TuckCenter for Global Business and Government

Slaughter & Rees Report - Third Time’s the Charm?

November 3, 2014

At 2 p.m. EDT last Wednesday, with a mere 707 words, the Federal Reserve announced the end to one of the largest monetary experiments ever. On Aug. 1, 2007, just before the World Financial Crisis started with a few tremors in some Bear Stearns hedge funds, the Federal Reserve’s balance sheet stood at $874 billion. How big was the Fed’s balance sheet last week? $4.48 trillion, more than five times its pre-crisis level.

What happened? To try to stem the financial crisis and prevent it from cascading into the real economy to cause another Great Depression, the Fed bought assets. A lot of assets, to be precise, mostly in three waves of buying that came to be known as Quantitative Easing 1, 2, and 3.

QE1 started deep in the crisis on Nov. 25, 2008. Part of what made QE1 historic was the Fed’s decision to target the assets of a particular industry—housing—deemed to be in dire straits. The plan to buy $100 billion in Fannie Mae and Freddie Mac debt plus another $500 billion of their mortgage-backed securities was justified “to reduce the cost and increase the availability of credit for the purchase of houses, which in turn should support housing markets and foster improved conditions in financial markets more generally.” Near the trough of the crisis, QE1 was expanded on March 18, 2009, by over $1 trillion because, as the Fed calmly stated, “Information received since the Federal Open Market Committee met in January indicates that the economy continues to contract.” Those were the darkest days of the Dow closing at 6,547.05 on March 9, and of the loss of over 2.2 million payroll jobs in just the first three months of that year.

QE2 started on Nov. 3, 2010. Recovery on nearly all indicators had been underway for at least a year, but at this point the Fed concluded that “the pace of recovery in output and employment continues to be slow” and that progress toward the Fed’s statutory goals of maximum employment and price stability was “disappointingly slow.” Thus did the Fed initiate a course of buying $600 billion in additional long-term Treasury securities. Amidst QE2, the U.S. labor market and broader economy continued to heal, but still haltingly.

Thus came QE3, on Sept. 13, 2012, when the Fed initiated new monthly purchases of mortgage-backed and Treasury securities because “the Committee is concerned that, without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions.” These new monthly purchases initially totaled $85 billion, and over the past two years that amount tapered to now being done.

Did all this QE work? Answering this question is devilishly hard, for two important reasons. One is that even the state-of-the-art economic theories can only imperfectly model linkages among central banks, capital markets, and the broader economy—let alone model massive shocks to central banks. The other is that economics is not like chemistry, physics, and other sciences that allow replicable experiments. In economics, for something as broad as the world’s largest central bank in the world’s largest economy, there is only one draw of historical data. To answer this paragraph’s simple question like chemists seeking new pharmaceuticals, we would need to rerun the past several years holding the Fed’s balance sheet at $874 billion.

It is difficult to imagine that conditions wouldn’t have been worse in this experimental hold-the-line-Fed world because of some combination of higher interest rates, lower asset prices, and more-damaged housing. Thus do we agree with Ben Bernanke, who shortly before stepping down from his Fed Chairmanship quipped that, “The problem with QE is it works in practice, but it doesn’t work in theory.” Many other central bankers have agreed in recent years as well. Indeed, just 36 hours after the Fed ended QE3 Japan expanded its QE program when Bank of Japan governor Haruhiko Kuroda surprised the world by overriding objections of four of his fellow BOJ board members and announcing that he will expand Japan’s QE program from the previously announced 60-70 trillion yen per year in asset purchases to 80 trillion yen per year.

Scholars will examine QE for years to come. QE was undertaken to help heal the U.S. economy, especially its labor market. As we have written recently, with the labor market today not too far from full employment at 5.9 percent, the central challenge facing America today (and so many other countries) is creating good-paying jobs, not just jobs. However helpful QE might be in helping create jobs, there is little evidence it shapes the quality of job creation. That depends far more on other public policies regarding education, infrastructure, immigration, trade, and the like. This caveat aside, for now, we all should cross fingers that, for the Fed, the third time’s the charm.

Articles © 2014 Matthew Slaughter and Matthew Rees. All rights reserved.
Publication © 2014 Trustees of Dartmouth College. All rights reserved.

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