Ben Bernanke gives us his “rule of thumb” on the effects of Quantitative Easing, but is he correct?

During his recent presentation to Congress the Chairman of the Federal Reserve has made several statements both about the US economy and the policy response which he and his fellow members of the Federal Open Markets Committee (FOMC) made to the recession caused by the credit crunch. I have been asked about the significance of his statements both on here and elsewhere and so I thought that I would address them today.

Policy Responses by the US FOMC

If we look at interest-rates the first cut in the Federal Funds rate took place on the 18th of September 2007 when a 0.5% cut reduced it from 5.25% to 4.75% Since then there have been 9 further cuts taking the interest-rate down to a range of between zero and 0.25%. This established what has been called the Zero Interest Rate policy or ZIRP as unless they are willing to reduce interest-rates below zero in nominal terms we are now at the lower bound.

As the flexibility in a downwards direction for interest-rates is restricted by zero at this time ( just to be clear whilst some have talked of negative interest-rates there are no official plans for this) then if a central bank wishes to further stimulate an economy then as it can no longer influence the price of money it has to influence the quantity of it. Accordingly as the FOMC wished to further stimulate the US economy it has indulged in several stages of asset purchases or Quantitative Easing. Central Banks like terms such as Quantitative Easing as they make people forget that the real aim of the policy is to put money (liquidity) in investors hands which put that way sounds like printing money an image they wish to avoid! The FOMC has been quite happy to in effect print narrow money it just does not want it put like that.

There have been three variants so far of Quantitative Easing which have been called QE1, QE-lite and QE2. Between them they are planned to purchase around US $2.3 trillion of assets. the assets purchased were mostly mortgage-backed securities in QE1 but QE-lite exchanged some of these for US Treasury Bonds (government debt) and QE2 involves purchases of US $75 billion per month of US Treasuries.

So in a nutshell we have interest rate cuts in excess of 5% and US $2.3 trillion of asset purchases.

Can we measure the impact of this?

Ben Bernanke thinks that we can as he introduced a rule of thumb in this speech that a 0.25% cut in interest-rates is equivalent to between US $150 and 200 billion of asset purchases. He then refined this to say that the total level of purchases under QE2 of some US $600 billion are equivalent to an interest-rate cut of 0.75%. I have watched the video and these are his words.

A 75 basis point (0.75%) cut is a strong but not unusual move.

But then he goes onto to say this which is quite significant.

The movement of a wide variety of financial prices are quite consistent with that 0.75% cut in interest-rates.

Well Are They?

I established some benchmarks for future reference on the day that QE2 was announced back on the 3rd of November 2010 so let me quote them now.

The Dow Jones Industrial Average closed at 11,188 which was up 64 points. As to whether this welcomed a likely Republican swing or was just getting ready for the FOMC statement it is hard to say. In terms of government bond yields then the ten-year yields 2.57% and the thirty-year yields some 3.91%. Moving onto currencies then the trade-weighted US dollar index stands at 76.68. Another possible benchmark is the gold price which has a front month futures price of US $1354.

Of these benchmarks only the level of the Dow Jones Industrial Average backs up Ben Bernanke’s claims as it closed last night at 12,066 which is up by 878 points or just under 8%. Whilst this is a tick in the column it also adds fuel to the claims by some that the real aim of FOMC policy is to reward equity investors in a strategy which is labelled the “Bernanke Put”! Whether you believe in it or not the fact remains that equity prices have risen.

The way that longer-term interest-rates have risen poses a much more difficult challenge for Mr. Bernanke however. The ten-year government bond yield has risen to 3.42% which is up some 0.85% since then and the thirty-year is at 4.55% which is up 0.64%. If you think about it this is an odd result for a policy which if we move to the UK was being praised as REDUCING longer-term government bond yields and by implication other longer-term yields. Charlie Bean a member of the UK Monetary Policy Committee had thoughts on this subject which were put like this on a comment on here

that QE has reduced gilt (government bond) rates by 100 bps, investment grade rates by c. 75 bps and non investment grade by even more

So there you have it according to central banks their policy of asset purchases is apparently a success if interest-rates go down and also a success if they go up! The go up view is apparently because it shows a recovery in the economy. Of course any realistic assessment of anything involves criteria and as a whole if everything is a success then you plainly have no criteria…

The performance of the US dollar is intriguing as during Ben’s testimony it dropped and at one point was at 76.68 raisng a smile from me at least, at the irony of something which has been debated so much (the so-called “currency wars” problem) in fact having at that point exactly zero impact!

The gold price has risen since then to US $1432 per troy ounce which represents a rise of 78 dollars or 5%. Is a rise in the price of gold a success? This is the hardest to measure as it is the instrument most affected by other influences and has been driven higher by the unrest in North Africa and Arabia although if you take my view that the rise in world commodity and food prices has been partly caused by QE then you have a complicated situation with lots of feedback. So both sides could call this move a success although if you stop to think for a moment and think logically then the definition of a central banker should be that an objective should be a lower gold price which would be likely to raise the faith in fiat money rather than the reverse.

A Measure I wish I had used

With the surge in commodity and food prices that has taken place since the beginning of QE 2 I wish I had established benchmarks for commodity and food prices back then. However that does not stop me from looking at what they would have been! Back then the Commodity Research Bureau spot index was at 495 and it closed last night at 567.21 for a rise of 14.5%

If we think of those poor souls who are struggling to feed themselves in North Africa the CRB food component has risen from 420 to 495.81 for a rise of 18%

Of course correlation does not cause causation but if I was Ben Bernanke then my conscience would be troubling me and I doubt I would be sleeping well.

Comment

Thank you to those who raised the remarks by Ben Bernanke as it is an interesting subject. However I do have a qualification for his “rule of thumb” which is that I am of the opinion that as you approach what economists call the lower bound for interest-rates ( presumably forgetting the word zero!) then cutting interest-rates has a weaker and weaker effect. At zero itself the effect may disappear. So if we take Ben at his word then not only do we need his rule of thumb but we need also the interest-rate at which it applies, otherwise it lacks credibility.

If you put this another way you arrive at one of my reasons for raising UK interest rates towards 2%. An effect of this would be to make monetary policy in its conventional form effective again as from here a rise in rates would have an effect and a cut would have at least an initial gain. So we would be returning monetary policy to effectiveness although in UK terms we would still be some 2.5% of what is considered to be the neutral level. Many who get very upset at the idea of higher official interest-rates forget that the policy would still be expansionary merely less so. One of the themes of this blog is “exit strategies” and the problems that reversing policies create. My question for those who would not raise official interest-rates in the UK goes as follows, what are your criteria for a rise?

Finally if you take Ben Bernanke’s “rule of thumb” and apply it to the UK you come up with the UK’s version of QE being equivalent to a 2.5% cut in interest-rates.

The Euro zone and its problems

One of the features of the crisis that is being inflicted on Portugal Ireland and Greece is statements by Euro zone officials which involve aid for these countries which are then regularly shot down by politicians from the country most likely to get the bill! The German Chancellor Angela Merkel has been busy doing just that over the past few days. This leaves them yet again without any sort of strategy and as recent elections in Hamburg went badly for Chancellor Merkel she is unlikely to be in favour of new policies right now as there are other elections due in Germany this month.

This leaves Portugal who was hoping for some sort of Euro zone support, and by this I mean money rather than hyperbole, at the next summit on the 24th and 25th of this month in a painful interregnum. Her ten-year government bond yield remains stuck around 7.5% leaving her looking consistently insolvent and for those who record such things she has been like this for a longer period of time than Ireland and Greece survived before being forced to call for help. Whilst yesterdays auction raised some one billion Euros if we look a the bill which expires on the 17th of February 2012 she had to pay 4.06% against an already inflated 3.99% from mid-February. Compared with the official European Central Bank rate of 1% Portugal is forced to pay 3% more and that in such times is a severe penalty and illustrates the depth of her problem.

Some analysis from Barclays Capital has illustrated that the moves by the ECB have in fact allowed foreign investors (banks) to leave the Portuguese bond market. In 2010 they feel that the ECB bought some 20 billion Euros of Portuguese government debt whilst foreign investors aka banks sold the same amount. Convenient eh? We are back to the theme of this being a bank rather than a country bailout. As Portugal only issued 21.7 billion Euros of debt in 2010 then we can see that she has only one buyer of any size.

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3 thoughts on “Ben Bernanke gives us his “rule of thumb” on the effects of Quantitative Easing, but is he correct?

  1. Thanks Shaun
    I tend to find that the arguments in favour of QE ( either US or UK style) and explanations for it tend to shift over time. US QE v1 was an overt attempt to prevent fire-sales of financial assets and support debt markets. UK QE v1 started life as a debt support operation, then morphed in to a targeted gilt buy-up with liquidity lifeboats riding shot-gun. On the latter, the real economy was supposed to benefit from the much vaunted ‘portfolio’ effect whereby gilt-holders would invest their QE money in higher risk assets boosting credit and the real economy. Depository reserves would increase aiding banking liquidity and maybe the very support operations deployed.

    The only tangible result the BoE tend to talk about now is the suppression of long term gilt yields and other investment-grade user/banking industry benefits. Where is the evidence on portfolio transfers in to the general economy?

    • Hi Shire
      As I have said before the Bank of England’s view on Quantitative Easing is like buses don’t worry too much about each one because a new one and sometimes several will soon be along. They have mostly tired of mentioning it recently which I found revealing in itself as £200 billion is hardly the sort of money you drop down the back of the sofa and forget. Whilst I do not agree with Adam Posen on much at least he continues to mention it rather than ignore it ( He of course wants more).

      Put another way I feel that QE3 in the United States is starting to appear more and more of a possibility as if you keep going then you can keep asset prices up but then we get the problem I have raised ever since I started this blog, where is the exit strategy or how do you end it? To which I have seen no official answer at all….

  2. Hi shaun,

    Great analysis, readers might also wish to search online for Mr. B’s 60 min interview on CBC news back in December 2010 – He’s usually fairly shy and his quivering lip during the pertient parts of the interview is a must watch lol! My reading of that interview was the following points: 1) – he’s attributing QE1 and 2 to the stockmarkets success – looking back at the key dates when QE1 was announced the stock market continued to fall off the cliff and when it was released it continued to fall, it could be argued that once in the “system” the stock market then rose – but at those 2 key dates it failed to improve the sentiment on wall street – this can clearly be seen by the fact that the markets continued to fall. Hes’ now pinned the success of QE2 on the stockmarket – is QE designed to prosper the stockmarkets? Or has he cottoned onto the fact that a rising and bullish stockmarket bouys up investors and the publics confidence and deflects attention away from QE! Cynical I know! 2) During that interview he clearly states and this was preceded a few weeks earlier by words uttered by the President – they’d combatted DEFLATION – I would say not many people were aware that DEflation was an issue, but apparantly it (is)was! Also if you strip out food and energy from the US CPI figs prices (from memory) actually fell? I might be corrected on that, but what if DEflation arose from the mess rather than inflation – It has to be a consideration as both the president and fed chairman mentioned it back in later 2010.
    If therefore we are to believe the president and the fed chairman that QE1 and QE2 defeated DEflation why would QE3,4,5….. be required. We know QE is meant to be inflationary, food and energy price inflation has masked the true extent of the effect QE has had I think and also it will be interesting to see over the next year or so exactly what and how things pan out.
    To make a point ref your later blog on ECB – I was hugely sceptical of the “Stress-test” of banks in euroland in 2010 – I thought they all passed with flying colours? then Irish banks went bang! I think we could have banking crisis no. ? (lost count) soon as if Germany decides to impose protectionism policies and refuse to be the lender of last resort it could send shudders right through the entore banking system, with those banks (and countries) with the greatest exposure to the debt of countries going belly up. We’ll have to wait and see what happens – but it’s all good food for thought.
    Also interesting to see that more USA states are filing for bankruptcy.

    Regards

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