QE counter-factuals and counter-arguments | FT Alphaville

QE counter-factuals and counter-arguments

Here’s a pop quiz for macro fans: Federal Reserve asset purchases were equivalent to an X hundred basis point reduction in the federal funds rate and contributed Y million jobs. What are X and Y?

In a recent paper on zero lower bound events and the impact of quantitative easing, economists at the San Francisco Fed try to find X and Y.

Their modeling was then used by Fed Vice Chair Janet Yellen on Saturday, in the latest speech by a Board of Governors member justifying QE2.

We’ve written before about the right and wrong criticisms of QE(2). A quick reminder — wrong: rising nominal yields; right: whether it shifts inflation expectations, its impact on the real economy, and whether it can be easily unwound.

In her speech Yellen offered some now standard defences of QE2 but also quantified its job impact and discussed the Fed’s escape plan. Quickly, then — the defence.

Fears that QE2 will cause excessive inflation are overblown, she says. As we’ve noted before, there’s no sign of this yet in the consumer inflation figures (see chart below).

Indeed, the San Francisco Fed economists’ paper argues that without the (entire) asset purchase programme we’d be in a sticky deflationary scenario:

Finally, under the assumption of a “neutral” response of conventional monetary policy, the FRB/US simulations suggest that the asset purchase program has importantly contributed to price stability. Specifically, Figure 10 implies that inflation is currently a percentage point higher than would have been the case if the FOMC had never initiated the program, implying that the economy would now be close to deflation.

(More on the models in a sec.) Yellen also reckons that equity prices and credit flows don’t show any signs of “adverse financial imbalances”, and that the dollar’s devaluation has been modest.

Now for the offense. According to the paper cited in her speech, quantitative easing has had a jobs impact at least equivalent to that claimed for the fiscal stimulus:

In particular, the model simulations suggest that private payroll employment is currently 1.8 million higher, and the unemployment rate ¾ percentage point lower, than would otherwise be the case. These benefits are predicted to grow further over time; by 2012, the incremental contribution of the full program is estimated to be 3 million jobs, with an additional 700,000 jobs provided by the most recent phase of the program alone. Based on other simulations of the FRB/US model (not shown), providing an equivalent amount of support to real activity through conventional monetary policy—had it been possible—would have required cutting the federal funds rate approximately 300 basis points relative to baseline from early 2009 through 2012.

X = 300; Y = 3. Bonus points for the QE2 number.

In pretty picture form:

But what of those fears that the Fed will be stuck unable to sell assets in a jiffy should inflation fears quickly emerge> No problem — they’ve tried it out, “less tests” rather than “stress tests”, perhaps (from the speech):

To build the capability to drain large quantities of reserves, the Federal Reserve has expanded the range of its counterparties for reverse repurchase operations beyond the primary dealers and has developed the infrastructure necessary to use agency MBS as collateral in such transactions. The Federal Reserve has also put in place a Term Deposit Facility through which it can offer deposits to member institutions that are roughly analogous to the certificates of deposit that these institutions offer to their customers. We have tested both of these tools by conducting several small-scale operations and have the ability to initiate them quickly if needed. The use of reverse repurchase operations and the Term Deposit Facility would allow the Federal Reserve to drain hundreds of billions of dollars of reserves from the banking system should conditions necessitate. We don’t think that draining such large amounts of reserves will be necessary for a smooth exit, but it makes sense to be prepared, and hence we have followed this “belt and suspenders” approach.

Views welcome on whether this optimism is well-placed.

Does the Fed’s defence stack up? Counterfactuals are inherently tricky as anyone who has watched the otherwise irksome Big Bang Theory can attest.

It’s worth noting though that the Fed economists’ predictions come at the end of a paper where they pick apart their models for their lack of predictive power about the zero bound.

These criticisms make for a clearly argued case that using data and assumptions from periods of moderation will unsurprisingly result in an underestimation of the likelihood that adverse risks come true, such as arriving at the zero bound. It’s also harder to forecast the durability of these adverse risks.

But it’s also an apposite reminder that even “neutral” assumptions might not produce accurate simulations in the current climate. Remember: strange things happen at the zero bound.

Related links:
Everyone should relax about rising nominal yields – FT Alphaville
Bernanke and the real costs of QE2 – FT Alphaville
Maybe it’s working, and maybe it isn’t – FT Alphaville
When strange things happen at the zero lower bound – FT Alphaville