The guest commentary below was written by Dr. Daniel Thornton of D.L. Thornton Economics.
Bernanke, Yellen, and other policymakers argue QE reduced long-term interest rates, increased output and employment and reduced the unemployment rate to something approaching the so-called full-employment level. One might ask: “If QE is such a powerful tool, “why don’t they use it all the time?” Why didn’t they use at the outset of the financial crisis?”
“Why did they wait until late in the worst financial crisis since the Great Depression to unleash this powerful economic stabilization weapon?” The answer is they stumbled into it. This essay shows how they stumbled into to it and why. The essay begins with a brief discussion of the events leading up to QE.
Lessons Learned from Lehman's Collapse
The financial crisis was caused by the nationwide decline in home prices that peaked in 2006, but it is typically dated as beginning on August 9, 2007, when a large French bank suspended redemption of three of its investment funds. The FOMC responded by reducing its target for the federal funds rate from 5.25 percent to 2.0 percent by April 30, 2008. The Fed also increased its lending to banks and $19 billion to bail out Bear Stearns on March 18, 2008.
However, to keep the Fed’s balance sheet from increasing, Bernanke (not the Federal Open Market Committee, FOMC) decided to sterilize the effect of the Fed’s lending on its balance sheet by selling an equivalent amount of Treasuries (this is called sterilization). That these actions were ineffective is witnessed by the facts that the recession, which began in December 2007, intensified, and the financial crisis worsened. The financial crisis culminated with the bankruptcy of Lehman Bros. on September 15, 2008.
Lehman’s announcement produced widespread panic among banks and investors. The problem was banks (especially large banks) and many investors held a large amount of mortgage-back securities (MBS) with little or no knowledge of the real estate that backed them. Home prices were declining nationally, so these MBS were “toxic;” i.e., no one knew what they were worth. Consequently, most banks were unsure of their own solvency and had no idea of the solvency of other banks.
In these circumstances, banks wouldn’t lend to one another so the inter-bank market froze up. Banks were likewise unable to borrow issuing large negotiable certificates of deposit (CDs) as they did before Lehman’s announcement. The cost of borrowing in the CD market exploded: The spread between the 3-month CD rate and the 3-month T-bill rate, which had already increased from about 40 basis points from early 2007 to 107 basis points in August 2008, exploded to 465 basis points by October 8, 2008. Other credit risk spreads increased similarly.
Because they couldn’t obtain funds elsewhere except at a very high interest rate, banks increased their borrowing from the Fed. Moreover, the Board of Governors decided to lend to non-bank financial institutions by invoking Section 13(3) of the Federal Reserve Act. The Fed’s balance sheet increased by $1 trillion between September 11 and October 30, 2008.
This is shown in Figure 1, which shows the composition of the Fed’s balance sheet from January 2007 to December 2010. Prior to the beginning of the financial crisis, the Fed’s balance sheet consisted of a large amount of short-term Treasuries, a small amount of lending to financial institutions, and an even smaller amount of long-term Treasuries (denoted in black). Note that despite the marked increase in short-term lending before September 2008, the balance sheet was flat. This is due to the fact that Bernanke decided to “sterilize” the effect of the increased lending on the balance sheet by selling an equivalent amount of short-term Treasuries. This was done in order to prevent an increase in banks’ reserves that would have seriously impaired the FOMC’s ability to keep the funds rate close to the target level.
The Fed Was Slow to Act
Immediately, following Lehman’s announcement Fed lending increased to the point where it was no longer able to sterilize the effect of its lending on its balance sheet and bank reserves. QE was underway. However, little was said about QE at the October 2008 FOMC meeting beyond the suggestion by several participants that they were already doing QE and Bernanke’s acknowledgment, “We’re pretty close, yes.” There was a brief discussion of what the Committee should do should if it were to reduce its federal funds rate to effectively zero. Bernanke noted that there were a number of memos and studies done in 2003 that addressed this issue and they should be “updated.” The Fed was already engaging in QE, but the FOMC hadn’t thought much about how it would work.
Apparently oblivious to the fact that the funds rate had averaged just 82 basis points during the prior two weeks and that it was 67 basis points the day before, Bernanke led a discussion about whether the funds rate target should be reduced from 1.5 percent to 1 percent. Without dissent, the FOMC voted to adopt the meaningless gesture of reducing its funds rate target to 1 percent. A little sarcasm: “Wow that was a gutsy decision!”
On November 25, 2008, QE took the first step in a new direction. Specifically, the Board of Governors (not the FOMC) announced that the Fed would purchase $600 billion in securities: $100 billion of direct obligations of Fannie Mae, Freddie Mac, and Ginnie Mae and $500 billion of MBS backed by these government-sponsored enterprises. QE had taken a disastrous turn. It changed from being a short-term lending program that would give banks and other financial institutions the time necessary to obtain the information they needed to make their toxic MBS non-toxic, to being a large-scale asset purchase program of uncertain effect or duration.
Figure 1 shows that nearly all of the increase in the Fed’s balance sheet, i.e., quantitative easing, from Lehman’s bankruptcy announcement until March 2009 was due to short-term lending; not to asset purchases. The large scale asset purchase version of QE (the dark gray area) is tiny. This changed on March 18, 2009, when the FOMC announced that the Fed would purchase a total of $1.75 trillion in MBS and long-term agency and Treasury securities (QE1). Also, note that the lending peaked in January 2009. Banks were reducing their reliance on the Fed for funding, suggesting that financial institutions were on the mend because banks were finding out exactly what real estate backed their MBS.
The first version of QE was not planned. Bernanke and others didn’t wake up on September 15, 2008, and say “we need to stop implementing monetary policy by targeting the funds rate; we need to stop sterilizing our lending and permit our lending to increase the balance sheet and bank reserves. This will produce an increase in the supply of credit and allow banks time to find out exactly the real estate backing their MBS.” No, the Bernanke Fed literally stumbled into it. It happened because the Fed increased lending following Lehman’s bankruptcy announcement to the point where the Fed was no longer able to sterilize the effect of its lending on the Fed’s balance sheet.
The Dubious Effectiveness of QE 2
As I argued elsewhere (What the Fed Should Have Done), the first version of QE was successful. The increased lending to banks and others gave banks and investors time to get the information necessary to make their MBS non-toxic so financial markets could function properly. That it was successful is witnessed by the fact that most credit-risk spreads, which skyrocketed immediately following Lehman’s announcement, had returned to or below their pre-Lehman levels and by the fact that the recession, which began in December 2007, ended in June 2009—just nine months after the largest bankruptcy in U.S. history.
The second version of QE was based on the dubious notion that large-scale assets purchase would reduce long-term interest rates and, thereby, increase spending and output. “Why did the second version of QE happen?” In spite of the fact that the Board of Governors initiated the first large-scale asset purchase in November 2008, the first discussion of the second version of QE took place at the December FOMC meeting. The FOMC took no additional actions at the December meeting beyond the meaningless gesture of reducing the funds rate target to between zero and 25 basis points—the funds rate had been below 20 basis points for the 10 days prior to this momentous decision.
Bernanke announced that “of necessity” the Committee had to consider how it would operate in the future. However, he made it clear that he wasn’t excited about this, saying “we should continue to work to improve our control of the effective federal funds rate…We should not give up on that.” Like the first version of QE, the second version was not the result of careful and considerate analysis of what was needed. Bernanke didn’t say, “reducing the funds rate has been unsuccessful so we need to adopt some unconventional monetary tools that will be more powerful.” No, the FOMC adopted the second version of QE because with the funds rate at effectively zero, it was forced to implement monetary policy in another way. Once again, the Bernanke Fed stumbled into it.
“But why did they do it?”... 3 Reasons
I believe there are three reasons, none flattering or compelling. First, Bernanke and others failed to understand the core problems associated with the financial crisis and the recession. The major problem with the financial crisis was that banks and others were holding toxic assets. This is why markets froze up and credit spreads exploded. Had Bernanke and others realized this, they would have realized that once these investors determined exactly what real estate backed their MBS—once the MBS were no longer toxic—financial markets would start functioning properly.
Second, they failed to realize that there was a tremendous overproduction of residential, and to a lesser extent commercial, real estate. This guaranteed that the expansion necessarily would be characterized by an unusually low rate of investment spending. It guaranteed that recession would be more severe and last longer than the previous two recessions. Residential and commercial construction would all but vanish for an extended period of time. So too would employment in construction. Consequently, the unemployment rate would be uncharacteristically high for much longer than for most previous recessions.
The second reason is Bernanke and others failed to see that the economy and the financial markets were improving by early 2009. That the economy was improving was somewhat difficult to determine at the time, but there were a few signs. For one thing, by March 2, 2009, the FOMC knew that real personal consumption expenditures, which had declined dramatically, were leveling off, as shown in Figure 2.
Moreover, long-term bond yields had increased by over 100 basis points between mid-December 2008 and mid-March 2009 in spite of the fact that there was no evidence that inflation was accelerating. Market-based inflation forecasts were significantly below the FOMC’s 2% inflation target. Furthermore, the Committee estimates the gap between actual and “potential” output was extremely large. Hence, the marked increase in real long-term rates is evidence of an improving economy.
What the Fed Should have Done...
In addition, a variety of credit-risk spreads had declined dramatically. Many were below their pre-Lehman level and some to below their pre-financial crisis level by late February 2009. Taken together, these signs should have told Bernanke and others that the economy and financial markets were improving.The FOMC’s failure to read the economic tea leaves correctly led to a pervasive fear that is characterized by Janet Yellen’s statement at the March 2009 FOMC meeting, I think we’re in the midst of a very severe recession—it’s unlikely to end any time soon. The optimal policy simulations would take the fed funds rate to −6 percent if it could, and because it can’t, I think we have to do everything we possibly can to use our other tools to compensate.
There were three options on the table for the Committee’s consideration at the March 2009 meeting:
- Option A was to purchase an additional $500 billion of agency MBS and $500 billion of longer-term Treasuries.
- Option B was to purchase an additional $500 billion of agency MBS.
- Option C was to do nothing, wait for more information.
However, given their faulty analysis of the economic situation, doing nothing was not a serious option. Fear was so pervasive that the Committee decided to do more than any of the options suggested. It decided to purchase an additional $750 billion in agency MBS, an additional $100 billion in agency debt, and $300 billion in longer-term Treasuries, bring the Fed’s commitment to purchase longer-term securities from $600 billion in November 2008 to $1.75 trillion on March 18, 2009.
I would like to say that had they waited they would have realized that the financial crisis was essentially over and that the economy was on the mend so there was no need to purchase massive amounts of long-term securities. But, of course, this wouldn’t have happened. On September 20, 2010, the Business Cycle Dating Committee of the National Bureau of Economic Research announced that the recession had ended in June 2009. On November 3, 2010, the FOMC announced that:
"To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to expand its holdings of securities. The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month."
QE2 was underway. “Why did the FOMC engage in additional asset purchases even though the recession had ended 19 months earlier?” I think there were at least three reasons. First, the staff’s estimate of the output gap, defined as the percent difference between actual and potential GDP was -6.8 percent for the fourth quarter of 2010 and was projected to still be -3.8 by the end of 2012 (a negative number means that actual output was below potential). Second, output growth was about 2 percent rate, but the FOMC believed that potential output growth rate was 3 percent or somewhat higher. Third, the unemployment rate was 8.3 percent and rising. The Bernanke Fed was effectively trying to increase the growth rate of output despite the facts that economic theory strongly suggests that monetary policy cannot do this.
The second version of QE—the large-scale asset purchase version—was a choice. The FOMC was initially optimistic that the funds rate could be controlled by setting the interest rate the Fed paid banks on their holdings of excess reserves (IOER). However, as Governor Don Kohn noted at the December 2008 FOMC meeting, IOER didn’t work. Faced with this dilemma, Bernanke and Yellen led the FOMC into a large-scale asset purchase program, which was subsequently dubbed QE.
They did it because they didn’t know what else to do and they didn’t want to be seen as doing nothing. They did it because they failed to understand that the economy and financial crisis were already on the mend. They did it because output and output growth were stubbornly below their belief about potential output and the potential growth rate. They searched for theoretical foundations for their QE program because they believed the theoretical foundations of the Bank of Japan’s 2001 QE program were thoroughly discredited. They made up the theory on the fly. Unfortunately, as I noted in my previous essays, Markets Needn’t Panic, and Show Me Your Evidence, the theoretical justification was built on sticks.
Moreover, there is no convincing evidence that the Fed’s large-scale asset purchases reduced long-term rates. At least one member of the Committee was aware of this fact. At the April 2009 FOMC meeting Yellen said there is “compelling evidence that purchases of longer-term Treasury securities worked to bring down borrowing rates and improved financial conditions more broadly,” and that, having “tested the waters,” it was time for the Fed “to wade in by substantially increasing our purchases of Treasury securities.” “What was the evidence?” The 10-year Treasury rate declined 51 basis points on the FOMC’s March 18 announcement and had remained below it March 17 level during most of the period.
However, by the June meeting she changed her tune saying:
"Initially I was an enthusiast for long-term Treasury purchases. I thought the purpose of it was not only to improve liquidity and market functioning, but also to influence yields to push them down…On theoretical grounds, I believe there’s a very strong case that they should have some effect, but it has been awfully hard to identify exactly what that effect is, and I think that we’re beginning to run into costs of pursuing that further…I would say the benefits don’t merit the costs, but I wouldn’t want to see Treasuries taken off the table if conditions were to deteriorate and attitudes were to change."
“What changed her mind?” She didn’t say, but it seems reasonable that it was the simple fact that the 10-year Treasury yield was 121 basis points higher on June 24 than it was on March 18.
However, as I noted in a 2016 essay, The Effect of Policy on Yields, while QE had no effect in reducing long-term rates, the FOMC’s low-interest rate policy did reduce long-term yields, albeit temporarily.
My next essay is The Myth of Potential Output.
This is a Hedgeye Guest Contributor piece written by Dr. Daniel Thornton. During his 33-year career at the St. Louis Fed, Thornton served as vice president and economic advisor. He currently runs D.L. Thornton Economics, an economic research consultancy. This piece does not necessarily reflect the opinion of Hedgeye.