Transmission Channels for the Fed’s QE2
What are the channels for QE2? In a recent post, David Beckworth outlines his frustration:
“It has been frustrating to watch Fed officials explain QE2. The standard Fed story centers around the QE2 driving down long-term interest rates and stimulating more borrowing.“
On the tip of my tongue, I can think of three direct channels: (1) the interest rate channel, which is the source of his frustration, (2) the wealth effect channel, and (3) the weak-dollar channel.
- The interest rate channel: the Fed lowers current and expected real borrowing costs to firms and households, thereby stimulating domestic demand via increased consumption and investment. Clearly, this is the most clogged channel, as it requires increased bank lending and leverage build.
- The wealth effect channel: the Fed drives up the price of riskless assets (bonds), forcing substitution toward risky assets (equities, corporate bonds, etc.), which raises household wealth (via asset price appreciation) and current consumption demand. This channel was highlighted publicly in October by Brian Sack at the 2010 CFA Fixed Income Management Conference:”Nevertheless, balance sheet policy can still lower longer-term borrowing costs for many households and businesses, and it adds to household wealth by keeping asset prices higher than they otherwise would be.” In my view (see chart below), this has been the strongest channel through which Fed policy has worked.
- The weak-dollar channel: the Fed prints money, thereby debasing the currency relative to global trading partners. The technicalities of a weak dollar policy prevent the Fed’s actions as directly being a weak-dollar policy; however, the short-term effect on the dollar was quite strong. In the end, though, we see that the Fed’s policy has had no accumulated impact on the dollar to date (see chart below). This policy still has some time to work through, since the Fed only recently initiated its quantitative easing program again. Furthermore, it’s unclear to me how the dollar will play out in 2011 (perhaps another post), since it’s really a relative game: Fed QE versus the European debt crisis, EM inflation expectations rising, or the like.
The chart below proxies the three channels using the 5y-5yr forward TIPS rate (1), the S&P 500 equity index (2), and the dollar spot index (3). The value of each channel is indexed to the September FOMC meeting for comparability.
The interest rate channel has been negative, as expected real yields increased 35% since the FOMC meeting, driving up expected borrowing costs. The wealth channel has been strong and positive. The S&P 500 gained 9% since the September FOMC meeting date, but the gains really started earlier, as speculators front-ran the Fed decision. Finally, the dollar channel fizzled out, as the dollar index (against major trading partners) is pretty much flat over the period.
I’d like to hear your input regarding other potential channels for Fed policy. But the data has, objectively, been surprising to the upside. Thus the growth outlook has improved. The chart below illustrates the Citigroup economic news surprise index (compared to Bloomberg consensus), which turned to the positive at the outset of November.
Many moving parts.
Rebecca Wilder
I may be not so smart, but I cannot for the life of my understand how QE2 is going to stimulate more borrowing and spending in the current mess.
Consumer won’t spend because they fear for their jobs and incomes.
Businesses won’r spend because demand is week from fearful consumers.
So QE2 fixes this how? Someone please educate me.
QE2’s major success was raising inflation expectations. The jury’s out on its ability to stimulate the macroeconomy.
I am of the firm opinion that retail sales and consumer spending patterns are beating expectations for two reasons: (1) there’s all sorts of pent-up demand out there, and (2) massive pricing incentives. I went shopping today, and everything’s on sale! And that’s at the peak shopping time before Christmas!
The pent-up demand is really important. Consumers have been bogged down for going on 5 years now with the banking mess. In my veiw, there is finally a slight air of certainty regarding economic prospects – this is pushing consumers to spend (frugally, according to the Fed Beige Book).
But it’s highly questionable that consumers will continue to underpin the growth trajectory. With hours still to be added back in lieu of jobs, and the monthly payroll growth still meager at best, workers have NO pricing power. Therefore, it’s highly questionable (1) if consumers will increase spending further when wages do grow, something north of 4.5% per year. Most of the upwardly-revised forecasts are contingent on consumer saving rate remaining at the current 5.7%.
The success of QE2 depends on the consumer, when it’s the firms that are holding all of the wealth. What the government should be doing is increasing incentives to firms for hiring and the investment of capital.
I’m with you. Rebecca
E2’s major success was raising inflation expectations. The jury’s out on its ability to stimulate the macroeconomy.
I am of the firm opinion that retail sales and consumer spending patterns are beating expectations for two reasons: (1) there’s all sorts of pent-up demand out there, and (2) massive pricing incentives. I went shopping today, and everything’s on sale! And that’s at the peak shopping time before Christmas!
The pent-up demand is really important. Consumers have been bogged down for going on 5 years now with the banking mess. In my veiw, there is finally a slight air of certainty regarding economic prospects – this is pushing consumers to spend (frugally, according to the Fed Beige Book).
But it’s highly questionable that consumers will continue to underpin the growth trajectory. With hours still to be added back in lieu of jobs, and the monthly payroll growth still meager at best, workers have NO pricing power. Therefore, it’s highly questionable (1) if consumers will increase spending further when wages do grow, something north of 4.5% per year, and (2) whether infomce will grow sufficiently to support rising consumption and saving simulaneously. Most of the upwardly-revised forecasts are contingent on consumer saving rate remaining at the current 5.7%.
The success of QE2 depends on the consumer, when it’s the firms that are holding all of the wealth. What the government should be doing is increasing incentives to firms for hiring and the investment of capital.
I’m with you. Rebecca
QE2’s major success was raising inflation expectations. The jury’s out on its ability to stimulate the macroeconomy.
I am of the firm opinion that retail sales and consumer spending patterns are beating expectations for two reasons: (1) there’s all sorts of pent-up demand out there, and (2) massive pricing incentives. I went shopping today, and everything’s on sale! And that’s at the peak shopping time before Christmas!
The pent-up demand is really important. Consumers have been bogged down for going on 5 years now with the banking mess. In my veiw, there is finally a slight air of certainty regarding economic prospects – this is pushing consumers to spend (frugally, according to the Fed Beige Book).
But it’s highly questionable that consumers will continue to underpin the growth trajectory. With hours still to be added back in lieu of jobs, and the monthly payroll growth still meager at best, workers have NO pricing power. Therefore, it’s highly questionable (1) if consumers will increase spending further when wages do grow, something north of 4.5% per year, and (2) whether income will grow sufficiently to support rising consumption and saving simulaneously. Most of the upwardly-revised forecasts are contingent on consumer saving rate remaining at the current 5.7%.
The success of QE2 depends on the consumer, when it’s the firms that are holding all of the wealth. What the government should be doing is increasing incentives to firms for hiring and the investment of capital.
I’m with you. Rebecca
i didnt think you could stay away long, rebecca…
retail sales are practically at a new nominal high; yet we have ten percent unemployment, 20% if you count those underemployed…one out of six have been unemployed in the last 18 months, and 17% are working in a lower paying job out of their field…so who could be pushing retail sales back up?
for the most part, i figure it must be the same people who will be getting the extra big tax cuts when the bush cuts are renewed…
maybe if we all get lucky, they’ll trickle down on the rest of us…
I agree with the pent up demand, but people are bargain surfing and I do not see any breakout from the general lack of confidence.
At some point people will need to buy autos and houses, but I see them waiting just a slong as humanly possible, excepting the few who have enough confidence or cash to go bargain surfing.
Long, ugly cold winter I fear. QE2 will have little or no impact, I suspect.
Wonder when someone on the TV econ shows is going to note that gas is now over $3.00 and so is heating fuel.
There may be pent up demand, but I think as time passes, that will fad, not do to satisfying that demand, but do to having gone without for long enough that “wanting” is no longer the emotional driver it was.
Oh yeah, deductables are not hitting $1000 to $2000 for regular health insurance. That use to be considered a “high deductable” plan. Now it’s the norm. Have you checked your auto insurance? Mine I just noticed is up 19% in 2 years. Got the agent investigating.
Groceries anyone?
Maybe it’s just my living in RI that’s clouding my thinking.
Wonder when someone on the TV econ shows is going to note that gas is now over $3.00 and so is heating fuel.
There may be pent up demand, but I think as time passes, that will fad, not do to satisfying that demand, but do to having gone without for long enough that “wanting” is no longer the emotional driver it was.
Oh yeah, deductables are now hitting $1000 to $2000 for regular health insurance. That use to be considered a “high deductable” plan. Now it’s the norm. Have you checked your auto insurance? Mine I just noticed is up 19% in 2 years. Got the agent investigating.
Groceries anyone?
Maybe it’s just my living in RI that’s clouding my thinking.
QE2 has made us all poorer. Sure, in theory the value of the dollar declines against other currencies, but that just makes most of us poorer. Then there is the matter of the Fed’s hubris thinking they can tame inflation.
Let’s agree for a minute there is pent-up demand. Pent-up demand is satisfied by a few. Not many. There is way more job insecurity for those holding onto their wage earnings over the last few years. For the bottom 90 without work, a steep, decline in living standards. How is that the groundwork for a recovery?
I don’t think the Fed acknowledges what used to be called the Middle Class. So, where are these consumers they need going to come from?
Rebecca,
I’d say there’s an over abundance of pent up demand for employment. Seriously though, on the point you make regarding the wealth effect channel: Could it not be the creation of another bubble? (If consumption demand doesn’t keep pace with asset price appreciation.)
It seems to me that the Fed will have to find a way to increase the velocity of the money sitting in excess reserves.
The interest rate channel is operating outside bank lending. Corporate spreads are very narrow, and corporate bond issuance has been very active. There is a split between those firms with access to the bond market and those restricted to borrowing from banks. This will, I think, lead to less activity among small and smaller medium-sized firms, more among large firms. If that’s right, it means more economic concentration over time.
One result of the high level of corporate bond issuance is that roll-over risk has been reduced. There was a very heavy refinancing schedule over the next three years, which has been significantly reduced. That means any rise in borrowing cost has been partly avoided, and that aggregate roll-over risk to the economy as a whole has been reduced. To the extend that Fed policy has helped narrow spreads, there has been a significant “lending channel” impact through the corporate debt market.
I think we’ve been over this before.
And since you cover it in the “wealth effect channel” I’m surprised you seem to doubt the impact of Fed policy via the “interest rate channel”. They go together.
Whence the faith in the consumer? The mass of US consumers (those whose income was below the top one percent) used to have somewhere between 89% to 91% of all income not so long ago. They now have somewhere in the vicinity of 76.5% and that share is still shrinking,
All of these fiscal and monetary tools are aimed at marginal changes in mass behavior … not all consumers but just some millions of consumers will respond to a tax cut or an interest rate change by using a marginal dollar in income to buy McDonald’s at lunch instead of brown-bagging it. That means, say, forty million of new burgers being sold, then more employees being hired and so on. And that has been our experience with these tools when income distribution was much less skewed.
There are just not enough people in the top one percent (who now collect 23.5% of national income) to respond to these marginal cues in a wat that can move the economy. Ten thousand of the top income earner might eat out more frequently but they are not eating forty million burgers.
Whence the faith in the consumer? The mass of US consumers (those whose income was below the top one percent) used to have somewhere between 89% to 91% of all income not so long ago. They now have somewhere in the vicinity of 76.5% and that share is still shrinking,
All of these fiscal and monetary tools are aimed at marginal changes in mass behavior … not all consumers but just some millions of consumers will respond to a tax cut or an interest rate change by using a marginal dollar in income to buy McDonald’s at lunch instead of brown-bagging it. That means, say, forty million of new burgers being sold, then more employees being hired and so on. And that has been our experience with these tools when income distribution was much less skewed.
There are just not enough people in the top one percent (who now collect 23.5% of national income) to respond to these marginal cues in a wat that can move the economy. Ten thousand of the top income earner might eat out more frequently but they are not eating forty million burgers.
Whence the faith in the consumer? The mass of US consumers (those whose income was below the top one percent) used to have somewhere between 89% to 91% of all income not so long ago. They now have somewhere in the vicinity of 76.5% and that share is still shrinking,
All of these fiscal and monetary tools are aimed at marginal changes in mass behavior … not all consumers but just some millions of consumers will respond to a tax cut or an interest rate change by using a marginal dollar in income to buy McDonald’s at lunch instead of brown-bagging it. That means, say, forty million of new burgers being sold, then more employees being hired and so on. And that has been our experience with these tools when income distribution was much less skewed.
There are just not enough people in the top one percent (who now collect 23.5% of national income) to respond to these marginal cues in a wat that can move the economy. Ten thousand of the top income earner might eat out more frequently but they are not eating forty million burgers.
“The interest rate channel is operating outside bank lending.”
Yes, we’ve been over this before; but I disagree that corporate issuance has or has created any real economic impact. Because
I concur with the the lowered activity among small and medium firms. I do not see the logjam breaking anytime soon, and there is continuing attrition among smaller firms.
I suppose it’s a question of what one means by “working”. As in, “the interest rate channel isn’t working”. It is having an impact, just not the one on which you are focused. My interest in roll-over is that it reduce the risk of yet another financial shock – firms that may have faced roll-over troubles in a crowded market are refinancing now, instead of waiting. Firms are changing their debt/equity ratio, too – not necessarily for the good. Even so, the interest rate channel is having substantial effects, just not on aggregate debt.