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Tuesday, September 4, 2012

Strong Push Back at Jackson Hole

In his Jackson Hole speech, Ben Bernanke argued that quantitative easing (in particular Large Scale Asset Purchases, or LSAPs) has had large macroeconomic effects, saying that “a study using the Board’s FRB/US model of the economy found that, as of 2012, the first two rounds of LSAPs may have raised the level of output by almost 3 percent and increased private payroll employment by more than 2 million jobs, relative to what otherwise would have occurred.” He footnoted a Fed paper by Hess Chung et al, in which the authors plugged in other people’s estimates of the impact of LSAPs on long term rates into the FRB/US model which does not have its own estimates.

However, a number of conference participants pushed back on this view, including John Ryding of RDQ, Mickey Levy of Bank of American and me, but most of all Michael Woodford whose paper showed in detail how empirical evidence and basic economic theory did not support these beneficial effects.

Woodford’s empirical evidence included a simple graph (Fig 15) showing that there was no economic growth effect around the times of the expansions in the size of the Fed’s balance and thus that the quantitative easing had “little evident effect on aggregate nominal expenditure…”

He challenged the view that the LSAPs lowered long term rates or at least had the kind of impact assumed by Chung et al. He explained that “‘portfolio-balance effects’ do not exist in a modern, general-equilibrium theory of asset prices…” which is what many of us have been teaching students for thirty years. 

He questioned the various event studies cited by the Fed, such as Gagnon et al, saying "it is not clear that their announcement-days-only measure should be regarded as correct."

He showed that the often-cited evidence reported by Arvind Krishnamurthy and Annette Vissing-Jorgensen that “purchases of long-term Treasuries could raise the price of (and so lower the yield on) Treasuries…would not necessarily imply any reduction in other long-term interest rates, since the increase in the price of Treasuries would reflect an increase in the safety premium, and not necessarily any increase in their price apart from the safety premium…This means that while the US Treasury would then be able to finance itself more cheaply at the margin, there would not necessarily be any such benefit for private borrowers, and hence any stimulus to aggregate expenditure….There seems little reason to believe that purchases of long-term Treasuries should be an effective way of lowering the kind of longer-term interest rates that matter most for stimulating economic activity.”

Woodford also questioned the beneficial impacts of forward guidance as practiced by the Fed so far, saying that “simply presenting a forecast that the policy rate will remain lower for longer than had previously been expected, in the absence of any reason to believe that future policy decisions will be made in a different way, runs the risk of being interpreted as simply an announcement that the future is likely to involve lower real income growth and/or lower inflation than had previously been anticipated — information that, if believed, should have a contractionary rather than an expansionary effect.”

In Woodford’s view, forward guidance could have achieved positive effects if it had “made it clear that short-term interest rates will not immediately be increased as soon as a Taylor rule descriptive of past FOMC behavior would justify a funds rate above 25 basis points,” because “this would provide a reason for market participants to expect easier future monetary and financial conditions than they may currently be anticipating, and that should both ease current financial conditions and provide an incentive for increased spending.”

Many Fed watchers interpreted the benefit-cost analysis in Ben Bernanke’s speech as signaling more quantitative easing. But viewed in the context of the whole Jackson Hole meeting, which many FOMC members attended, the benefits are considerably smaller than stated in that speech, and perhaps even negative.