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Reviewing the Monetary Transmission Mechanism

The Federal Reserve is expected to officially announce the end of Quantitative Easing.  I’ve spilled an unhealthy amount of ink here over the years on the topic and I doubt that my “QE Pen” is going to be tucked away for all that long.  That is, as I’ve stated in the past, I think QE is the new monetary policy tool of choice.  So this is good bye, for now….

Anyhow, after all this time can we finally make any conclusions about QE?   Honestly, not really.  It’s almost impossible to quantify the impact of QE because there is no reasonable counterfactual to judge the program against.  We just don’t know how the US economy would have done without it.  But we can, in my opinion, make some reasonably simple and common sense conclusions based on understanding the accounting and transmission mechanisms of QE.

First, as I’ve long stated, QE is really just a simple asset swap at its most basic level.  The Fed buys bonds from the private sector by creating new money thereby printing reserves/deposits into the private sector in exchange for T-bonds or MBS.  While there’s obviously more “money” in the economy after this transaction there are also fewer bonds.  What most people don’t account for in the transaction is the fact that the Fed’s balance sheet is like a big black hole.  In theory, there’s gazillions of dollars sitting there, but since the Fed doesn’t shop at WalMart their balance sheet doesn’t have a discernible impact on the actual economy (aside from the interest income channel that the Fed remits to Treasury every year). So, when QE is implemented the private sector’s balance sheet has the same net worth, but a different composition.   All the Fed has done is altered the composition of balance sheets.  It has not “printed money” in any meaningful sense because it has also “unrpinted” the bonds.  You don’t spend more when your savings account gets swapped for a checking account so why would QE make much of a difference either?  That’s the basic and vastly oversimplified view.  You can read my paper on how this works in more detail in case you’re looking for something to put you to sleep tonight.

In theory, QE works through lots of different channels.  There’s the interest rate channel, the financial crisis channel , the asset price effects (wealth effects & housing & equity price channels), expectations channel, credit channel and the exchange rate channel.  There’s considerable debate about the efficacy of each of these.  For instance, there’s been substantial research done arguing that QE lowered long-term interest rates.  But there’s also the counterfactual perspective that interest rates would likely be low whether QE was initiated or not because inflation has been so low.  Global interest rates have been falling even in countries without QE and many are at record lows so there’s actually no reason to think that interest rates would be a lot higher today if QE had never been implemented.

The financial crisis channel was, in my opinion, the most impactful, but it had diminishing rates of return.  That is, QE1 was important in that it helped put a floor under the markets at a time when there was a great deal of uncertainty.  This bolstered asset prices, improved balance sheets and helped the economy stabilize.  On the other hand, the impact of this declined as confidence was restored.  Monetary policy works wonders in a crisis much like a good doctor works wonders calming down a hypochondriac.

The most popular view about QE is that it is just a way to manipulate asset prices via the asset price channel.  While QE has clearly had an enormous psychological impact on the economy’s participants it’s almost impossible to quantify this impact.  But we know that QE isn’t the only reason for rising asset prices.  After all, with corporate profits near all-time highs it’s totally reasonable to assume that stocks have had a very solid fundamental underpinning over the last 5 years.  You can see my more thorough explanation here.  So again, a basic understanding and a little perspective goes a long way to debunking the idea that QE falsely bolsters asset prices.

The expectations channel is the most widely touted in academic circles, but again, there’s no evidence that this has a substantial impact on the economy.  After all, the most popular view following QE1 was that high inflation and hyperinflation would ensue as a result of all that “money printing”, but we never saw a sustained pick-up in inflation.  We saw a brief blip in commodity prices and reports of farmers hoarding commodities waiting for the inflation to come, but didn’t last and the high inflation view has been soundly debunked by now.  QE clearly doesn’t create high inflation and many academics are now wondering if the program isn’t actually deflationary.

The credit channel is often cited as one powerful way for the Central Bank to expand the broad money supply.  It’s been widely believed that more bank reserve balances would lead to more bank lending in some money multiplier fashion.  I still read, on a near daily basis, how banks aren’t “lending out” their reserves.  Paul Krugman said it just the other day  and we’ve seen this view expressed by some of the most prominent economists in the world over the years.  Of course, banks don’t lend reserves.  The money multiplier is a myth.  And banking is primarily a demand side business.  Well capitalized banks don’t run out of the ability to type new loans into their computers.  But they do run out of creditworthy borrowers in an economic environment where consumers are excessively indebted. This is why negative interest rates are failing in Europe and also why QE never led to a huge lending boom.  Demand for debt has been weak.  End of story.

The exchange rate channel has varying degrees of efficacy.  For instance, in Japan where the country is a significant exporter the exchange rate can make a meaningful impact on the economy.  And I believe that much of the recent success of QE in Japan (if we can still call it successful) has been due to the exchange rate channel.  The US Central Bank, on the other hand, has not been targeting the exchange rate so there’s been no meaningful impact from currency devaluation.

When you connect all of these dots it’s hard to see what the big fuss has been all about.  QE just doesn’t have a direct or powerful transmission mechanism  to bolster the economy once the uncertainty of a crisis has stabilized.  That doesn’t mean it’s had no impact at all, but I think its impacts on the economy have been vastly overstated for the most part.  But since the Fed is the only game in town thanks to an incompetent Congress which won’t cut taxes or invest in infrastructure because they buy the false narrative about the USA’s impending bankruptcy then we’re stuck here hoping the Central Bank can work miracles by continually waving their hands in the air.

Of course, QE isn’t really ending.  The Fed is still reinvesting principal proceeds and it’s my opinion that we’ll meet QE in the not so distant future since inflation is likely to remain low, interest rates are likely to remain low and QE becomes the obvious policy variable of choice.  So it’s so long…for now.

Some related work: