The large-scale asset purchase (LSAP) or Quantitative Easing is the balance sheet expansion tool that was unleashed by the Federal Reserve in late 2008. This tool is part of the extraordinary suite of monetary policy tools developed by the Fed to resuscitate the U.S. economy from the brink of a deflationary spiral, in a Zero Interest Rate Policy (ZIRP) regime. Ever since the first version of LSAP was unleashed in the form of QE 1.0, economists and investment professionals world-wide have questioned the efficacy of LSAP as a tool to stimulate the economy. In spite of all the drawbacks that have been brought to our attention in the recent years, I believe that the Fed has been right all along with the LSAP measures, considering Washington's inaction in arriving at a cogent fiscal policy to tackle the crisis.
At the onset, let me declare that I endorse Nomura economist Richard Koo's view, which evolved from his understanding of the lost decade of Japan, that the recent economic crisis was different in nature from the others the U.S. had seen in recent times. According to him, the severe decline in economic activity in the USA that emanated from the global financial crisis of 2008 and the bursting of the housing bubble was a "balance sheet recession". Koo, the pioneer of the concept, adds that during such a recession, debt minimization rather than profit maximization becomes the economic axiom, and that fiscal policy is more effective than monetary policy in keeping the economy away from the deflationary spiral.
As this discussion is on the efficacy of Fed's LSAP measures, we can examine the concept of "balance sheet recession" later. However, Koo's recent book "The Holy Grail of Macroeconomics" provides a detailed account of "balance sheet recession" and his understanding of the Japanese episode (for a brief summary, read this note from Nomura Research Institute). Some of the arguments made by Koo were also made by Irving Fisher in his debt-deflation view of the Great Depression. With impasse in Washington, enacting fiscal policy has become a nightmare, and with eurozone periphery undergoing a severe sovereign debt crisis, fiscal policy grounded in economic doctrine rather than economic pragmatism has been the mantra in recent debates. The loudest proposition that has emerged from Washington in recent times has been refrains of fiscal consolidation, and besides there has been no honest debate in Congress on counter-cyclical fiscal policy to put the economy back on track.
With the executive as well as the legislative branches of the U.S. government unable to come together and arrive at a cogent and pragmatic fiscal policy to tackle the economic decline, the major burden of resuscitating the economy naturally has fallen on the shoulders of the Federal Reserve. The stimulus that has emerged from Washington so far has been mostly insignificant, misallocated and limited in duration to have a major impact on the economy. It has not provided any sizable allocation to infrastructure spending, which percolates through the economy rapidly and has a bigger multiplier effect.
It should also be noted that fiscal policy has a longer policy enactment lag (inside lag) but a shorter expenditure lag (outside lag) when stacked up against monetary measures. It's not to say that fiscal consolidation and debt reduction have no place in our current economic debate. They certainly do, provided they tail the principles of counter-cyclicality. In practice, it would have been literally impossible to see only fiscal policy in action, as suggested by Koo, to counter the enormous recession, as there would have been definitely a clamor from the polity and the media on the independent Fed to act in order to soften the blows from the impending economic collapse. The apt policy prescription would have been longer-duration fiscal policy of substantial size accompanied by monetary accommodation through traditional monetary tools and open-ended LSAP measures - measures smaller in size than those that have been enacted so far by the Fed through QE1, QE2 and QE3 cumulatively.
In order to endorse the efficacy of the Fed's LSAP programs so far -- QE1, QE2, and QE3-- this article will first weave through a cursory summary of monetary transmission mechanisms, and then will look in detail at those transmission mechanisms that are in play when LSAP measures are enacted in a Zero Interest Rate Policy (ZIRP) environment,. The analysis will focus, in particular, on those transmission mechanisms that feed into the real economy through reflation of equity markets. Bank lending channel and unanticipated price level channel have been excluded from this discussion as they are trivial in a ZIRP environment and therefore, can be left to a later discussion.
Monetary transmission mechanisms: Figure 1 is a pictorial summary of various traditional monetary transmission mechanisms, some of which are relevant for the dynamics that are in play when LSAP measures are enacted.
Source: Frederic Mishkin, Economics of Money, Banking, and Financial Markets, 9/e.
According to the Fed, how does LSAP work? In chairman Bernanke's remarks at the last year's annual Federal Reserve Bank of Kansas City Economic Symposium held at Jackson Hole, he outlined the Federal Reserve's motives behind large-scale asset purchases (LSAP) or Quantitative Easing (QE):
In using the Federal Reserve's balance sheet as a tool for achieving its mandated objectives of maximum employment and price stability, the FOMC has focused on the acquisition of longer-term securities--specifically, Treasury and agency securities, which are the principal types of securities that the Federal Reserve is permitted to buy under the Federal Reserve Act. One mechanism through which such purchases are believed to affect the economy is the so-called portfolio balance channel, which is based on the ideas of a number of well-known monetary economists, including James Tobin, Milton Friedman, Franco Modigliani, Karl Brunner, and Allan Meltzer. The key premise underlying this channel is that, for a variety of reasons, different classes of financial assets are not perfect substitutes in investors' portfolios. For example, some institutional investors face regulatory restrictions on the types of securities they can hold, retail investors may be reluctant to hold certain types of assets because of high transactions or information costs and some assets have risk characteristics that are difficult or costly to hedge.
Imperfect substitutability of assets implies that changes in the supplies of various assets available to private investors may affect the prices and yields of those assets. Thus, Federal Reserve purchases of mortgage-backed securities (MBS), for example, should raise the prices and lower the yields of those securities; moreover, as investors rebalance their portfolios by replacing the MBS sold to the Federal Reserve with other assets, the prices of the assets they buy should rise and their yields decline as well. Declining yields and rising asset prices ease overall financial conditions and stimulate economic activity through channels similar to those for conventional monetary policy. Following this logic, Tobin suggested that purchases of longer-term securities by the Federal Reserve during the Great Depression could have helped the U.S. economy recover despite the fact that short-term rates were close to zero, and Friedman argued for large-scale purchases of long-term bonds by the Bank of Japan to help overcome Japan's deflationary trap.
Traditional interest rate channel: This is the traditional Keynesian IS-LM view of the transmission mechanism and is shown below schematically -
where monetary policy accommodation (M ↑) leads to a fall in real interest rates (ir ↓), which lowers the cost of capital, causing a rise in investment spending (I ↑), and thereby, resulting in an increase in aggregate demand and output (Y ↑). The important feature of this mechanism is that it centers on real rather than nominal interest rates. Initially Keynes envisioned this channel engaging through businesses' decisions about investment spending, but later research confirmed that this channel also plays out through consumers' decision about housing and consumer durables expenditures. Let's not forget that it's the real long-term rates, and not short-term nominal rates that are viewed to have an impact on spending. Nominal rigidities put downward pressure on short-term real rates when central banks lower short-term nominal interest rates, and with long-term rates being average of expected future short-term rates (from expectations hypothesis), long-term real rates also decline. Even if nominal short-term rates are at a floor of zero or close to zero as it stands today, monetary expansion (M ↑) puts upward pressure on expected price level (Pe ↑) and the expected inflation rate (πe ↑), and thus lowering the real interest rates (ir ↓).
The monetary expansion through non-traditional Fed's balance sheet expansion or otherwise, the LSAP program, as outlined earlier, puts downward pressure on the long-term interest rates through the portfolio balance channel. The lower nominal long-term interest rates raise inflation expectations putting downward pressure on the long-term real interest rates. As we can see in figure 2, inflation expectations rose after each round of LSAP program (QE1 & QE2) albeit after a lag, and real interest rates have shown a steady decline since late December of 2008 (see figure 3). The lowering of long-term real interest rates was expected to spur investment spending, housing expenditures (with steep decline of mortgage rates) and consumption of consumer durables.
But, in spite of the lower long-term real interest rates, the economy has not received the jolt required to put it on a path to sustainable recovery and job growth. There have been tremendous headwinds to this transmission channel including: deleveraging by the private sector, stricter underwriting standards for mortgages, and declining prices of houses preventing lot of people from refinancing their mortgages to the lower rates. All of those headwinds put a lid on growth of discretionary income and consumer confidence. Considering the recession was of a "balance sheet" nature, the strength of this channel was not adequate enough to promote economic growth and create jobs.
Exchange rate channel: This transmission mechanism is now a standard feature outlined in numerous under-graduate textbooks, and it operates in a flexible exchange rate regime. This channel involves interest rate effects because when real interest rates fall (ir ↓) during monetary expansion (M ↑), domestic deposits become less attractive relative to deposits denominated in foreign currencies, leading to the depreciation of dollar with respect to other currencies (E ↓). When dollar depreciates in real terms, domestic goods become cheaper than foreign goods, spurring net exports (NX ↑) and domestic aggregate output (Y ↑).
As you can see in figure 4, the LSAP programs since 2008 have put downward pressure on the real value of dollar as predicted by the exchange rate channel. However, the LSAP program by the Fed has resulted in massive portfolio rebalancing (as discussed in Bernanke's address) with investors moving out of low-yielding assets (treasuries, agency debt, and MBS) to higher risk assets - corporate bonds, equities and commodities. With commodities priced in dollars, the depreciation of the dollar resulted in further reflation of commodities including oil (see figure 5), reinforcing the reflation of commodities (an unintended consequence) through the portfolio rebalance channel . This has caused the growth of exports to be stymied, thereby neutralizing the exchange rate channel transmission mechanism triggered by the Fed's LSAP programs (figure 6). In addition to the flight to safety factor, the effects of LSAP on the real economy through this channel were complicated even further by efforts of Central Banks in the developed world to keep short-term interest rates lower for an extended period to counter the global financial crisis and Euro debt crisis, thereby putting a lid on the depreciation of the dollar.
The next few channels are based on transmission via equity prices, and in fact a lot of criticism of the LSAP programs especially QE2 and QE3 have centered on the Fed's thesis on wealth effect, emanating specifically from the reflated equity markets (see figure 7). Even though Ben Bernanke and the Fed have repeatedly stressed on the expansion of the economy through the "stock effect" or the "wealth effect" induced by reflated equity prices, we need to remind ourselves that LSAP is fundamentally a program to reflate all financial assets and non-financial assets like housing (of course reflation of commodities was an unintended consequence of LSAP).
Most of the recent debates on wealth effect from rising equity prices have revolved on the consumers' propensity to consume from wealth effect. Most empirical research hasconcluded that wealth effect from rising stock prices are weak, however various research has shown that variations in housing wealth have tremendous influence on consumption. Even though some of the criticisms of the "wealth effect" may be valid, not enough attention has been paid to other monetary transmission mechanisms through equity prices like Tobin's Q theory and the balance-sheet effects. However, it's my understanding that the secondary effects of rising equity prices-- like balance-sheet and Tobin's Q theory-- have been framed under the single umbrella of "wealth effect" by the Fed, rather than as separate and unique modes of monetary transmission. Therefore, they have been neglected from the mainstream debate on the efficacy of LSAP programs.
Tobin's Q theory: Tobin's q theory provides a mechanism by which monetary policy affects the economy through its effects on the valuation of equities. Tobin defined q as the market value of firms divided by the replacement cost of capital. If q is high, the market price of firms is high relative to the replacement cost of capital, and new plant and equipment is cheaper relative to the market value of firms. Consequently, investment spending will rise because firms can buy a lot of new investment goods with less issue of equity.
The crux of this transmission mechanism is that when real interest rates decline (ir ↓) from monetary accommodation (M ↑), bonds become less attractive relative to equities, and so investors move out of bonds into equities causing price of equities to go up (Pe ↑) from portfolio rebalancing effects (which were discussed earlier) leading to a higher q (q ↑).
Tobin's q has so far been highly correlated with the LSAP programs, with its magnitude touching as high as 1 in both the rounds of QE, and it has remained in and around that region ever since the LSAP programs were initiated (see figure 8). Tobin's q is naturally correlated with the LSAP programs, as it is a function of the market value of the equities, which rose in both the rounds of QE. With the Fed proposing an open-ended QE called the QE3, and committing to keep the ZIRP regime till 2015, the uncertainty risk premium from monetary policy will all but disappear from the discount rate, pushing equities even higher.
The open-ended QE will promote a bull market in the equities, which will encourage fixed non-residential investment spending that so far has barely kept up with depreciation. With below par spending on investment goods since the outbreak of the crisis (Y ↓) firms have been tightening their belt pushing the labor productivity higher and higher (θ ↑) to unearth higher profits from weak sales. With labor productivity increasing, every unit of additional capital should now produce higher units of output, or in other words, marginal product of capital should also be increasing (MPK ↑) in the economy. With real interest rates very low and the marginal product of capital increasing, sooner or later demand curve for new capital will shift out, resulting in the increase in investment spending (I ↑) and the expansion of the economy. But, monetary policy has long outside lag, and therefore, transmission of the LSAP program through this channel will take longer to reach the economy. But, with open-ended and sustained LSAP program, investment spending should be seeing some upsurge (see figure 9).
Balance-Sheet Channel: This channel is one form of monetary transmission through the credit channel. The balance-sheet channel evolves from the presence of asymmetric information problems in credit markets. The lower the net worth of firms, extreme is the adverse selection and moral hazard problems in lending to these firms.Lower net worth firms have inferior collateral for their loans, and so losses from adverse selection are higher. LSAP measures (M ↑), which encourage rise in equity prices (Pe ↑), result in raising the net worth of firms (see figure 10) leading to higher investment spending (I ↑) and aggregate demand (Y ↑) because of decrease in adverse selection and moral hazard problems.
As explained earlier, LSAP measures lower nominal interest rates (i ↓) causing improvement in firms' balance sheets (see figure 3) because they raise cash flow, thereby reducing adverse selection and moral hazard problems. The higher cash flow mostly materializes from lower borrowing costs, and businesses refinancing their debt to take advantage of the low interest rates.
Wealth effect: This thesis is based on Modigliani's life-cycle model, which states that consumption spending is determined by the present value of life-time resources (PLVR) made up of real capital, human capital, and financial wealth. A major component of financial wealth is common stocks. Through LSAP programs (M ↑), price of stocks have risen (Pe ↑), and therefore, wealth as well as PVLR of consumers have risen (wealth ↑, PVLR ↑). The rise of PVLR would result in increased consumption. Most of the major studies on wealth effect from stock prices and housing prices have been done by Robert Shiller for the Cowles Foundation. You can review his major studies here - study 1, study 2, and study 3. The wealth effect also comes into play with a rise in wealth through housing prices and land prices. As stated earlier, most empirical research has concluded that wealth effect from rising stock prices are weak, whereas housing wealth has tremendous influence on consumption (see table 1).
Source:Congressional Budget Office (CBO).
As discussed earlier, the debates regarding the wealth effect from stock prices have been mostly on the consumers' marginal propensity to consume from rising stock wealth. Equally at the center of those debates was the fact that the top 20% of the income earners in the country account for 81% of the entire financial wealth accumulated in stocks. As rightly pointed out by critics, this imbalance precludes the wealth effect from having a sizable consumption influence on the economy.
Household Balance Sheet Effect or household liquidity effect: As part of the recent debates on stock prices and wealth effect, the thesis on household balance sheet effects, like the few mentioned above, has been neglected entirely. In the household liquidity view, household balance-sheet effects diffuse through their impact on consumers' desire to spend rather than on lenders' desire to lend. Due to asymmetric information, consumer durables and housing are considered very illiquid assets. In times of distress, consumers who require liquidity would not be able to raise money by selling consumer durables and housing because they cannot realize the full value of these assets in a distress sale. However, if they held financial assets like stocks, they could sell them quickly and raise cash by realizing their market value. A consumer's balance sheet provides insights into his estimate of the likelihood of suffering financial distress.
So, when a consumer has a large amount of financial assets relative to his debt, his estimate of probability of financial distress would be low, and therefore, would be more willing to buy discretionary items. When LSAP measures (M↑) reflate equities (Pe ↑), what it ends up doing is enlarging the worth of the consumer's financial assets relative to his debt, thereby reducing his estimate of likelihood of suffering a financial distress, and fostering consumption. The similar mode of transmission manifests from LSAP programs' reflation of agency debt, MBS, and corporate bonds too.
Conclusion: Most of the censuring of the Fed's recent QE programs has been on their efficacy in stimulating the economy through the "wealth effect". But, as discussed earlier, such criticisms are unwarranted as the Fed's perception of the wealth effect includes, apart from the core wealth effect, other secondary effects, including Q theory effects, balance sheet effects, and the household liquidity effects. We have to admit that in spite of the massive quantitative easing programs job growth has been tentative to say the least. But, the Fed's commitment to an open-ended LSAP program and a ZIRP regime till 2015 will give the monetary policy enough time to invigorate the economy promoting secular job growth.
Consequently, using the arguments outlined in the sections on wealth effect, Tobin's Q theory, balance-sheet effects, and household liquidity effects in this article - Consumer Discretionary (XLY), Technology (XLK), and Industrials (XLI) will be the best performers during the QE3 program, and thereafter. Information technology and industrials will see tremendous revenues from increased investment spending and discretionary spending by the firms as a result of the open-ended QE3 program, and with profit margins already very high, earnings should boom. QE3 will also put housing (part of consumer discretionary sector) on a higher growth trajectory and the resulting consumer confidence will percolate throughout the economy. The consumer discretionary should also begin to see revenues shoot from renewed consumer confidence and rising housing wealth.
Source: The Channels of Monetary Transmission: Lessons for Monetary Policy, Frederic S. Mishkin, 1996.