They Also Serve Who Only Stand and Graph: A Graphical Response to Paul Krugman on the Effect QE1 and QE2

by Mike Kimel

They Also Serve Who Only Stand and Graph: A Graphical Response to Paul Krugman on the Effect QE1 and QE2

I’ve taken a lot of flak for critiquing two posts by Paul Krugman in two posts of my own (the second one is here).

To summarize the point where people keep telling me I’m wrong, it has to do with quotes from Prof. Krugman’s pieces, and whether or not I’m misinterpreting those quotes. So I’m going to try this again… I’m going to put up the quotes and tell you how I’ve been told I should be interpreting those quotes. Then I’m going to put up a graph.

Before I get started, I want to be clear: Prof. Krugman is often the only voice of reason, particularly on issues like austerity and taxes, among those allowed up onto the platform to speak. What follows is not a polemic against Prof. Krugman. All of us are wrong sometimes. But I’m focusing on this issue precisely because it seems to be one of the factors leading one of the few voices of reason out there astray on an important issue. Anyway, enough with the editorial comment. First, a quote from Prof. Krugman’s first post.

Furthermore, Fed efforts to do this probably tend on average to hurt, not help, bankers. Banks are largely in the business of borrowing short and lending long; anything that compresses the spread between short rates and long rates is likely to be bad for their profits. And the things the Fed is trying to do are in fact largely about compressing that spread, either by persuading investors that it will keep short rates at zero for a longer time or by going out and buying long-term assets. These are actions you would expect to make bankers angry, not happy — and that’s what has actually happened.

Now, from Prof. Krugman’s second post in which he responds directly to me :

Ordinary monetary policy involves cutting short-term rates to fight a slump; it’s not what we’re talking about here, since it’s hard up against the zero lower bound. But the large-scale conventional expansion the Fed engaged in by getting to the zero bound has, of course, widened the spread between short and long term rates, since markets expect short rates to rise above zero eventually. So looking at the raw data on the short-long spread tells you nothing.

The bolding, in both cases, is mine. Now, I’ve had people writing to tell me I’ve interpreted these two paragraphs the wrong way. The way to interpret them, I’m told (and now that it has been pointed out, I can see the logic) is this:

1. The Fed engaged in conventional expansion at the beginning of the financial meltdown, and that widened the spread between the short term rate at which the banks borrow and the long term rates at which the banks lend.

2. During the nonconventional expansions (i.e., QE1 and QE2), the spread narrowed).

3. Banks prefer wider spreads, and thus, we have evidence that banks are actually unhappy with the things the Fed is (or was) trying to do.

Point number 1 is partly consistent with the graph shown in my first post on the topic, or at least kind of. The graph shows the spread between the FF rate and the 30 year mortgage rate. (i.e., the spread between the shortest rate at which banks borrow and the longest rate at which they regularly lend.) As the graph shows, the spreads widened… but best I can tell, they hit a local bottom in December of 2006. That big process of widening of spreads began in early December 2006.

If you think of monetary policy in terms of interest rates, which most people (and not to speak for Prof. Krugman, but based on reading his posts on a daily basis for many years, it is evident he does), there is nothing magical about early December 2006. The Fed Funds rate was about 6.11% at the time. It rose (not quite continuously) through mid June of 2007, but remained above 6.11%. But from early Dec 2006 to mid June of 2007, the spread increased from 0.86 to 1.48, a jump of 72%. Yes, as interest rates tightened, the spread continued rising, but the whole big rise got jumpstarted not with conventional monetary expansion, but rather with conventional monetary tightening, and this happened before anyone was thinking slump.  

Here’s a second graph. It shows the FF rate, the spread between the FF and the 30 year mortgage rate, QE1 and QE2. The QEx periods are represented by the Gray bars. I’ve also labeled the non-QEx periods as C1, C2 and C3 for “conventional 1,” “conventional 2,” and “conventional 3” – not that any of what we’ve seen in this time has been conventional.

As I noted already, the C1 period is not entirely consistent with how I’ve been told I should be interpreting Prof. Krugman’s quotes, though it isn’t inconsistent with the quotes either. Call it a wash.

What about QE1? Well, the spread peaked the weak of Nov 6 2008 (spread of 5.96), and QE1 began on Nov 26 (spread of 5.41). During QE1, the spread got as low as 4.59 in Dec 2009, and then widened out. The spread was at 4.92 at the end of March 2010 when QE1 ended.

I don’t know what to make of this. Was QE1 telegraphed? It sure doesn’t look like it if you at the FF, but I don’t know enough about that market. I will only say that from where I’m standing, it sure likes the compression Prof. Krugman was talking about is due to something other than QE1. I say this because the narrowing of the spread was actually about the same (actually, a smidge greater) over a three week period leading up to the start of QE1 as it was from the beginning of QE1 to the end of QE1. Worse, it seems that the last four months of QE1 show a widening, not a compression of the spread.

Where the story begins coming apart completely, though, comes in period C2. Somehow the spread begins to narrow precisely, and I do mean precisely, at the point where QE1 ends. From March 31, 2010, to November, 2010, we see a narrowing of the spread that looks more like a straight line than anything else in the graph.

And then…. the spreads begin to widen again beginning in early November 2010. But QE2 began November 3, 2010, and, according to what people tell me, QE2 should have led to a narrowing of the spread, not the end of the narrowing of the spread.

In sum, the evidence is neutral when it comes to what Prof. Krugman believes happened to the spread during QE1, and it contradicts his views on QE2. None of this is to knock anyone, not Prof. Krugman, nor any of the folks who wrote me. We’re living in unconventional times, and the old rules don’t apply. I would merely suggest that in the light of this information, people re-evaluate whether unconventional monetary policy really is hurting the banks. As I suggested in my previous two posts, I believe the evidence shows quite the opposite.

  (As always, if anyone wants my spreadsheet, just drop me a line. I’m at my first name (mike), my last name (kimel with one m), at gmail.)