presume the normal conduct of policy and that the prices of financial assets like stocks and bonds are broadly consistent with expectations for the real economy. Nothing could be further from the truth in the current recovery…. Earnings of the S&P 500 have grown about 6.9% annually… pales in comparison to prior economic expansions… half of the profit improvement… from… share buybacks. So the quality of earnings is as deficient as its quantity…. Extremely accommodative monetary policy… $3 trillion in… QE pushed down long-term yields and boosted the value of risk-assets…. Business investment in the real economy is weak. While U.S. gross domestic product rose 8.7% from late 2007 through 2014, gross private investment was a mere 4.3% higher. Growth in nonresidential fixed investment remains substantially lower than the last six postrecession expansions….

As I have said before and say again, weakness in overall investment is 100% due to weakness in housing investment. Is there an argument here that QE has reduced housing investment? No. Is nonresidential fixed investment below where one would expect it to be given that the overall recovery has been disappointing and capacity utilization is not high? No. The U.S. looks to have an elevated level of exports, and depressed levels of government purchases and residential investment. Given that background, one would not be surprised that business investment is merely normal–and one would not go looking for causes of a weak economy in structural factors retarding business investment. One would say, in fact, that business investment is a relatively bright spot.

Yes, businesses have been buying back shares. How would the higher interest rates and higher risk spreads in the absence of QE retard that? They wouldn’t. Yes, earnings growth from business operations over the past five years has been slower than in earlier expansions. How has QE dragged on earnings growth. It hasn’t.

Efforts by the Fed to fill near-term shortfalls in demand… have shown limited and diminishing signs of success. And policy makers refuse to tackle structural, supply-side impediments to investment growth, including fundamental tax reform.

And the Federal Reserve’s undertaking of QE has hampered efforts to engage in “fundamental tax reform” how, exactly? Is an argument given here? No, it is not.

We believe that QE has redirected capital from the real domestic economy to financial assets…. How has monetary policy created such a divergence between real and financial assets?

OK: Now there is a promise that there will be some meat in the argument.

How do Spence and Warsh say QE has reduced corporate investment? Let’s look:

First, corporate decision-makers can’t be certain about the consequences of QE’s unwinding on the real economy… [that] translates into a corporate preference for shorter-term commitments–that is, for financial assets….

Let’s see: when QE is unwound, asset prices are likely to fall. The period of QE may have boosted the economy and created a virtuous circle–in which case unwinding QE will still leave asset prices higher than they would have been in its absence. Unwinding QE may return asset supplies and demands to where they would have been if it had never been undertaken–in which asset prices will be what they would have been in its absence. Is there a story by which first winding and then unwinding QE leaves asset prices afterwards lower than in QE’s absence? Is there? Anyone? Anyone? Bueller?

Without an argument that the round-trip will leave lower asset prices than the absence of QE, this “uncertainty” argument is incoherent. No such argument is offered.

And I cannot envision what such an argument would be.

The financial crisis taught an important lesson…. Illiquidity can be fatal….

So in the absence of QE people would have forgotten about the financial crisis and would be eager to get illiquid–no, wait a minute! This is not an argument that QE has depressed business investment.

QE reduces volatility in the financial markets, not the real economy…. Much like 2007, actual macroeconomic risk may be highest when market measures of volatility are lowest…

QE reduces volatility in financial markets by making some of the risk tolerance that was otherwise soaked up bearing duration risk free to bear other kinds of risk. That is what it is supposed to do. With more risk tolerance available, more risky real activities will be undertaken–and so microeconomic risk will grow. A higher level of activity with more risky enterprises being undertaken is the point of QE. To say that it pushes up macroeconomic risk is to say that it is doing its job, isn’t it? If that isn’t its job, then there needs to be an argument to that effect, doesn’t there? I do not see one.

QE’s efficacy in bolstering asset prices may arise less from the policy’s actual operations than its signaling effect…

The originator of the idea of signaling equilibrium thinks that such a thing is bad? If QE has effects because it is an informative signal, then it is a good thing as long as its dissipative costs are not large. Is an argument offered that its dissipative costs are large? No. Is there reason to think that its dissipative costs are large? No.

We recommend a change in course. Increased investment in real assets is essential to make the economic expansion durable.

And unwinding QE more rapidly accomplishes this how, exactly? In the absence of QE increased investment in real assets would be higher why, exactly?

If you set out to take Vienna, take Vienna. If you are going to argue that QE has reduced real business investment, argue that QE has reduced real business investment. I see no such argument anywhere in the column.

So Warsh and Spence should not be surprised at my reaction: “Huh!?!?!” and “WTF!?!?!?!?”