As should now be obvious, Goldman Sachs is very keen on the idea of QE2. In fact, barely a day goes by when it is not discussed by the bank.
Already this week, Goldman’s chief US economist Jan Hatzius has told the world why a further $1,000bn of QE is justified, even though recent US economic data points more towards a slow down than a double dip.
And now the debate at Goldman has turned to how QE2 will be implemented not if; will it be a large one off purchase programme along the lines of the $600bn MBS scheme announced in November 2008 and subsequently extended by $1,500bn and included in the purchase of Treasuries? Or will the Fed decide to buy a small amount of assets on an ad hoc basis (the open-ended approach) or even purchase a specified amount of assets until certain condition are met – i.e. the unemployment rate falls below 9 per cent.
After weighing the pros and cons, Goldman’s Sven Jari Stehn concludes the Fed should go for the big bang approach; a $1,000bn purchase programme starting either late this year or early next:
Which option should the FOMC opt for? Here are three dimensions that should be taken into account:
1. Effectiveness.
Our analysis of the effectiveness of past purchases suggests that the boost to financial conditions came from the stock of announced purchases rather than the flow of actual purchases. This finding implies that the “small steps” option would be least effective in easing financial conditions. While our analysis suggests that a $1tr ‘big bang’ announcement might immediately reduce the 10-year Treasury yield by around 25bp, buying the same amount by incrementally announcing $100bn at every meeting spread over ten meetings would only gradually lower the 10-year yield and thus have a delayed effect on growth unless the pattern were sufficiently regular that the markets could spot it after a few meetings. In that case, the markets would likely anticipate the purchase of more securities, though the average level of real GDP during the operation is still likely to be smaller.
How about the “open ended” option? The effect on financial conditions would depend on the market’s expectation of how much the Fed would end up buying. On the one hand, this is a desirable feature because this expectation would vary with the data flow—i.e., the market would expect the Fed to keep purchasing assets for longer during times of economic weakening which in turn would ease financial conditions. On the other hand, the uncertainty associated with this approach might lead to a smaller effect for each dollar that is actually spent than under the “big bang” option.
2. Flexibility.
Given the disagreement about the need for additional easing steps within the FOMC, retaining some flexibility might be critical to the adoption of any QE2. This is the main advantage of the “small steps” option over the other two, as no commitment is made. Although the flexibility of the “big bang” option could be raised by announcing purchases of “up to” a specified amount, this might undermine its effectiveness in reducing the expected stock of Fed purchases.
3. Ease of communication.
One of the key challenges facing the Fed during the next couple of months is to achieve clear communication of its policies. Two issues stand out in particular: (1) the FOMC should avoid scaring market participants, some of whom seem to believe that the Fed operates with a significant amount of nonpublic information about the economic outlook, and (2) the option selected should be easy to communicate. The “big bang” option appears easier to communicate than either the “small steps” or “open ended” programs, though it may falter on the first criterion.
Once the time has come, the FOMC faces a trade-off between the effectiveness, flexibility and ease of communication of an additional purchase program. In the end we expect the FOMC to opt for the most familiar ‘big bang’ approach by announcing a large ($1tr or more) purchase Treasury program by the end of 2010 or early 2011, but there are certainly arguments to be made for the other approaches
Related links:
A revisionist history of the week begining Aug 30, 2010 – FT Alphaville
These are the voyages of the starship QE2 – FT Alphaville
Uncooperative QE – FT Alphaville