Effects of operation twist

The Federal Reserve announced on Wednesday that it will sell some of
its shorter-term assets in order to buy more longer-term assets. Here
I assess some of the possible consequences of this move.

The maneuver is being referred to by some as "operation twist", an
expression that was originally used to describe a plan implemented by
the Kennedy administration and the Federal Reserve in 1961, and given
its moniker after a dance popular at the time. The idea then was that
the Treasury would replace some of its longer-term debt with
shorter-term obligations, and the Federal Reserve would simultaneously
sell some of its shorter-term securities and buy longer-term
Treasuries. Some of the early research (e.g., Modigliani and Sutch,
1966) concluded that the original Operation Twist was not terribly
successful. However, Federal Reserve Bank of San Francisco economist
Eric Swanson has a new paper recently presented at the Brookings
Institution that makes a convincing case that Operation Twist did
succeed in its goal of modestly lowering long-term interest rates.

The Fed announced on Wednesday that it is going to try something
similar, intending over the course of the next 9 months to sell about
$400B worth of its Treasuries that have maturity between 3 months and
3 years in order to buy securities with maturities of 6 years or
longer. According to the latest H41 statement, the Fed currently only
has $129B in Treasuries between 3 months and 1 year, meaning that much
of what they plan to sell has to be in the 1-3 year range. The details
of the plan released by the Federal Reserve Bank of New York indicate
that about 2/3 of the securities purchased will be in the 6 year to 10
year range, and most of the rest will be over 20 years.

The idea behind this plan is that, in the current setting, dumping an
increased supply of shorter-term Treasuries on the market should have
little or no effect on the short-term interest rate. But by buying
more of the existing supply of longer-term Treasuries, the intention
is to nudge the price of those securities a little higher, or in other
words, try to move the long-term interest rate a little lower. The
hope is by lowering interest rates, there would be slightly more
opportunity for households and firms to borrow or refinance and
perhaps increase spending a bit. The new measure thus represents
something the Fed could try, over and above what it already did in
QE2, that might further stimulate the economy without expanding the
overall size of its balance sheet any bigger than it already is.

In a research paper, we came up with a framework for evaluating the
effects that policies like this might have. Our estimates are based on
how changes in the relative supplies of publicly-held Treasury debt of
different maturities correlated historically with changes in the basic
factors determining interest rates on different securities, which
factors we summarized by the level, slope, and curvature of the term
structure of interest rates. We also built a simple model of how
latent level, slope, and curvature factors have been influencing the
evolution of interest rates in an environment like the current one in
which the overnight interest rate is stuck near zero.

We decided to redo some of our earlier analysis in order to evaluate
the potential effects of a policy like that just announced by the Fed.
We conducted the following counterfactual experiment. Suppose that at
some historical date t, the Federal Reserve were to have sold off its
entire holdings of securities between 3 months and 3 years duration,
and used the proceeds to buy an equiproportional amount of all
outstanding Treasury securities between 6 years and 30 years duration.
For example, if implemented in December 2006, this would have been an
operation involving about $343 billion in securities. We calculated
what this would have done to the level, slope and curvature factors,
and what that would mean for interest rates of different maturities in
the present setting where the overnight rate is stuck near zero. The
result is plotted in the graph below. The horizontal axis reports the
maturity of a given security (measured in weeks), and the vertical
axis reports how the yield on that security (measured in annual
percentage points) might change in response to operation twist.

Horizontal axis: maturity of security (in weeks). Vertical axis:
predicted change in yield on that security (in annual percentage
points) as a result of "operation twist". Calculated using same
methodology as dashed line in Figure 11 in Hamilton and Wu (2010). The
figure plots 5200bn*'φΔ3 for Δ3 = (0.014313,0.012336,-0.0047943)'
corresponding to the average impact on q of the Fed historically
selling all its 3m-3y and buying 6y and up.

We don't claim to have very precise estimates for the outcome of this
new counterfactual experiment-- the values in the figure above are not
statistically distinguishable from zero, according to our analysis.
Nevertheless, they represent the best estimates I can give for the
effects of operation twist. Our estimates suggests that a policy such
as the newly announced operation twist might increase 1-3 year yields
by 2 basis points and lower the yield on the longest term securities
by a little less than 10 basis points.

In addition to the statistical accuracy, there's another big caveat
for these estimates, which is that we are analyzing the effects of Fed
policy alone, assuming that there are no changes over the next 9
months coming from the Treasury. However, this assumption proved
definitely not to be the case with QE2. There, while the Fed was
trying to buy more long-term securities, the Treasury was
preferentially issuing new long-term securities at an even faster
rate, with the net result that the Treasury basically undid any
stimulative effects of QE2. Thus, in contrast to the original Kennedy
Operation Twist, in which the Treasury and Fed were working together,
it's quite possible that in the current environment, they will
continue to be pulling the economy in opposite directions. So I expect
the effects of the Fed's latest measure could turn out to be
significantly less than 10 basis points.

How then do I explain the fact that the 30-year Treasury yield fell 17
basis points on Wednesday? My answer is, this wasn't just the Fed.
News of a weakening European economy may have been more important.
There also may have been some signaling effect with investors
concluding, "Gee, if the Fed thinks they have to do this, the economy
must be in even worse shape than I thought!" As evidence in support of
such an interpretation, commodities and equities also fell
significantly, moving in the opposite direction from what you would
have expected if you believed new stimulus from the Fed was the key
development driving markets.

The modest effects that one could reasonably anticipate for a measure
like operation twist are easily swamped by other developments, and
even a sizable effect on 30-year Treasury yields would not in my mind
provide a major stimulus. I think the correct interpretation is that
the Fed would like to bring some more stimulus, this was something
they could do in that direction, so they did it.

But if you were about to drown, I wouldn't want to count on operation
twist as your lifeline to safety.

Analysis: QE3 may do more harm than good

There may be a point at which global investors get indigestion from
U.S. money printing.

A fresh round of U.S. monetary easing may even do more harm than good
for long-term investors as another flood of easy money into
fast-growing emerging economies risks refueling oil and commodity
price inflation, sapping consumption and growth.

Prospects for a third round of the Federal Reserve's quantitative
easing program (QE3) grew this month after Chairman Ben Bernanke said
the central bank was prepared to ease further if economic growth and
inflation falter again.

Nearly in one in two fund managers surveyed by Bank of America Merrill
Lynch this month said QE3 was likely.

The temptation for risk-loving investors is to rub their hands with
glee. Traditionally risky or high-yielding assets such as global
equities, energy and commodities and emerging markets surged in the
months after the Fed gave the green light for Round Two of QE -- which
involved $600 billion in new money in the form of Treasury debt
purchases and which ended last month.

But the impact on the U.S. economy and the labor market has been less
obvious, given that growth has slowed significantly into 2011 -- at
least partly because higher energy costs have undermined consumer
spending everywhere. Asset prices, as a result, have retreated sharply
again since April's peaks.

This has given rise to a debate about whether QE3 works. If it doesn't
give a sustained boost to financial markets and is ambiguous for the
real economy, is there any point?

"We have a negative opinion of QE2, and believe QE3 could very well
turn out to be ineffective at best, and counter-productive at worst,"
said Stephen Jen, managing partner of London-based hedge fund SLJ
Partners.

"If we are right, QE will be self-defeating in that the more the Fed
eases, the more commodity prices rise, which erodes the capacity of
consumers to spend on non-energy products and services."

Since Bernanke unveiled the Fed's QE2 bond buying program in a speech
in Jackson Hole in August last year, Brent crude oil have risen 58
percent, while the benchmark CRB commodities index has gained nearly
30 percent.

Developed and emerging stock indexes are both up around 20 percent
since that speech but they are coming off their April highs. On the
year both of them are largely flat.

"My best guess is that there will be a few weeks of positive reaction,
followed by a sell-off, as investors realize the circular and
pointless logic of (the argument that) QE2 could lead to permanent
increases in economic activities," Jen said.

UNINTENDED CONSEQUENCES

Some advocates say quantitative easing works best by revaluing
financial assets so that there will be a positive wealth effect for
U.S. consumers, encouraging them to start spending again. The Fed
argues that it boosts credit in a similar way to an orthodox easing by
directly lowering long-term benchmark borrowing costs.

But the effect of ample dollar liquidity spreads beyond the United
States, largely because emerging economies either are pegged to the
dollar or have inflexible exchange rate policies. Even economies that
do allow their currencies to appreciate are at risk of asset bubbles
as cheap money seeks higher yields.

This means these fast-growing emerging economies effectively import
the Fed's monetary easing and lift their demand for oil and
commodities, whose prices also tend to rise on a weaker dollar.

The other problem is that easy money chasing high-yielding assets
drives hot money into the emerging world, fans inflation and triggers
monetary tightening which in turn slows growth -- creating a vicious
circle.

"If QE3 is simply a repeat of QE2, I don't think it has a positive
impact that has sustainability," said Bob Janjuah, head of tactical
asset allocation at Nomura.

"(It) will make a commodity problem even worse. It won't help the
economy but create a much bigger inflationary pressure.

QE3 will force one globally positive growth area, emerging markets, to
slow down because of inflation ... We could end up with a negative
effect."

Janjuah's preconditions for QE3 are a rise in the U.S. unemployment
rate above 10 percent and a 20-25 percent fall in the S&P 500 index.

As benefits wane, many fear the cost of repeated QE operations could
be self-defeating in that more money printing fuels inflation, debases
the currency and ultimately raises the government's borrowing costs.

According to Jen, the Fed's balance sheet has grown by 10 points to 18
percent of GDP in two years - a similar scale to Japan's in the five
years to 2006.

"The marginal impact of QE is decreasing progressively... The weight
of debt on Fed balance sheet is increasing indeed," said Didier
Saint-Georges, member of the investment committee at private asset
manager Carmignac Gestion in Paris.

Why QE3? Fed Right to Focus on Other Things

Jackson Hole and Federal Reserve Chairman Ben Bernanke's speech there,
attention has shifted to this month's Federal Open Market Committee
and the debate over QE3 -- a third round of so-called quantitative
easing.

Given the weakness of the recovery, volatile financial markets and the
headwinds from fiscal austerity, why wouldn't the Fed engage in
another round of easing? After all, QE2 was initiated last year when
the recovery and global financial markets were less fragile.
The Federal Reserve is considering a third round of quantitative easing.

QE3 is not a done deal and could prove to be ineffective despite the
current economic weakness. More and more, monetary policy (especially
quantitative easing) appears ill-equipped to provide support for the
fragile recovery.

Consider these factors:

QE2 remains controversial, and its timing was better: It is always
difficult to isolate cause and effect in an environment as tumultuous
as this global economy, so QE2 remains controversial. Unlike the first
set of actions the Fed took in 2007 and 2008 to stabilize the global
financial system, the impact of QE2 is more muddled. Clearly, the
dollar depreciated, equity markets improved and inflationary
expectations (and retail price movements) increased. It is also clear
that economic activity did not accelerate, commodity prices increased
further and overseas central banks had to respond to the Fed's
actions. In today's environment, retail price pressures are more
prevalent (and not deflation), the dollar is already weak and interest
rates are at modern lows. From the standpoint of interest rates, Fed
statements over the past few weeks have accomplished what QE3 would
do, namely bring down rates. So what else QE3 would accomplish
(besides a temporary bump in equity prices) is something that is not
clear at this juncture.
The Fed still has options, but ... : The Fed's actions since the
beginning of the crisis have been unprecedented, including aggressive
rate cuts, asset purchases totaling almost $3 trillion and a
willingness to provide liquidity to financial and nonfinancial
institutions. Yet there comes a point where monetary policy is pushing
on a string, and the Fed is probably past that point. Liquidity is no
longer an issue. Financial institutional balance sheets have improved
considerably and households have begun the long journey of rebuilding
balance sheets. In addition, remaining committed to its current
accommodative stance through 2013 is a bold action in support of the
recovery. Maybe the time has come to stay on the sidelines for a time
and let other policy solutions support the recovery?

Fiscal policy in the U.S. and Europe matters more than the Fed:
Support for the recovery is not a monetary policy issue. The focus
should be on fiscal policy and the need to provide support in the
short term and a credible plan to address debt levels over the
intermediate to long term. One concern with the Fed repeatedly
intervening is to shift the focus away from where the policy issue
sits -- namely in Washington and European capitals. Enhanced
confidence levels stemming from stronger fiscal policy would have a
more substantial impact on the recovery than QE3 or any other measures
the Fed can bring forward.

QE3 may not be a done deal at this point, and if it does not come to
pass, it will certainly not be the end of the world.

And perhaps the focus will shift to where it should be: the next round
of fiscal negotiations

What are the differences between QE1, QE2 and QE3?

20 June 2011 10:00 

Because the Federal Reserve has become a political target, it is in no hurry to have monetary policy displace fiscal policy in underpinning the economy, but it may be forced to do so given its dual mandate and the likelihood of fiscal contraction. Last week, when discussing what QE3 could look like I indicated that were the Federal Reserve to start expanding its balance sheet, QE3 will see interest rate caps after a pause and period of reflection. Let me address the differences between the various QEs here to illustrate why interest rate caps are being contemplated.

QE1

The LSAPs were not aimed at supplying liquidity to financial institutions or at reducing systemic risk. Instead, they were intended to support economic activity by keeping longer-term private interest rates lower than they would otherwise be.

A primary channel through which this effect takes place is by narrowing the risk premiums on the assets being purchased. By purchasing a particular asset, the Fed reduces the amount of the security that the private sector holds, displacing some investors and reducing the holdings of others. In order for investors to be willing to make those adjustments, the expected return on the security has to fall. Put differently, the purchases bid up the price of the asset and hence lower its yield. These effects would be expected to spill over into other assets that are similar in nature, to the extent that investors are willing to substitute between the assets. These patterns describe what researchers often refer to as the portfolio balance channel.

-The Fed's Expanded Balance Sheet, Brian P. Sack, Executive Vice President, Federal Reserve Bank of New York, Dec 2009

I am not sure why Brian Sack stressed the Fed's intention to support economic activity as the chief aim of QE1 in December 2009. While I won't dispute a Fed official's interpretation of the Fed's intentions, it is abundantly clear that QE1 was a different animal than QE2. In QE1, the Fed purchased agency securities and mortgage-backed securities rather than Treasury securities as it did in QE2. This is significant as Fed Chairman Ben Bernanke was at pains to stress that QE1 was "credit easing", focused on the asset side of the balance sheet, and therefore distinct to what the Japanese had done. See the Bernanke speech at the LSE from January 2009. When he says "in addition to easing monetary policy, the Federal Reserve has worked to support the functioning of credit markets by providing liquidity to the private sector" at the 7-minute mark, it is clear to me that he means that credit easing has provided liquidity that the purchase of mere Treasury securities could not. Whether these asset purchases were "aimed at" providing liquidity is largely semantic.

In my view, the difference between Sack's commentary in December 2009 and Bernanke's in January 2009 owes to the political backdrop because bailouts of the financial sector had become extremely unpopular. During QE1, the Fed purchased $175 billion of agency debt securities and $1.25 trillion of mortgage-backed securities in addition to purchases of Treasuries. In effect, the Federal Reserve became the market as the shadow bank sector imploded. The mortgage-backed securities market had ground to a halt and the Fed took the entire market onto its balance sheet to prevent a second Great Depression.

So, if I had to characterize QE1 I would say: the first round of large scale asset purchases by the Federal Reserve was intended to support economic activity. However, because the Fed focused on the asset side in increasing its balance sheet by buying assets it had not previously purchased in large quantities, the Federal Reserve worked to support the functioning of credit markets by providing liquidity to the private sector. Without this easing, the US and the global economy would have had a depression of indescribable severity with unknown attendant geopolitical and military consequences.

Was QE1 a bailout? Yes. But QE1 was also a legitimate lender of last resort operation. We should question the terms of QE1 i.e. "The Fed lent freely, but at a low rate, on dodgy collateral" not the operation per se.

QE2

The second round of quantitative easing was distinct from the first – and more akin to what the Japanese had done. The aim was to support economic activity in the US domestic economy. Starting in August 2010, the Federal Reserve started reinvesting principal payments from agency debt and agency mortgage-backed securities that it had acquired in QE1 in longer-term Treasury securities. By November 2010, after the 2010 mid-term elections, the FOMC decided to expand its balance sheet by $600 billion through the purchase of Treasury securities.

But, as we have detailed many times here at Credit Writedowns, quantitative easing doesn't actually have an impact on the real economy. It is an asset swap. The Federal Reserve buys Treasury bonds and sells dollars it has created expressly for that transaction. After the asset swap, the balance sheet of the primary dealer which sold the Treasuries to the Fed has not increased; it now has cash instead of Treasuries. So there are more reserve deposits and fewer Treasuries in the private sector. The Federal Reserve has Treasuries instead of the money it created in expanding its balance sheet. While the reserves can ostensibly be lent out, the reality is that this money will sit in a bank vault idle unless the demand for loans warrants otherwise. It is a misunderstanding of how the banking system works to assume the mere creation of reserves has any significance regarding lending. I would argue the swap drains the economy of higher interest-bearing assets that add to income, replacing them with essentially non-interest bearing assets. Why would we want the Fed to conduct QE then if we know this will just create excess reserves as it did when the Fed began credit easing in QE1?

In particular, central bank purchases of longer-term securities work through a portfolio balance channel to depress term premiums and longer-term interest rates. The theoretical rationale for the view that longer-term yields should be directly linked to the outstanding quantity of longer-term assets in the hands of the public dates back at least to the 1950s.

-Unconventional Monetary Policy and Central Bank Communications, Janet Yellen

This is problematic because the Fed had intended to lower interest rates via the lowered risk premia. That was their stated purpose when they started QE. I know they talk only about having boosted asset prices now to prove QE2 was a success. But, initially, the Fed wanted to lower interest rates too. So while the Fed lowered risk premia, It is conceivable that accommodative monetary policy could provide tinder for a buildup of leverage". Moreover, the Fed's QE2 raised inflation expectations, causing interest rates to actually rise and working at cross-purposes with the lowered risk premia. Thus, QE2 was only successful insofar as it has increased business credit and raised asset prices. As we now see, the economy has actually cooled during QE2. So soon after I told you the QE2 trade was effectively over in late March, asset prices and bond yields started to come down as inflation expectations plummeted.

QE2 has been a bust.

"desperate measures for desperate times seems like the best characterization." I think we all agree here:  It's totally ineffectual.  It makes the Fed look like a bunch of amateurs.

-Let's talk about QE, inflation, and consumer demand, Marshall Auerback, Nov 2010

QE3

The FOMC has already considered offering unlimited quantitative easing to target specific interest rates and buying municipal bonds has been broached by well-connected Fed watcher David Blanchflower. I want to focus on the interest rate caps here because I believe this is politically more feasible, and therefore more likely.

When it comes to quantitative easing, we have to look both at the quantitative and the easing. Going back to the Fed's failure to reduce longer-term interest rates during QE2, it has more to do with the quantitative than the easing. Ultimately, one can influence the price or the quantity of something, but not both. And with QE2, the Fed decided to influence the quantity (of bank reserves), when its stated aim was to influence price (of money reflected by interest rates).

It is unlikely that the Fed will go back to the well for the same policy since QE2 has proved ineffective. So now that the economy is weak again, it will up the ante and target rates instead of specific easing quantities. This has the potential political benefit of the Fed's not having to expand its balance sheet. The Fed would essentially guarantee a rate and let the markets move interest rates to that level. Of course, the Fed would promise to defend the rate(s) if and when necessary. The Fed may be tested initially, but punters would lose their shirts fighting a market player with a potentially unlimited supply of liquidity. So I would expect the balance sheet effects for the Fed to be muted. And clearly, if QE3 reduced rates in addition to having largely the same impact as QE2 as well, it would be a more powerful tool.

There could be internal dissent to such an aggressive policy. I do not expect QE3 now nor do I expect it unless the economy deteriorates further. So the Fed could start off by signalling to the market that it will conduct what I have been calling 'permanent zero'. Look for how the Fed reinforces its commitment to "exceptional low levels for the federal funds rate for an extended period". If Bernanke is forceful about this commitment in this week's FOMC press conference, people will be forced to accept the likelihood of permanent zero and the term structure will flatten further and further out the curve.

I hope this post spells out the differences between the various QEs. QE3 is qualitatively different than credit easing (QE1) or quantitative easing (QE2). Let's call QE3 rate easing. And while we can hope the economy strengthens so that rate easing is unnecessary, the push for it is already well-advanced.

Three Lessons From QE1 & Thoughts On The End Of QE2

As we get closer and closer to the end of QE2 it's wise to begin game planning for the potential impacts.  The following are some goods thoughts from Glenview Capital regarding QE2 and lessons from QE1:

The first lesson we should take from 2010 is to respect the end of quantitative easing, either as an actual or psychological calendar event that could trigger a change in liquidity and economic activity. There are three reasons we should be concerned about the end of QE2 and the unlikelihood of QE3:

1) QE2 is set to expire in June, and it took seven months last time before a new round of quantitative easing was enacted. Thus, it seems reasonable to expect QE2 to lapse, particularly as the economy has rebounded and deflation seems contained as a risk (see #2).

2) US Fed Chairman Bernanke said in his most recent congressional testimony on March 1 that the "risk of deflation has become negligible." If that is the case, it would be odd for the Fed to come forward four months later with further extraordinary monetary stimulus.

3) Two days later, the ECB President Trichet said that an increase in rates at the next meeting (April) is possible. Again, this doesn't seem consistent with an extension of QE2 globally.

As such, we will be closely watching liquidity and economic conditions as the first elements of the unprecedented level of global monetary stimulus are withdrawn.

Second, we believe that the markets are next going to deal with the economic ball bouncing off the "right gutter" of inflationary pressures in early 2011. We already have seen extreme spikes in food and textile commodities, and since late August, the price of oil has risen 50% as a result of global demand and Middle East turmoil. Interest rates on the US 10-year Treasury bond rose over 100bps from the early October lows and, as described above, the tone and tenor of Central Bank commentary are now more weighted towards the risks of inflation.

Finally, it appears that the practical implications of a rising federal deficit ($1.3 trillion) in the US and a renewed emphasis on deficit reduction in Congress (not only the "Tea Party" but across both major parties) will likely slow the growth of both Federal and State/Local spending that has played such a key role in reinforcing the economy to prevent a double-dip recession. This is playing out in state legislatures in Wisconsin and New Jersey, in the President's budget that calls for reductions in discretionary spending, and in the debates this month about extending the debt ceiling to accommodate additional federal deficits.

Taken together, these factors pose a complex scenario for our relatively simple and straightforward gutter guard scenario: just as the ball seems to be bouncing off the inflation gutter guard, both Congress and the Fed seem to be removing the left gutter guard. This is of course logical – if we want to fight inflation, we should first stop fueling it. However, it does beg the question – if the contemporaneous removal of extraordinary monetary and fiscal stimulus through the expiration of QE2 and a move to a more balanced budget does in fact slow the economy, will there be sufficient time, will and resources to re-establish a left gutter? Such is the danger of a zero interest rate policy, as it gives you little incremental room to provide incremental stimulus.

QE2 Is Likely to More Successful than QE1

On November 3, the FOMC announced that it would increase the quantity of its outright holdings of securities by a net $600 billion by the end of the second quarter of 2011. Thus, the Fed has re-embarked on a policy of quantitative easing. Its first real "voyage" of quantitative easing, QE1, started at the end of November 2008 and ended in March 2010. The expected (hoped for?) outcome of a quantitative -easing policy is increased nominal demand for goods and services. Under normal circumstances when the commercial banking system is not constrained by actual or expected capital inadequacy, the Fed is able to stimulate the nominal demand for goods and services by lowering its key policy interest rate, the federal funds rate.

The federal funds rate is the one-day cost of immediately available funds in the financial system and, therefore, represents the marginal cost at which banks can fund themselves. As banks' cost of funds goes down, due to competition, banks pass on their lower cost of funds to their loan customers. The decline in loan rates leads to an increase in the quantity demanded of bank credit. The increase in bank credit supplied leads to increased nominal spending on goods, services and assets. When the banking system is constrained by actual or expected capital inadequacy, banks collectively are unable to increase their supply of credit even though their marginal cost of funds has fallen. This actual or expected banking- system capital inadequacy has been hampering the effectiveness of the Fed's low interest-rate policy in stimulating the nominal demand for goods, services and assets. Thus, the Fed is now turning to a second round of quantitative easing.

There has been much misinterpretation in the media of how quantitative easing "works." Indeed, we are not sure that even the Federal Reserve fully understands how quantitative easing works. The typical explanation of how quantitative easing works is that the Fed's purchases of longer-maturity securities will bring down the interest rates on these securities. The lower interest rates on longer-maturity securities will then induce the nonbank private sector to borrow and spend more. Also, the lower interest rates on longer-maturity securities will make equities more attractive investments at the margin, thereby causing a really in equity prices, which, in turn, will induce the private sector to increase its current spending on goods and services via a wealth effect.

Lastly, the lower interest rates on longer-maturity securities and the expectation that the Fed will hold short-term interest rates at a very low level for a extended period of time will weaken the foreign -exchange value of the dollar, thereby making U.S. exports more price competitive in global markets. All else the same, we do not dispute that interest rates on longer-maturity securities would fall, that equities would become more attractive and that the foreign-exchange value of the dollar would decline with the implementation of quantitative easing on the part of the Fed. What we do dispute is that these are the main channels through which quantitative easing operates to stimulate the nominal demand for goods, services and assets.

Have you noticed by now that whenever we mention quantitative easing, we italicize quantitative? We have done this to emphasize that the main channel through which quantitative easing stimulates the nominal demand for goods, services and assets is through the quantity of credit created by the combined Federal Reserve System and commercial banking system, not the price of credit (the interest rate), not the price of equities and not the price of foreign exchange. If one were to review Econ 101 text books, one would discover that central banks are able to create credit figuratively "out of thin air." The important implication of this is that the recipients of central bank-created credit are able to purchase goods, services and assets without any other entity in the economy having to cut back on its current purchases of goods, services and assets.

The Federal Reserve, of course, is the U.S. central bank. If one were to read a little further in the Econ 101 text, one would discover that the commercial banking system, not an individual bank, also is able to create credit figuratively "out of thin air,"providing that the central bank supplies the "seed money" for this to the commercial banking system. The important implication of the creation of credit by the commercial banking system, is the same as that of the creation of credit by the central bank: the recipients of this credit created by the commercial banking system are able to purchase goods, services and assets without any other entity in the economy having to cut back on its current spending on goods, services and assets. Thus, if combined central bank and commercial banking system credit increases, there is a presumption that current nominal aggregate spending on goods, services and assets will increase. That same presumption with regard to an increase in nominal aggregate spending cannot be made when credit is granted by the nonbank sector. In this case, the presumption is that the grantors of credit will decrease their current nominal spending, transferring purchasing power to the recipients of the credit. Thus, when the nonbank sector extends credit, the presumption is that nominal aggregate spending does not increase. The exception to this presumption would occur if the quantity of currency and bank liabilities desired to be held by the nonbank public were to fall by an amount equal to or greater than the amount of nonbank credit extended.

To reiterate, the logic or theory of quantitative (we have stopped italicizing it now) easing is that an increase in the quantity of combined central bank and commercial banking system credit will lead to an increase in nominal aggregate spending on goods, services and assets. Chart 1 shows that the correlation coefficient between percentage changes in the annual average of combined Federal Reserve and commercial banking system credit and the percentage changes in nominal U.S. GDP from 1960 through 2006 is relatively high at 0.62. (A perfect correlation between the two series would be represented by a correlation coefficient of 1.00). Chart 2 demonstrates that this correlation coefficient is reduced to 0.49 when the period is extended through 2009. In 2008, there was a large percentage increase in combined Federal Reserve and commercial banking system credit but a reduction in the percentage change in nominal GDP. We believe that a significant amount of this increased Fed-commercial bank credit was acquired to build up "cash" holdings for precautionary reasons due to the turmoil in the financial markets.

Now, let us examine what happened to combined Federal Reserve and commercial banking system during the Fed's first round of quantitative easing that covered the 16 months ended March 2010. Chart 3 shows the net change in total Federal Reserve credit, Federal Reserve outright holdings of securities and Federal Reserve credit excluding outright holdings of securities in the 16 months ended March 2010 (the shaded area in the chart). Notice that although Federal Reserve outright holdings of securities increased a net $1.5 trillion during the first round of Fed quantitative easing, total Federal Reserve credit increased by only a net $200 billion during this period because other elements of Federal Reserve credit contracted by a net $1.3 trillion. Chart 4 shows that commercial banking system credit contracted by a net $875 billion in the 16 months of the Fed's first round of quantitative easing. Thus, when we sum the net change in Federal Reserve credit and commercial banking system credit in the 16 months ended March 2010, the period encompassing the Fed's first round of quantitative easing, we find that the net change in credit was minus $675 billion. Is it any wonder, then, why the response of nominal GDP growth was so restrained to QE1? We would argue that QE1 was a misnomer in that there was no quantitative easing, but rather a quantitative contraction.

What is the prospect that the Fed's second round of quantitative easing will not be a misnomer, that is, it will result in a net increase in combined Federal Reserve and commercial banking system credit? Chart 5 shows that in the seven months since the end of QE1, the rate of contraction in other elements of Federal Reserve credit besides outright securities holdings has slowed significantly. In the seven months ended October 2010, these other elements of Federal Reserve credit have contracted by only a net $36 billion. If these other elements of Fed credit continue to contract by only a small amount or stabilize, then the Fed's planned $600 billion net increase in its outright securities holdings will make almost a dollar-for-dollar increase in total Federal Reserve credit. Chart 6 shows the behavior of commercial banking system credit since the end of QE1 through September 2010, the latest full monthly data available. In the six months ended September 2010, commercial banking system credit contracted by only $47 billion. In each of three months ended September 2010, commercial banking system credit increased.

The latest Federal Reserve survey of bank lending practices, which covered the three months ended July 2010, showed a significant increase in the percentage of respondent banks easing their lending standards. The actual recent behavior of commercial banking system credit and the results of the recent Federal Reserve survey of bank lending practices suggest that commercial banking system credit will be a considerably smaller drag on combined Federal Reserve and commercial banking system credit creation or perhaps make a small positive contribution during the second round of Federal Reserve quantitative easing.

For the sake of argument, let us assume that in the next seven months combined Federal Reserve and commercial banking system credit increase a net $600 billion, the amount of the Fed's planned securities purchases over this period. This would represent a 5.2% increase in the September level of combined Federal Reserve and commercial banking system credit. Chart 7 shows that there has not been a seven-month increase in this credit aggregate of 5.2% or greater since March 2009. Now, a 5.2% increase in combined Federal Reserve and commercial banking system credit is unlikely to result in a boom in nominal aggregate demand, but it will help prevent the economy from slipping back into a recession within the next 12 months in the face of substantial economic headwinds emanating from the housing and state/local government sectors of the U.S. economy.

There appears to be some concern by foreign monetary authorities that QE2 will result in the Federal Reserve "exporting"some U.S. inflation to their economies. This could occur if foreign central banks peg their currencies to the U.S. dollar. If QE2 puts downward pressure on the foreign-exchange value of the dollar and foreign central banks purchase dollars in the open market in order to prevent an appreciation in their home-country currencies, paying for these dollars by issuing their own currencies, then, indeed, foreign central banks could be "importing" increased inflation. But foreign central banks are not obligated to do this. They could accept an appreciation in their currencies vs. the dollar. Would this have an adverse effect on exports to the U.S. of economies whose currencies are appreciating? At the margin it would. But overall exports to the U.S. from these economies might remain the same or even increase as the negative foreign-exchange effect, or price effect, might be more than offset by the "income"effect in the U.S. emanating from QE2. That is, QE2 would be expected to increase the nominal demand for goods and services, some of which would be imported goods and services.

We have not published an economic/interest rate forecast update since August due to no meaningful change in our outlook and due to an extremely heavy travel schedule. We apologize for this "silence"to any clients and partners who missed our updates. Since our August publication, we have reduced marginally our 2011 real GDP growth forecast from 3.2% on a Q4/Q4 basis to 3.0%. The reduction is primarily due to a reduction in our 2011 growth forecasts in the categories of residential investment expenditures and state/local government spending. Despite the downward adjustments to these categories, we believe that stronger real GDP growth can be achieved in 2011 compared with 2010 and some modest reduction in the unemployment rate can occur in 2011 with the small but positive growth in commercial bank credit that we anticipate and the increase in Federal Reserve credit as a result of QE2. We also have pushed back into early 2012 our forecast of the first Federal Reserve interest rate increase. Even if QE2 were to end in the second quarter of 2011, and there is no guarantee that it will end at this time, the FOMC is unlikely to begin raising its policy interest rates - the federal funds rate and the interest rate it pays on banks' excess reserves - immediately after the end of QE2.

Paul L. Kasriel
Asha G. Bangalore

A QE1 Timeline

November 25, 2008: $100 Billion GSE direct obligations, $500 billion in MBS

S&P 500: 851.81

The Federal Reserve announced

the purchase of the direct obligations of housing-related government-sponsored enterprises (GSEs)--Fannie Mae, Freddie Mac, and the Federal Home Loan Banks--and mortgage-backed securities (MBS) backed by Fannie Mae, Freddie Mac, and Ginnie Mae.
...
Purchases of up to $100 billion in GSE direct obligations under the program will be conducted with the Federal Reserve's primary dealers through a series of competitive auctions and will begin next week. Purchases of up to $500 billion in MBS will be conducted by asset managers selected via a competitive process with a goal of beginning these purchases before year-end. Purchases of both direct obligations and MBS are expected to take place over several quarters.

December 16, 2008 FOMC Statement: Evaluating benefits of purchasing longer-term Treasury Securities

S&P 500: 913.18

As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities.

January 28, 2009: FOMC Statement: FOMC Stands Ready to expand program.

S&P 500: 874.09

The Federal Reserve continues to purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand the quantity of such purchases and the duration of the purchase program as conditions warrant. The Committee also is prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets.

March 18, 2009: FOMC Statement: Expand MBS program to $1.25 trillion, buy up to $300 billion of longer-term Treasury securities

S&P 500: 794.35

To provide greater support to mortgage lending and housing markets, the Committee decided today to increase the size of the Federal Reserve's balance sheet further by purchasing up to an additional $750 billion of agency mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion of longer-term Treasury securities over the next six months.

QE1 purchases were completed at the end of Q1 2010, although it took a little time for the securities to settle on the balance sheet.

 

August 27, 2010: Fed Chairman Ben Bernanke hints at QE2: Analysis: Bernanke paves the way for QE2

S&P 500: 1064.79