Further reflections on QE2

As the chart above shows, 30-yr Treasury yields and equity prices have been moving higher ever since the end of August, which happens to be when the Fed first began to float the idea of QE2. Proponents of QE2 say this proves their case—that QE2 was needed and has been effective. Opponents of QE2 say just the opposite, that this proves QE2 was unnecessary and has been ineffective. The truth probably lies somewhere between.

Supporters of QE2 argue that QE2 has given the economy a boost (witness the 20% rise in equity prices since QE2 was first floated) and it has vanquished deflation fears (as reflected in the almost 100 bps rise in long bond yields, plus the rise in 5-yr, 5-yr forward breakeven inflation expectations from 2% to almost 3%—see chart below). Boosting the economy and raising inflation expectations was exactly what QE2 was meant to do, so it has worked.

So far this makes sense, but it doesn't jibe with the Fed's claim that QE2 would boost the economy by depressing bond yields and keeping borrowing costs low. Since QE2 actually go underway in early November, Treasury yields haven't fallen at all—they've actually risen a lot—and corporate borrowing costs have also risen. According to Merrill Lynch, yields on investment grade bonds have risen about 60 bps since the Fed began its QE2 purchases of Treasuries, while yields on high-yield bonds have risen about 30 bps. That's not a lot, in the great scheme of things, but it's hard to see from these facts how QE2 has stimulated the economy. For more detail on how Quantitative Easing has worked so far, please see this post.

But it does make sense that if a government program were successful in stimulating the economy, then we would expect to see higher bond yields, since a stronger economy almost always goes hand in hand with higher bond yields—especially since bond yields were extraordinarily depressed last summer because of concerns that the economy was slipping into a double-dip recession. But are higher bond yields proof that Fed purchases of Treasuries are stimulating the economy? Not necessarily.

An alternative explanation—one that I and others have been advancing—is that QE2 was never necessary, and has been counterproductive, since all it has done is to push inflation expectations up, weaken the dollar, and boost commodity prices. What was really necessary back in August was for the Fed to convince the world that deflation was no longer a risk. The fear of deflation had been a drag on confidence and animal spirits ever since late 2008, when deflation expectations first became firmly embedded in TIPS prices. As I mentioned quite a few times, fear and uncertainty have played a major role in the recent recession and recovery, so anything which reduced investor fears would likely improve the economy's prospects. Deflation fears have surely worried many of the FOMC governors, especially Bernanke, and those fears have generated some contagion among the wider public. If QE2 has been successful, it is because it has raised inflation expectations and thus all but vanquished the fear of deflation, not because it has stimulated the economy.

Deflation was always more of a theoretical rather than a real risk, since while some measures of inflation were sliding perilously close to zero in recent months, others were rising (e.g., the GDP deflator was -0.3% in Q4/09 but rose to 2.0% in Q3/10). Similarly, although housing prices have been plunging, commodity prices have been soaring; we are nowhere near a deflationary situation, which is defined as a general decline in the overall price level. Plus, key indicators of liquidity conditions last summer were suggesting an abundant supply of dollars: the dollar was demonstrably weak, while gold and energy prices were rising, and swap spreads were very low.  What was needed was some positive shock to investors' confidence about in the future, not more dollars in circulation.

Another reason to think that QE2 wasn't necessary is that it didn't actually get approved until October and wasn't implemented until the first part of November, yet equity prices started rising the day after the idea of QE2 was first floated, and commodity prices were rising strongly by late July. We've only just begun to see a meaningful amount of Treasury purchases, and little if any evidence of unusual expansion in any measures of the money supply. In short, the evidence supports the notion that the economy was doing fine before QE2 started, and QE2 has not had any demonstrable impact on the economy beyond raising inflation expectations and eliminating deflation fears. As the charts below show, M2 growth has only been 4.5% annualized over the past six months, and 3.6% annualized over the past two years.

What this all means is that while QE2 may well have made a positive contribution to the economy to date, there is a risk that it could create a good deal of fear and uncertainty in the future. The Fed is creating hundreds of billions of new bank reserves that are sitting idle. Should banks decide to put them to work, no one knows whether the Fed can reverse course fast enough to prevent a true eruption of inflation.