Scott Sumner  

What were the "costs and risks" of QE?

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One of the puzzles of the Great Recession is why the Fed did not move more aggressively to promote recovery in NGDP growth and/or inflation. Many observers, including Christina Romer and Lawrence Ball, noted that the Fed's passivity seemed to be a bit if a puzzle, given that Ben Bernanke had previously criticized the Bank of Japan on very similar grounds in a 1999 paper entitled:

Japanese Monetary Policy: A Case of Self-Induced Paralysis?
Bernanke's answer was basically "yes".

During the recovery from the Great Recession, Bernanke seemed frustrated by the slow rate of growth in aggregate demand and the price level. And yet various QE programs were often ended before their objective had been achieved. When asked why the Fed did not do even more QE, Bernanke referred to vague "costs and risks" of an excessively large Fed balance sheet. At the time, I was quite dismissive of this argument, as the Fed's assets (T-bonds) are the Treasury's liability. Thus for the consolidated Federal government balance sheet, there is essentially no risk associated with a change in the price of T-bonds held by the Fed. And the Fed's mortgage backed securities issued by the GSEs had already been essentially guaranteed by the Treasury. (Joseph Gagnon discusses four possible risks, and is rightfully dismissive of all four.)

I recently came across evidence that, prior to the Great Recession, Bernanke held similar views on balance sheet. In a 2003 speech that was critical of BOJ passivity, Ben Bernanke dismissed the fear that QE could induce excessive balance sheet risk:

In short, one could make an economic case that the balance sheet of the central bank should be of marginal relevance at best to the determination of monetary policy. Rather than engage in what would probably be a heated and unproductive debate over the issue, however, I would propose instead that the Japanese government just fix the problem, thereby eliminating this concern from the BOJ's list of worries. There are many essentially costless ways to fix it. I am intrigued by a simple proposal that I understand has been suggested by the Japanese Business Federation, the Nippon Keidanren. Under this proposal the Ministry of Finance would convert the fixed interest rates of the Japanese government bonds held by the Bank of Japan into floating interest rates. This "bond conversion"--actually, a fixed-floating interest rate swap--would protect the capital position of the Bank of Japan from increases in long-term interest rates and remove much of the balance sheet risk associated with open-market operations in government securities. Moreover, the budgetary implications of this proposal would be essentially zero, since any increase in interest payments to the BOJ by the MOF arising from the bond conversion would be offset by an almost equal increase in the BOJ's payouts to the national treasury. The budgetary neutrality of the proposal is of course a consequence of the fact that, as a matter of arithmetic, any capital gains or losses in the value of government securities held by the BOJ are precisely offset by opposite changes in the net worth of the issuer of those securities, the government treasury.
The specific proposal discussed by Bernanke is less important than the final sentence, where he makes exactly the same point that I made above. The so-called costs and risks were never really about true risks to the economy; they were mostly about the risk of central bank embarrassment, of having to be bailed out by the Treasury.

This reminded me of a 2011 article by Vincent Reinhart, who worked with Ben Bernanke:

I was one of Bernanke's co-authors for an academic paper published in 2004 that did some of that criticizing. After seeing how other major central banks, including the Fed, handled similarly trying circumstances, I admit that Gov. Shirakawa has reason to feel aggrieved. In particular, the main point of contention, quantitative easing, is a policy that looks good on paper but has a flaw when implemented by a democratic central bank. . . .

Market participants have to be convinced that the central bank is committed to the policy for quantitative easing to be effective. If investors think the authorities will stop or reverse soon, then long-term yields will not move much nor will the extra reserves be used. Underappreciated in the theory (and the criticism) is that the monetary policies of major central banks, such as the BOJ, are decided by committees. Individual members do not usually see the world exactly in the same way. Because the balance of judgments may change over time, a decision at one meeting cannot presume the outcome of the democratic process at future committee meetings. As a consequence, policy statements tend to be hedged to foster compromise, making them tentative and undercutting the effectiveness of policies relying on a credible long-term commitment.


I believe these examples help us to understand why Bernanke seemed to hold back from his more aggressive recommendations for the BOJ, after joining the Fed in 2003. Before 2003, Bernanke believed that central banks had almost unlimited power to boost aggregate demand and prices, if they chose to do so. After joining the Fed, his perspective changed from what a central bank could do, to what a central banker could accomplish. This is especially important given that Bernanke moved the Fed away from Greenspan's dictatorial approach, towards a more collegial approach to decision-making.

In both of the cases discussed above the problems were not technical, they were political. The BOJ could have used forward guidance, if they were in fact committed to creating inflation. Unfortunately they were not. Every time (until 2013) the inflation rate rose up to zero (from negative territory) the BOJ raised interest rates with the intentional of preventing inflation from rising above zero. And the risks and costs of QE are entirely political; there is no actual risk to the consolidated balance sheet of the federal government.

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Some of this seems to go against my longstanding view that policy decisions are better made by committee (or better yet markets), not individuals. Might we have been better off with Bernanke as dictator of monetary policy? Maybe, but of course there is also downside risk with dictators (Hitler, Mao, Stalin, Pol Pot, Kim, etc.) More to the point, Reinhart points out that the credibility problem can be overcome with a suitable policy rule:

Ill effects of this drawback of democracy can be tempered if the central bank follows a policy rule. The BOJ ultimately did so, with the promise made in 2001 to keep the policy rate at zero as long as the price level was declining. The Fed has not yet seen fit to do so.
As I just indicated, this was the wrong policy rule---one that put a zero percent ceiling on inflation. Similarly, the Fed had the wrong policy rule. As an academic, Bernanke had suggested that the BOJ engage in level targeting, promising to create inflation to offset the previous deflation. After joining the Fed, however, Bernanke found strong institutional resistance to this (level targeting) idea.

To conclude, I find no convincing evidence that Bernanke's technical views on monetary policy have changed dramatically. Prior to 2003, he believed that central banks had almost unlimited powers over nominal aggregates. After 2003 he discovered that the head of a central bank had very limited powers.

Both can be true.


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COMMENTS (13 to date)
Thaomas writes:

Good post. But now we need to start figuring out where the political support for the "wrong rule" (no price level trend targeting) came from?

Cloud Yip writes:

In doing my series of interview and research, I can't help but keep having seen evidence that politics, rather than macroeconomics, worsen the Great Recession. Your argument in this post sort of reinforced my observations.

One question in my mind is, should economists start to incorporate politics (say simple political economy analysis) into their main models (say DSGE) to help better policy making?

I don't think this should be a main feature of the flagship models. But we have incorporated financial sectors in the models, why not politics?

What do you think, Prof Summer?

Below Potential writes:

"Prior to 2003, he believed that central banks had almost unlimited powers over nominal aggregates. After 2003 he discovered that the head of a central bank had very limited powers. Both can be true."

I think something similar could be said in the case of Mario Draghi.

The problem with most central banks (but not the Fed) is that they cannot choose the monetary policy regime but have to follow whatever mandate they are given by politicians.

The ECB, e.g., has been given a mandate of inflation targeting, so they have to conduct mortary policy accordingly no matter whether or not they regard this as optimal. ... And many of them do not consider inflation targeting the best possible monetary policy regime. In fact, the majority of the people working for the ECB with whom I talked about it did not consider inflation targeting optimal (whereby my sample is far too small to be representative though).

bill writes:

Great observations: 1. the risk the Fed focused on was the risk of embarrassment and 2. Bernanke was just one vote on this Fed.
Here's something I find really odd about today's Fed. Why would they increase IOR now instead of starting to let the balance sheet run down? Reverse QE if you will; which is clearly the logical progression, especially for someone who is (used to be?) worried about balance sheet size. One answer I can come up with is "optics" (which is related to embarrassment). They really wanted to be able to say that they were raising rates. That they are tightening. That they are normalizing.
Another answer is the endowment effect. Abandoning the status quo of managing policy via changes in the Fed funds rate was really hard for some Fed members. And now, also abandoning this large balance sheet appears to be giving them agita too.
One last thought. In lieu of an NGDP market, maybe the Fed is now using the 10 year yield as some sort of proxy. If so, I'm scared because it appears that they are targeting a yield between 2.0% and 2.5%.

bill writes:

Here are two quotes from Courage to Act that I have always found disheartening.

Page 325, middle paragraph
We had initially asked to pay interest on reserves for technical reasons. But in 2008, we needed the authority to solve an increasingly serious problem: the risk that our emergency lending, which had the side effect of increasing bank reserves, would lead short-term interest rates to fall below our federal funds target and thereby cause us to lose control of monetary policy. When banks have lots of reserves, they have less need to borrow from each other, which pushes down the interest rate on that borrowing - the federal funds rate.

And entire last paragraph on 325/326
Until this point we had been selling Treasury securities we owned to offset the effect of our lending on reserves (the process called sterilization). But as our lending increased, that stopgap response would at some point no longer be possible because we would run out of Treasuries to sell. At that point, without legislative action, we would be forced to either limit the size of our interventions, which could lead to further loss of confidence in the financial system, or lose the ability to control the federal funds rate, the main instrument of monetary policy. The ability to pay interest on reserves (an authority that other major central banks already had), would help solve this problem. Banks would have no incentive to lend to each other at an interest rate much below the rate they could earn, risk-free, on their reserves at the Fed. So, by setting the interest rate we paid on reserves high enough, we could prevent the federal funds rate from falling too low, no matter how much lending we did.

Kevin Erdmann writes:

I agree bill. It leaves one speechless. It's even worse when you consider that at the same time they were telling Congress that the world was going to end if they didn't pass TARP, etc. Why was a 2% rate target so important that, not only was there no public discussion about reducing it, but the Fed engaged in this weird workaround to mimic selling treasuries? The fact that the Fed takes heat for dozens of things, but this has generally flown under the radar, really shines a light on the frightening lack of accountability inherent in public institutions.

Capt. J Parker writes:
they were mostly about the risk of central bank embarrassment, of having to be bailed out by the Treasury.

If being bailed out by the Treasury means that the central bank might find itself in a situation where its balance sheet losses are so large that it must ask treasury for tax dollars to burn because that's the only means left to tighten monetary policy when needed, then that is a mighty big risk.

Now, I know the problem at hand wasn't too much inflation. It was just the opposite. And I read Gagnon saying no one at the Fed was worried about the Fed's ability to control inflation. But, I believe Treasury can't be a last resort to tighten monetary policy because it would be politically impossible.

Scott Sumner writes:

Cloud, I'd prefer that we start moving away from DSGE models, and add market prices to the models. But yes, I agree that economists need to be aware of political limitations when thinking about the optimal policy rule.

Below Potential, That's true, but keep in mind that in both cases policy was too tight even by the standards of the policy rule.

Bill, I think it's unlikely the Fed is targeting the long term i-rate. I still think they have a 2% inflation target.

I agree about the IOR.

Captain, No, it's not a risk at all, because any loss to the Fed is exactly offset by a gain to the Treasury. Hence the consolidated Federal government balance sheet absorbs no risk at all.

Thaomas writes:

"Bill, I think it's unlikely the Fed is targeting the long term i-rate. I still think they have a 2% inflation target"

Scott, what evidence do we have for that? It looks to me like they still have a (soft) 2% ceiling. A 2% inflation target would force them to have inflation greater than 2% for a while to get back on target.

Jeff writes:

If the Fed had a clear rule that it followed, and everyone knew that they were going to continue following the rule, the members of the FOMC would be obscure bureaucrats that nobody paid any attention to. The way it is now, close attention is paid to every word they say or write. And we're surprised they don't follow a rule?

Capt. J Parker writes:

Dr. Sumner said:

No, it's not a risk at all, because any loss to the Fed is exactly offset by a gain to the Treasury. Hence the consolidated Federal government balance sheet absorbs no risk at all.

To tighten monetary policy the Fed needs positive cash flow, either to burn it, to pay IOR or to pay interest on reverse repos. Neither a balance sheet loss by the Fed nor a balance sheet gain by treasury creates a positive cash flow to the Fed. A decrease in US debt burden will in no way make Treasury payments to the Fed more palatable to taxpayers. Interesting that Gagnon brought up the consolidated government balance sheet business while Bernanke did no such thing.

bill writes:

I concede that the Fed isn't targeting the 10 year T. I do think they are closer to a 2% inflation ceiling than a symmetrical target (and a symmetrical target is not the same as level targeting). I think, and I think most of them agree, that current policy is at least 3 times as likely to produce PCE inflation below 1.8% as it is to produce inflation greater than 2.2%. The reason we are closer to a ceiling than a symmetrical target is the committee approach. All it takes is for a few members to see it as a ceiling combined with a tough to predict future and the committee's votes will result in policy decisions that look like a ceiling (at least a soft one). Add in asymmetrical risks of embarassment (ie, few complaints when inflation is 1.6% but tons of approbation for 2.4% inflation) and here we are. Core PCE has been higher than 2% for only 3-4 months in the last 8 years. In 2013, Bernanke was defending the Fed from attacks in front of Congress that he was a dove where he had to cite his inflation record as one of success.

Alex S. writes:

"Some of this seems to go against my longstanding view that policy decisions are better made by committee (or better yet markets), not individuals. Might we have been better off with Bernanke as dictator of monetary policy?"

I just read Roger Lowenstein's Jan. 20, 2008 article, "The Education of Ben Bernanke" (NY Times) two days ago. The entire article is worth reading.

I'm going to drop the following hypothesis out here: If Alan Greenspan had still been Fed Chair in 2008, the Great Recession, wouldn't have been so great (I can't believe I'm typing those words)--but I don't mean because of his "genius", but because of his perceived ability to target NGDP--if only by sheer luck. Ben Bernanke turned out to be the anti-Benjamin Strong.

Here are some excerpts from the article...keeping in mind that this was JANUARY 2008:

"Bernanke’s attempt to improve the way the Fed communicates has misfired and often left investors confused, partly because he has repeatedly shifted course over the future direction of interest rates. His hero, Milton Friedman, is said to have warned against an indecisive Fed acting like a “fool in the shower” fumbling with first the hot water and then the cold...Perhaps worst of all, he has failed to persuade investors that the Federal Reserve, which was formed in 1913 for the very purpose of halting market panics, is up to the job. “Bernanke is seriously behind the curve,” says David Rosenberg, chief North American economist for Merrill Lynch, one of many critics who maintain that the Fed has not responded to the crisis with sufficient vigor."

"Bernanke has also shown his academic bent in how he runs the Fed. He has democratized interest-rate policy by giving the members of the Open Market Committee more of a voice. Bernanke’s collegial style worked at Princeton, where he taught. But as the point man for the U.S. economy in a time of crisis, perhaps the Fed chief should be more commanding, suggests Alan Blinder..."

"Greenspan was known to insist on unanimous support from committee members at critical junctures, to assure the country of the Fed’s resolve; Bernanke has not."

"Under Bernanke, the various Open Market Committee members have felt freer to speak their minds, and they have done so. This free speech has sometimes sounded cacophonous; the president of the Philadelphia Fed has clamored for a more hawkish policy, the Boston Fed for a dovish one. (In Fed parlance, hawks want to tighten rates; doves favor easing them.) Not surprisingly, Wall Street has found this dissonance confusing. Bruce Kasman, chief economist at JPMorgan Chase, insists that several times in recent months the market hasn’t heard what the Fed is saying."

"Bernanke wrote policy-oriented papers that raised his profile in Washington. One Bernanke idea was a direct response to the market’s frustration with Greenspan, who refused to be tied down on what his inflation objective was. Bernanke maintains that if the Fed is clear about its policies, the public will tailor its behavior accordingly."

"Being a Fed governor was a low-profile job, especially with Greenspan making all the decisions. But Bernanke delivered a series of often-provocative speeches (albeit in a monotone) that made him visible."

This one is for David Beckworth:
"Bernanke made a small contribution to a problem that would blossom in a big way on his watch. In the aftermath of the 2001...Bernanke’s argument provided a major element of support to Greenspan for keeping interest rates low."

"A few months after his February 2006 confirmation, at the annual White House correspondents’ dinner, he told the CNBC anchor Maria Bartiromo that markets had misinterpreted his testimony in Congress as dovish. When his comments were reported, stock and bond markets tanked."

Scott, I know you emphasize the September 2008 meeting as a critical juncture for the Fed's failure to move...here's some earlier evidence too (especially since he was resolved to show he wasn't dovish after the false start in 2006).

"When the committee met on Aug. 7 [2007], many expected it to give markets a little relief by easing the fed funds rate, then at 5.25 percent...The committee voted to hold rates firm...Bernanke maintained that inflation was still the greater risk, and he prevailed."

"In November [2007], Wall Street began to agitate for a third rate cut...But when the rate cut came, in December, it was only a quarter-point instead of a half. Markets went ballistic: the Dow Jones average plummeted 300 points, and traders interpreted the committee’s moderate stance as a betrayal. Paul McCulley, a managing director at Pimco, a big bond-trading firm, accused the Fed of “breaking a covenant.” Mark Zandi, chief economist of Moody’s Economy.com, complained that the Open Market Committee’s press release, a waffling statement citing the “uncertainty surrounding the outlook,” read as if it were the product of a committee."

"[Bernanke] says that central bankers have finally learned how to guide economies — not with mystique but with economic science. If that is so, we will not need a wizard behind the curtain anymore, only intelligent engineers who can steer markets to a promised land of rational expectations."

There's also an interesting tidbit in there about how LBJ beat (literally) Fed Chair William McChesney Martin.

I think the main takeaway is that monetary policy is too important to be left to one or a few individuals. The psychological and political constraints are too great. I made the pro-Greenspan comment because I think he was incidentally an NGDPLT-guy--perhaps not explicitly--but the data under his tenure suggest he was closer.

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