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.)
There are two different forces, the market and the Fed, and two different effects a Fed action may induce. A perceived decrease in expectations will narrow the spread and a increase will widen it. A perceived increase in risk will widen the spread and a decrease will narrow it. A fall in expectations may increase risk while a rise in expectations may decrease it. A Fed action may have a direct effect of increasing or lowering short (conventional) or long (unconventional) rates, but it can also have indirect effects of changing both perceived expectations and risks. During QE, the Fed focused on the size of its balance sheet rather than long rates themselves making it less effective at affecting long rates or the spread. The market then had to interpret the Fed actions as either an increase or decrease in expectations or risk, often countering each other. Is the economy in worse shape than we think? Is this action sufficient to counter this change in perceptions or not? While risk may be reduced, expectations may also.
Lord,
I’m with you, Lord knows. This is kind of my theme song since I started writing here at AB: “yes, the theory sounds good, but the data shows its not happening.”
Mike,
Not that its the best source, but if it is any consolation in distinction from the barage of criticism that you note you have had to endure, here is the headline of an article on the same subject matter on Counterpunch:
“The Fed Works for the Very Rich” Why Paul Krugman is Full of Shitby ROB URIEhttp://www.counterpunch.org/2012/04/23/why-paul-krugman-is-full-of-shit/They tend to be far less deferential at that web site magazine. Maybe they’re a little more left of center. Or just a little more pissed off at all the rhetoric that seems to spin around like a dervish or tumble weed in a wind storm. But nothiing changes for the better for the majority. Then again maybe that majority doesn’t want too much change for the better or worse. What Krugman has to say, and he says it from the big stage through big amp speakers, is often ignored regardless of its validity or lack thereof. Maybe we’re all just spittin’ in the wind. I heard a campaign report yesterday on NPR/WNYC-FM. A voter at a Romney/Rubio stop in Nowhere, PA was questioned about her preferences. She was luke warm on Romney, but effucive regarding Rubio. Her voice carried her delight right through the airwaves. “He’s a real conservative. Its in his blood.” She made nearly no sense in regards to why she blushed over Rubio, but she obviously would have voted for him for President. With that kind of thought process out there and prevading the voting public, what difference does it make whether Krugman is right or wrong? Better he shave, die his hair black, build up his pecs and then say any stupid crap about the economy that he cares to and he’ll have far greater influence over public opinion.
Seriously, Mike, if you mention FF one more time, I’m gonna buy an airline ticket, come over there and plant a sign in your front lawn with an explanation of what it is! 🙂
Going back to the last post:
“1. the housing market was tanking, driving down home prices and driving up foreclosures
2. the expectation was that the situation in the housing market was becoming worse and foreclosures were going up with no end in sight
3. the perceptions described 1. and 2. was that derivatives based on mortgages would continue losing value and nobody knew where the process would end
4. as a result of 1., 2., and 3., nobody wanted derivatives based on mortgages… those who had such derivatives on their books wanted them gone, and nobody else would buy them at any price”
1, 2, and 3 are absolutely correct, and 4 is true for the, shall we say, shadier tranches of MBS. However, what the Fed bought was not MBS as a whole — they bought the tippy-toppiest safest-least-toxic AAA rated bonds. Not some fake-Aaa CDO-squared: the real thing, with real people and real income paying off their realistically-valued mortgages.
And what this did (I’ll send you a mail with a graph or two) is drive down the rates on AAA MBS by about 2 percentage points, which I think is quite impressive, and drive down consumer mortgage rates by … not quite so much, but then when you and I go to the mortgage broker, we do have to pay a risk premium.
And if you go back to my comment two posts ago that banks can lend at a rate determined by (a) their cost of capital [which isn’t relevant here] or (b) the yield at which they can securitise the loans [which is], then the Fed definitely did exert a downward pressure on mortgage rates.
Two posts ago:
“Remember the toxic asset purchase? When the Fed spends over a trillion bucks paying the face value for securities whose real worth has declined to a fraction of that face value”
Not quite true. 15-year FNMA/FHLMC bonds were, at the time, yielding about 6% (pretty much average for the whole of the 00s, and about where you’d fund investment-grade debt in the 90s). Not the 15, 20, 30% you’d expect on junk bonds, nor the pennies on the dollar you’d expect for something really toxic.
In TALF, they did the same thing for securitised lending (auto loans, credit cards, etc.) with similarly-positive results. (Don’t buy the Taibbi story about Wall St widows making out with the Fed’s largesse. The program turned a profit, i.e., it transferred wealth from frightened capital to the Treasury. Result!)
Seriously, Mike, if you mention FF one more time, I’m gonna buy an airline ticket, come over there and plant a sign in your front lawn with an explanation of what it is! 🙂
Going back to the last post:
“1. the housing market was tanking, driving down home prices and driving up foreclosures
2. the expectation was that the situation in the housing market was becoming worse and foreclosures were going up with no end in sight
3. the perceptions described 1. and 2. was that derivatives based on mortgages would continue losing value and nobody knew where the process would end
4. as a result of 1., 2., and 3., nobody wanted derivatives based on mortgages… those who had such derivatives on their books wanted them gone, and nobody else would buy them at any price”
1, 2, and 3 are absolutely correct, and 4 is true for the, shall we say, shadier tranches of MBS. However, what the Fed bought was neither MBS as a whole, nor the toxic stuff — they bought the tippy-toppy safest-least-toxic AAA rated bonds. Not some fake-Aaa CDO-squared: the real thing, with real people and real income paying off their realistically-valued mortgages.
And what this did (I’ll send you a mail with a graph or two) is drive down the rates on AAA MBS by about 2 percentage points, which I think is quite impressive, and drive down consumer mortgage rates by … not quite so much, but then when you and I go to the mortgage broker, we do have to pay a risk premium.
Remember, as I said two posts ago, banks can lend at a rate determined by (a) their cost of capital [which isn’t relevant here] or (b) the yield at which they can securitise the loans [which is].
Also two posts ago:
“Remember the toxic asset purchase? When the Fed spends over a trillion bucks paying the face value for securities whose real worth has declined to a fraction of that face value”
Not quite true. 15-year FNMA/FHLMC bonds were, at the time, yielding about 6% (pretty much average for the whole of the 00s, and about where you’d fund investment-grade debt in the 90s). Not the 15, 20, 30% you’d expect on junk bonds, nor the pennies on the dollar you’d expect for something really toxic.
Also related:
In TALF, they did the same thing for securitised lending (auto loans, credit cards, etc.) with similarly-positive results. (Don’t buy the Taibbi story about Wall St widows making out with the Fed’s largesse. The program turned a profit, i.e., it transferred wealth from frightened capital to the Treasury. Result!)
I’m very tired and haven’t been getting much sleep, but here is what I’m talking about when I keep saying this is all an argument over trivia and the real problem lies elsewhere. Think of this:
“not quite so much, but then when you and I go to the mortgage broker, we do have to pay a risk premium. “
I understand that there should be a risk premium. But why was it considered kosher to create a program that beneifted those who desperately wanted MBS off their balance sheet and not those who had mortgages? (Note – I say this as someone who had no dog in that fight. I didn’t have a mortgage until Dec 2009 myself.) I don’t like the idea of bailing out one group of bad decision makers.
As to the FF, as I said, its a short term rate at which banks can borrow. Don’t blame me – Prof. Krugman was the one who brought up banks borrowing at a short term rate.
“ The program turned a profit, i.e., it transferred wealth from frightened capital to the Treasury.”
Let’s stop right there. That may have been true on some programs. But it is still missing the point. The point is, when the Treasury did X with entity GS, and Warren Buffett did X with entity GS, at roughly the same time, Warren Buffett got much better terms. I can understand if Warren Buffet brought more cash and credibility to the deal than the Treasury, but otherwise, the only conclusion is that Treasury was not driving a hard enough bargain. Put another way: a gift.
“4 is true for the, shall we say, shadier tranches of MBS. However, what the Fed bought was neither MBS as a whole, nor the toxic stuff — they bought the tippy-toppy safest-least-toxic AAA rated bonds.”
Yeah? Then it wouldn’t have been a bailout. If people still wanted those traunches tht the Fed was buying, what was the point of the Fed stepping in?
Mike 3, Cameron 0!!!
As noted above, in spite of all of the objective and knowledgeable information and analysis being made available we are in a perpetual spin with the ignorant and the dissemblers well out ahead for the attention and minds of the general public.
you have done a great work ………. its really working and important for us. so please keep sharing ….
Branding and Advertising
Mike,
Or you could put it another way: Goldman payed a risk premium/penalty to Buffett which the Treasury offset with a gift.
OK, last reply on the topic and I’ll leave it (hoping you get some sleep). In opening commentary, let me say that I’m honestly trying to:
a) clear up misinformation
b) get you to believe Krugman (who’s right)
c) explain how the system works so you can better understand how to fix its flaws
and that:
d) I’m not American, so I have even less dog in the fight, but
e) if I were, I’d be a progressive Dem
OK?
So, claim #1 is: Krugman is wrong because Fed interventions didn’t move the mortgage rate.
Except they did:
http://research.stlouisfed.org/fred2/graph/?graph_id=73502
See the big sell-off in Aug-Sep 08 and the continued downward movement? That’s the Fed moving rates, proximally in agency bonds, and distally in actual rates paid. That allows people to refinance, etc.
Claim #2: PK – “These are actions you would expect to make bankers angry, not happy — and that’s what has actually happened” is wrong.
Look at the green line. FRED is limited in its dataseries, but I’ve replicated this with bank-only 5-year bond data and financials’ CDS spreads and corporate yields are a reasonably good proxy, so I’ll go with what I can get.
See how the green line (proxy for banks’ 5-year borrowing rates) go above the 30-year mortgage rate? That’s the Fed making the business unprofitable, and hence “angry bankers”. See how much closer the green and red lines are after 2008 compared to before? That’s the Fed squeezing banks.
“As to the FF, as I said, its a short term rate at which banks can borrow. Don’t blame me – Prof. Krugman was the one who brought up banks borrowing at a short term rate.”
I pointed you at the right short-term rate to use in the comments on the OP, but you chose to run with something else and got the analysis wrong. 😉
“If people still wanted those traunches tht the Fed was buying, what was the point of the Fed stepping in?”
I already explained that banks were fine with agency debt, holding it at 6% yield. The Fed wanted to move mortgage rates, which it did.
“Then it wouldn’t have been a bailout.”
Agreed: it wasn’t. It was a policy move.
==
As the the power asymmetries and political implications, I reiterate points (d) and (e) above, and hope y’all do the right thing come November.
Sorry, “sell-off” is wrong in the above; should be “drop in yields”.
Sorry, “sell-off” is wrong in the above; should be “drop in rates”.
Carmeron,
I don’t think I ever wrote anything that said or implied that the Fed’s interventions had no effect on the mortgage rate. Obviously it did. Push the FF down to almost zero and the mortgage rates are going to (with a lag) move down too. I’m not sure that’s a good thing, mind you,
My problems with what Prof. Krugman wrote are two:
a. He’s wrong about what happened to the spread
b. He’s wrong about whether this is good or bad for banks
I don’t really care, to be honest, about a except that Prof. Krugman uses a as evidence for b. And Ir eally don’t care about b except that somehow that somehow is produced as evidence that the Fed is not acting in a way to benefit the banks, and therefore… well, I’m not sure what the therefore is, except that it is causing a very smart guy to pay attention to some strange bits of trivia while ignoring big important issues.
I can’t comment on the green line – I don’t enough to know how its calculated and right at this moment I’m packing (giving a speech on ensemble methods in Toronto tomorrow) so I can’t go through it except to say this… the timing of that spike clearly has nothing to do with QE1 which began in late Nov 2008. Pull the data.
From Jan 1 2008 to the day before QE1 began, the green line went from 5.46 to 9.11. In fact, the bulk of the run-up seems to have begun after the summer. On August 7, the rate was 6.42. So most of the run-up took place from early August to the day before QE1 launched.
What happened after that? The same day QE1 launched, the green line started falling. By 12/31 it was down to 8.31, and on the way down. Precisley one year after QE1 began, the FF was down to 5.02. Still slightly above the mortgage rate, but dropping.
Clearly, the spike in the green line wasn’t caused by QE1. In fact, QE1 caused the green line to fall.
So why did the green line spike? Simple – that was the recession hitting home in the financial sector. That was a few banks paying the price for making bad loans.
Like I said, I don’t have the time to do it right now, but my guess is that we’d see something similar if I used a different rate for banks borrowing. The FF doesn’t move in isolation. The green line spiked because corporate borrowers were, all of a sudden, being seen as a big risk. The Fed didn’t have to do anything to move down mortgage rates – they were already moving down by themselves, so this “The Fed wanted to move mortgage rates, which it did” is wrong.
Basically, it was a bail-out intended to help a group of entitites that was now being seen as a big risk because some members of that group had made abysmal decisions. Everything possible was done to prevent the bad decision makers from paying any price for those decisions.
In terms of what that does to the financial markets in general, I think in the long term its harmful. Sure, people have no choice in their 401-Ks, but non 401-K may be going elsewhere in the long run. My wife and I have taken just about all of our savings out of the market and put it into rental properties beginning in 2008.
OK. Gotta find my flight info. Probably will be off-line until Friday.
Jack,
I think Cameron just has the timing wrong, nothing more. We all lived through that period, and our own memories are often misleading.
no cameron is correct. We had a huge wave a refinancing because the Fed pushed rates down. Millions of people got to keep their houses because of this – and that vast bank profits that keep being imagined are not there.
http://delong.typepad.com/sdj/2012/04/why-does-wall-street-dislike-obama-so-much.html
rootless_e,
Seriously? Where did I state that the Fed’s pushing down FF didn’t also push down mortgage rates? It is other parts of Cameron’s (and Prof. Krugman’s and your) story that don’t fit, timing-wise.
Oh! So much wrong. I know I said I’d leave it, but … one more time.
Banks don’t fund their mortgage operations using Fed Funds.
Banks fund their mortgage operations using short (2-3 year) to medium (5-7 year) debt for loans they hold on the books, or by securitising those mortgage either through private label operations, or through agencies (FNMA/FHLMC). The rate at which they can lend on those mortgages is determined by the rate at which they can borrow through those channels.
Look at the pre-crisis graph. Bank bond yields (actually corporates, but as I explained, it’s a reasonable proxy) and mortgage rates move in lockstep, and are completely unaffected (well maybe a little) by the rise in FF from 2004-06.
So why should the drop from 5.25 in 2006 to 0.25 in 2009 make a difference? Answer: it shouldn’t.
Because banks don’t fund their mortgage operations using Fed Funds.
However, the shift from the Fed moving rates by buying treasuries, to moving rates by buying agencies, did move mortgage rates, because it changed “the rate at which [banks] can borrow through [that] channel”.
For better or worse, it’s a credit economy. It’s all about rates, channels, and risk segmentation.
Cameron,
Once again, I would suggest you zoom in on the data. You might find something different if you stare at it in shorter segments. For instance, I downloaded the data you linked to above… the FF and the B of A Merril Lynch 5 to 7 year. Then I considered this statement:
“Bank bond yields (actually corporates, but as I explained, it’s a reasonable proxy) … are completely unaffected (well maybe a little) by the rise in FF from 2004-06.”
I then looked at monthly data from Jan 2004 to Dec 2006 for the series you mentioned. The correlation between the two series during that time period is 0.86. If the two series aren’t moving in lockstep during that period, they’re sure seemed to be doing a good imitation of it.
I would suggest that if you want to talk about a specific period of time, you might want to zoom the graph in on that period rather than retain the view from a longer period of time as you seem to be getting the timing of things you state wrong.
I downloaded the data you linked to above… the FF and the B of A Merril Lynch 5 to 7 year. Then I considered this statement from your most recent comment:
“Bank bond yields (actually corporates, but as I explained, it’s a reasonable proxy) … are completely unaffected (well maybe a little) by the rise in FF from 2004-06.”
I then looked at monthly data from Jan 2004 to Dec 2006 for the series you mentioned. The correlation between the two series during that time period is 0.86. 0.86 is past the point where you start thinking about multicollinearity.
I’ll send you data in a sec, but I did a regression of 10 and 30-year agencies vs. FF and 3-5, 5-7, and 7-10-year bank bond yields.
Regression coefficients were:
10s: -0.02 (FF), -0.26, 0.18, 1.04 (R2: 0.99)
30s: -0.01 (FF), -0.90, 0.00, 1.69 (R2: 0.98)
Take a look and see if you agree!
But this is kind of irrelevant to the real discussion which is (or was) about the Fed buying MBS in late Nov-08. 😉
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