Tuesday, August 13, 2013

Why QE was a successful failure

Taken at face value, the most massive expansion of a major central bank's balance sheet in history, in which almost $2.5 trillion was added to the U.S. monetary base for the purpose of artificially lowering long-term interest rates in order to stimulate the economy, was a failure. Why? Because 10-yr Treasury yields are no lower today than they were when QE1 was first announced in late November, 2008, and 30-yr Treasury yields are actually a bit higher, and because real GDP has grown at a 1.6% annualized pace over the same period, making this the weakest recovery on record. These facts say that the Fed was incapable of bringing down interest rates, and did absolutely nothing to boost the economy.


The first round of Quantitative Easing involved the purchase of about $1.3 trillion of MBS, $0.3 trillion of Treasuries, and $0.1 trillion of Agency debt. Over the course of 17 months, Fed purchases essentially doubled the monetary base. With the addition of QE 2 and QE 3, the Fed has effectively quadruped the size of the monetary base compared to what it was at the end of the third quarter 2008. The last five years of U.S. monetary history were absolutely unprecedented in both size and scope, and for that reason alone there has been much confusion as to what was really happening. Was the Fed crazy? Did they want to destroy the dollar and bring on hyperinflation? Was the economy so weak that gargantuan amounts of monetary stimulus failed to move the economic needle?


The chart above shows the periods during which each QE program was in effect. In addition, it shows the 15-month period during which the Fed attempted, via what it called "Operation Twist," to bring down long-term rates by selling short-term securities and buying long-term securities. Note how 10-yr yields ended up higher at the end of each round of QE, and how they were unchanged at the conclusion of Operation Twist. There is absolutely no evidence here that quantitative easing has lowered interest rates.


Part of the Fed's balance sheet expansion, almost $400 billion, was necessary to allow the expansion of currency in circulation, which has grown at an 8% annualized pace since the third quarter of 2008. Since the Fed only issues currency on demand, this expansion is not considered to be "stimulative." This is what the Fed needed to do to accommodate the very strong worldwide demand for U.S. currency during a time of financial market and economic turmoil. Most of the remainder of the reserves created by QE is being held today in the form of "excess reserves." Banks have apparently been content to accumulate a massive amount of reserves (which are not money and are held on the Fed's books) because they are functionally equivalent (and in a sense superior) to T-bills. Reserves are virtually as safe as T-bills, since the Fed can't default, and they carry what is presumed to be a floating interest rate. Reserves currently pay an interest rate of 0.25%, which is more than the 0.05% rate of interest that can be had on actual T-bills.


It's hard to believe, but the net result of the Fed's Treasury bond purchases was to restore the Fed's holding of marketable Treasuries to about the same percentage as it held prior to 2008. This obscures the fact, however, that most of the decline in the Fed's holdings of Treasuries in early 2008 was the result of the Fed's sale of most of its T-bill holdings, which in turn was necessary given the world's voracious demand for safe assets at the time; bills were in desperately short supply at the time.

BUT, when viewed from a different perspective, the Fed's balance sheet expansion was a success, since (with the benefit of hindsight) it served to accommodate the world's enormous demand for safe assets. In effect, the Fed's monetary expansion was equal to the world's increased demand for safe assets. Without all that QE, there would have been a serious shortage of safe money in the world, and that could have been deflationary and/or contractionary.


As the chart above shows, there has been no acceleration of inflation since the Fed began its aggressive balance sheet expansion. Indeed, many have worried that inflation in recent years has been too low. To borrow from Milton Friedman's classic description of inflation, we can argue from the evidence (inflation, or the lack thereof) that the Fed's supply of money was not greater than the world's demand for money. It was pretty close to being just about right.

If there is any revelation here, it is that the real point of QE was not to lower bond yields, but to create bank reserves for a world that desperately wanted them. It also follows, I would argue, that the Fed has little or no power to directly influence bond yields. Bond yields are determined by the market's desire to hold the outstanding stock of bonds, which is measured in the tens of trillions, since a good portion of the global bond market trades relative to Treasuries. The Fed's bond purchases have been paltry in comparison to the size of global bond market. Since Fed purchases have little or no impact on bond yields (or the economy), then it follows that the cessation of such purchases should have little or no impact either. Tapering is not something to fear.

Finally, this analysis suggests that bond yields are up over the past year not because the Fed is considering tapering its purchases, but because the market is less eager to hold bonds at extremely yields. The world's declining demand for bonds, in turn, is likely related to the market's growing perception that the U.S. economy rests on a more solid foundation these days—that the economy is more likely to be able to sustain growth in the future. As fears decline, the demand for safe assets declines as well, and this can be seen in the 25% decline in the price of gold over the past nine months and in the 130 bps rise in real yields on 5-yr TIPS.

In this sense, the rise of bond yields and the apparent "failure" of QE is actually a testament to the Fed's success. Bond yields are up because the world is leaving behind the fear and loathing that kept bond yields depressed for the past several years, and the Fed—through its aggressive provision of bank reserves—can take a good deal of credit for vanquishing the fears which have contributed to keep economic growth rates disappointingly slow.

Quantitative Easing: the financial world's biggest, most spectacular, and most successful "failure."

More background on many of the points touched on in this post can be found here, here, here, and here.

15 comments:

Benjamin said...

Very interesting post.

One point:

QE was never intended to lower interest rates. Central banks go to QE when they are in the "zero lower bound" or rates are already dead. In fact higher interest rates are a goal of QE.

I think the Fed has always been too timid in its use of QE, first limiting the size and duration of QE purchases, and then finally hitting stride by committing to an open-ended program dependent upon results---that is, they will buy $80 billion a month in bonds until unemployment or inflation hit certain levels. Scott Sumner has suggested that QE should actually "taper up" until certain goals are hit and I think that idea has a lot of merit.

To reduce QE now does not strike me as prudent, is is probably reckless. The threat now is not inflation, indeed, some moderate inflation would be a good thing. The risk is that we sink back into being a Japan.

Shessh, call me crazy, but i like prosperity, boom times, Fat City.

The problem is, central bankers regard such outcomes with suspicion and aversion.

Side note on the Fed paying interest on excess bank reserves. This perhaps should be scaled down. Some say IOER encourages banks to just sit on their reserves and not lend them out. But, as Grannis has pointed out, C&I lending has risen nicely, perhaps because of the QE program. Real estate ;ending seems to back on track.

Anyway, one must remember that central bankers are bankers first---the IOER is a policy designed by bankers for bankers.

theyenguy said...

QE was a stunning success as it has brought in Liberalism's Peak Sovereignty and Peak Seigniorage, that is Peak Moneyness.

The world has attained Peak Sovereignty, as is seen in Small Cap Nation Investment, IFSM, Nation Investment, EFA, World Producers, FXR, and Small Cap Pure Value Stocks, topping out in value.

And, the world has attained Peak Seigniorage, that is Peak Moneyness, as the hoped for end game with Quantitave Easing, read money printing,was done to achieve four purposes, and has proven to be extremely successful.


Firstly, to increase the M2 Money Supply, and thereby goose the economy so much that tax reveunes would increase; this was achieved as Yahoo Finance reports US budget deficit down 37.6 percent through July.


Secondly, to stimulate the service economy; this was achieved as Steve Slifer of Number Nomics reports ISM Nonmanufacturing remains strong. The Institute for Supply Management not only publishes an index of manufacturing activity each month, they publish one day later a survey of non-manufacturing firms — which largely consists of services. The July index for business activity jumped 6.7 points from 51.7 to 60.4. That sounds impressive but in June the index inexplicably fell 4.8 points which did not square with anything else we knew about the economy. The 60.4 reading sounds more normal and roughly duplicates the high that was reached in the spring of last year, and is only a couple of points shy of the high for the cycle that was set in early 2011.


Thirdly, to create a vast reservoir of safe assets, that would preserve the US Dollar as the world’s reserve currency, whereby there could be currency carry trades and debt trades galore. It’s a well known fact that most of the assets traded out under QE are being held today in the form of "excess reserves." This points the way forward, as the Interest Rate on the US Ten Year Note, ^TNX, rises, banks of all types, the Too Big To Fail Banks, RWW, as well as Nasdaq Community Banks, QABA, and the Regional Banks, KRE, will be integrated into the US Federal Reserve, and be known as the Government Banks, or Gov Banks, for short.


Fourthly, to provide a cornucopia of moral hazard based investment choices, for the Speculative Leverage Investment Community to trade, this was achieved as is seen in the topping out of the 30 ETFs, seen in this Finviz Screener, ... http://tinyurl.com/kp4afty ... XIV, FDN, CARZ, PBS, IGV, IBB, RZV, PSCI, FPX, PPA, IAI, SPHB, SMH, XRT, PJP, PSP, UJB, TAN, RXI, FLM, EIRL, IYC, EUFN, RWW, ITB, FXR, IGN, BJK, PBJ, ING, with the last entry a life insurance company serving as proxy for the Life Insurance sector. If one is looking for short selling opportunities, these should be at the top of the list.


Bond yields are because investors fear that the debtors cannot make good and repay their loans.


World Stocks, VT, are tremendously leveraged over Credit, AGG, as is seen in the chart of World Stocks, relative to Credit, AGG, VT:AGG. The Risk Off ETN, OFF, and Volatility, XVZ, have been rising since August 5, 2013, confirming that a top in the stock market hass been achieved. Ambrose Evans Pritchard of The Telegraph reports Investors euphoric as US margin debt reaches 'danger' levels. Fund managers are around the world are gripped by euphoria, convinced that America is in full recovery and Europe has overcome its debt crisis.


One can use this Finviz Screener of 50 Leading ETFs, ... http://tinyurl.com/lgzgur8 ... to follow stock wealth trade lower.

William McKibbin said...

Recent QE initiatives will not do anything to fix the horrendous bills soon coming due -- ending the USA may be the only way forward -- the country could be divided into three new countries -- a West coast country lead my Sacramento (California) -- a Gulf coast country lead by Austin (Texas) -- and a Northern tier country lead by the Washington (DC) -- wiping out the national debt in one swoop would end future borrowing, effectively ending all entitlement and agency spending as well -- those with hard assets would then become the new lords of America -- I am fine with that -- I'm ready to hire a personal security detail and collect rent and dividends from my existing holdings -- now is not a good time to be invested in exotic investments -- those without means should be under cover hiding from the four horsemen of the apocalypse...

William McKibbin said...

PS: Urban refugees from places like Detroit are likely to become a real threat to rural communities in the near future -- be sure you are personally prepared to defend your property and assets from thieves and squatters...

William McKibbin said...

PPS: Watch out for some surreptitious bailout scheme for Detroit -- I can imagine a Goldman Sachs deal secretly funded by Federal Reserve funds under the table -- I fear that's what recently happened with JC Penny as well, thought bailout out JC Penny is chump change compared to bailing out Detroit, Chicago, and whomever else decides to go bankrupt...

William McKibbin said...

PPPS: The cost of bailing out US cities and towns has been estimated at $1 trillion minimum, and likely several trillions -- a municipal bond default appears imminent unless some deal is struck to fix these entities under the table...

steve said...

another perspicacious piece from scott. the real question is what happens when QE stops, not winds down but stops. is the market dependent on QE or will the "handoff" from fed to the economy go smoothly.

Scott Grannis said...

steve: It all depends on whether the Fed responds in timely and accurate fashion to a declining demand for safe assets. If the demand for safe assets drops, then the Fed should be able to unwind/reverse QE without any significant problems.

Hans said...

Why where not the 30 year UST bills omitted?

skydude said...

I believe that the effects of the unprecedented increase in the monetary base will not be felt until full confidence returns to the marketplace.

Reserves are desirable while the marketplace is in shambles and full of uncertainty. The full inflationary effect of the increase in reserves will not be known until the demand for those reserves are replaced by greater confidence and higher yielding investments.

It's similar to starting a barbecue with lighter fluid. If it doesn't start right away, keep adding more fluid. After a few rounds of adding lighter fluid you light a match and lose your eyebrows. You're left dazed and surprised that the light-off could happen so quickly....

William said...

Ed Yardini today:

"Washington is a Big Redistributor"

"During the four quarters through Q2-2013, federal outlays totaled $3.4 trillion, with $1.3 trillion attributable to spending on goods and services and $2.1 trillion attributable to entitlement outlays.

Prior to the expansion of the social welfare state under President Johnson’s Great Society program, entitlements accounted for less than 10% of government spending. They are now up to about 65%."

http://blog.yardeni.com/

William McKibbin said...

@William, at least entitlements serve humanity -- fighting counterinsurgency wars overseas promotes neither democracy nor Americanism while creating death -- I'll take butter over guns any day -- now, having said that, the spending problem in the US is not best characterized as entitlements or agency spending, but rather how to cut at least 40% from both entitlements and agency spending -- herein lies the real truth -- both entitlement spending and agency spending are lard -- the US needs to cut its spending immediately by a minimum of 40% -- right now -- no more talking -- across the board -- now.

William McKibbin said...

PS: Anyone who stands against immediate 40% cuts in government spending is part of the problem with America -- balancing the Federal budget is essential for our nation's continued existence -- every dollar that is spent above revenue is an investment into ending the USA and eventual anarchy -- more at: http://www.lp.org

Hans said...

The 30 year TB, starting 2009 was driven down from 142 to 113...It remained there until the second half of 2011.

http://finviz.com/futures_charts.ashx?t=ZB&p=w1

The last three years, seem to indicate a great deal of "influence" by the Central Bank.

Joe5858 said...

Interesting post, thanks. One question on one point:

Do you anticipate the reaction to taper to be similar in the agency mbs market? Of which the Fed owns or is projected to own roughly 50% of outstanding float in 30yr FN/FH securities by the end of the purchase program? The argument cannot be made that they own a small portion of this subset of the market...

If there is any revelation here, it is that the real point of QE was not to lower bond yields, but to create bank reserves for a world that desperately wanted them. It also follows, I would argue, that the Fed has little or no power to directly influence bond yields. Bond yields are determined by the market's desire to hold the outstanding stock of bonds, which is measured in the tens of trillions, since a good portion of the global bond market trades relative to Treasuries. The Fed's bond purchases have been paltry in comparison to the size of global bond market. Since Fed purchases have little or no impact on bond yields (or the economy), then it follows that the cessation of such purchases should have little or no impact either. Tapering is not something to fear