QE Worked, But Not As Advertised

Last week the Federal Reserve announced the end of its bond-buying program, which has been running with only brief interruptions for the last six years. Besides its ultimate size and duration, the striking thing about the Fed’s experiment with quantitative easing (QE) is that there is still not a firm consensus on exactly how it worked. Academic economists will be busy with this question for years. But from a bond investor’s point of view, there’s enough evidence to make a few tentative conclusions.

Early on the Fed’s message about unconventional monetary policy was straightforward. When short-term interest rates reach zero, a central bank can still affect the economy in two ways: (1) with forward guidance about the future path for short-term rates, and (2) with asset purchases or QE. Specifically, Fed officials argued that QE worked through a portfolio rebalancing channel, which is based on the idea that different assets are imperfect substitutes for each other. Here’s how then-Chairman Bernanke put it in his August 2012 Jackson Hole speech:

“Imperfect substitutability of assets implies that changes in the supplies of various assets available to private investors may affect the prices and yields of those assets. Thus, Federal Reserve purchases of mortgage-backed securities (MBS), for example, should raise the prices and lower the yields of those securities; moreover, as investors rebalance their portfolios by replacing the MBS sold to the Federal Reserve with other assets, the prices of the assets they buy should rise and their yields decline as well”

Bernanke was not shy about saying that QE was an exercise in “learning by doing”, and the views of policymakers may have evolved over the last six years. I expect that they have, because the practical experience of QE differed from this basic story in important ways.

First, portfolio rebalancing effects look small in hindsight. While we are sympathetic with this idea in theory, the assets the Fed purchased and the liabilities they issued to fund them—namely reserve deposits—were, in fact, close substitutes. As many others have pointed out, QE on government bonds can be thought of as changing the maturity structure of outstanding debt: the Fed buys bonds and “issues” short-term government liabilities in their place. Thus, at least in this one dimension, QE was economically equivalent to Treasury buybacks funded with bill issuance. History shows that these types of debt maturity changes tend to have small effects on bond yields—and in the U.S. they were in any case offset by the Treasury’s debt management practices.

In addition, the large sell-off in the Treasury market last year cast doubt on the idea that portfolio rebalancing was QE’s primary transmission mechanism. As Chairman Bernanke pointed out at the time, Fed officials “were a little puzzled by that”, and the rise in rates was “was bigger than can be explained I think by changes in the ultimate stock of asset purchases within reasonable ranges”. In fact, the total stock of assets the Fed purchased turned out to be much larger than anticipated before the taper tantrum. At the very least, the 2013 experience shows there is more going on than portfolio rebalancing effects—and we would argue they are not the primary channel through which QE operates.

Second, QE reinforced forward guidance. Although many observers have turned more skeptical about portfolio rebalancing effects, the recent behavior of bond yields suggests QE was a very effective complement to forward guidance. Fed officials can say that short-term interest rates will remain low for a long time, but market participants know that there is nothing committing them to stick to that promise—talk is cheap. Quantitative easing provides that commitment: bond investors know that while QE is ongoing the Fed will not raise the funds rate. And beyond that the program signals something about the central bank’s broader intentions. QE thus augments forward guidance and reduces uncertainty about short-term rates, which in turn lowers bond yields and stimulates the economy.

Third, QE reduced perceived tail risks. The unsung aspect of QE was its role in reducing perceptions about tail risks for the economy. When short-term interest rates are at zero, negative economic news can have an outsized effect because it feeds a perception that the economy will get stuck in a low growth and/or deflationary equilibrium (i.e. “Japanify”). Quantitative easing reduced these concerns because it demonstrated policymakers had not run out of tools—there remained a willingness and ability to stimulate the economy and defend the inflation target. A central bank is the ultimate deep-pocketed investor, and QE is a way to show that off.

These three lessons offer three implications for policymakers and investors:

First, policymakers should consider other commitment devices. We think QE proved very effective in reinforcing the Fed’s communication about short-term interest rates, but there could be simpler ways to achieve the same outcome. For example, well-advertised rules tied to the unemployment rate or inflation, yield targets for 2- to 4-year government bonds, or fixed-rate lending facilities at scheduled points in the future could reinforce forward guidance in much the same way.

Second, the U.S. experience with QE suggests it would be effective in Europe. While difficult to prove definitively, the U.S. experience suggests QE had a major impact in restoring market confidence and re-anchoring inflation expectations because it signaled to investors that the Fed still had policy options. Too many observers think the ECB is a weak institution with limited tools, and therefore that the Eurozone risks deflation. The ECB could take back the narrative with QE. While it’s true that high-quality bond yields in Europe are already low, that line of reasoning misses the point. The ECB would restore its credibility by refuting the idea that it is out of ammo—exactly the course the Bank of Japan has taken.

Third, investors should be more confident in a sustained recovery. The Fed wrapped up QE last week not because it was ineffective or because it was too risky. The Fed ended QE because it succeeded. That’s good news for investors: the Fed showed monetary policy is not powerless even when short-term interest rates reach zero. If the economy stumbles again, QE or other tools could play a role in fostering recovery.