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Reviewing the Monetary Policy 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 “unprinted” 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.

While QE is less impactful than many mainstream economists assume this does not mean there is no impact or that monetary policy can never be powerful. So let’s dive into the various transmission mechanisms of monetary policy.

In theory, QE (and monetary policy more broadly) works through lots of different channels.  This includes:

  1. The interest rate channel
  2. The financial crisis channel
  3. The portfolio rebalancing channel (asset price effects (wealth effects & balance sheet channels)
  4. The expectations channel
  5. The credit channel
  6. The exchange rate channel.

There’s considerable debate about the efficacy of each of these so let’s discuss each one a bit more.

The Interest Rate Channel. This is the most traditional form of the monetary policy transmission mechanism whereby the Central Bank alters interest rates to try to influence consumption and investment. Since interest rates on reserves serve as the benchmark interest rate across the economy the Central Bank can influence the cost of money which can alter interest rates across the entire interest rate structure.

The efficacy of this mechanism has come under debate more recently as higher interest rates seemed non-impactful during the housing bubble and 0% interest rates failed to substantially boost the economy. Further, there is considerable debate regarding the degree to which interest rates are the tail wagging the inflation dog. That is, do interest rates lead the economy or does the Central Bank simply set rates in response to other more important factors leading to a coincident impact across the economy.

I would argue the the interest rate channel has varying degrees of efficacy depending on the environment. For instance, there is substantial evidence that the high rates in the late 1970s were an important catalyst in boosting money demand and reducing inflation. There is less evidence, however, that low rates are a powerful stimulus during a low inflation environment.

The interest rate channel is also closely linked to the exchange rate channel (discussed later). Higher interest rates in the USA can create more demand for dollars as emerging market and developed markets borrow heavily in the global reserve currency and are highly sensitive to exchange rate changes that can be linked to interest rate changes. There is considerable evidence that rising interest rates in the USD can lead to slowing growth in countries that are highly dependent on dollar borrowing.

The financial crisis channel is, in my opinion, the most impactful monetary policy tool, 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 because the Central Bank is little more than a publicly supported clearinghouse that can help to substantially stabilize a banking system that is at risk of causing a broader crisis outside of the banking system.

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.

Further, there is relatively little out of sample evidence to support the asset price and portfolio rebalancing mechanism. While intuitive, there have been cases such as the EMU where QE and monetary policy has been much more aggressive than in the USA and yet asset prices have remained far more subdued.

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. Much of the recent success of QE in Japan 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. China has also very successfully targeted their exchange rate with meaningful evidence to support a powerful transmission mechanism.

Of course, there are varying degrees of sovereignty across certain Central Banks. The US Central Bank is constrained in many ways that other Central Banks are not. This limits the power of the transmission mechanism. Further, as I’ve often noted, the monetary policy transmission mechanism is best viewed in coordination with fiscal policy. For instance, QE with a very large government deficit is an entirely different (and much more powerful program) than QE with a government surplus.


¹ – The Monetary Transmission Mechanism – NY Fed

² – Symposium on the Monetary Transmission Mechanism. Journal of
Economic Perspectives
– FS Mishkin

Some related work: