Effectiveness of Quantitative Easing (QE)

Last week, October 29, 2014, the U.S. Federal Reserve (Fed) concluded its $4 trillion QE programs   saying "there has been a substantial improvement in the outlook for the labor market" and "there is sufficient underlying strength in the broader economy". Many economists’ opinions on QE are divided,  some arguing in favor of it and some against it. Let’s have a look at the things, how they unfolded…

How it all started?

It all started with 2007-2008 financial crisis, to avert the ripple effects of the crisis, Fed started with reducing its fed fund rate and ended up with pumping trillions of dollars of money through three QE programs. After New Century Financial Corporation, a leading subprime mortgage lender, filed for bankruptcy in April 2007, rating agencies became cautious and started downgrading subprime mortgage bonds. Looking at the financial markets’ nervousness and to maintain the liquidity in the system, Fed started with 50 basis points cut in fed fund rate to 4.75% in September 2007 and by April 2008 fed fund rate touched 2%. Within 8 months, Fed reduced its interest rates by 325 basis points.

On September 7, 2008, the Treasury department took control of mortgage giants Fannie Mae and Freddie Mac and pledged a $200 billion cash injection to help the companies cope with mortgage default losses.

World financial markets spooked on September 15, 2008, when Lehman Brothers filed for Chapter 11 bankruptcy protection. As result of Lehman collapse, global money market immediately dried up, equity markets routed like there is no tomorrow, bonds and dollar skyrocketed. After seeing this, U.S. government, Treasury department and Fed took various measures to calm the financial markets.

Immediately after Lehman collapse, Fed and the U.S. government helped the one of the world’s largest insurer, AIG with $85 billion. In other words, AIG was bailed out by Fed and the U.S. government.

Within matter of three months, Fed reduced fed fund rate by more than 175 basis points to keep it between 0 to 25 points in December 2008. In between, when fed fund rate was about reach near zero levels, Fed started realizing the liquidity trap problem in traditional monetary approach. Ben Bernanke at helm of the Fed, who extensively studied Japanese lost decade and 1930s the great depression, started thinking of unconventional ways to pump the money into the economy.

QE1, QE2 and QE3

QE1 began in November 2008, with Fed deciding to buy $500 billion worth of mortgage backed securities (MBS) from financial market participants, $100 billion worth of debt obligation mortgage buying from giants Fannie Mae, Freddie Mac, Ginnie Mae and Federal Home Loan Banks. Fed did extend another $100 billion to Fannie Mae, Freddie Mac and Fed also announced the purchase of another $300 billion worth of long term treasuries. When QE1 ended in first quarter of 2010, Fed almost spent about $100 billion every month on buying mortgage backed securities for 17 months. That means, Fed was sitting up on about $1.7 trillion worth of mortgage backed securities. Overall QE1 can be classified as bailout fund.

In November 2010, Fed restarted its unconventional monetary policy, QE2, with $600 billion worth of long term treasuries buying plan. Fed expected to keep long term treasury rates and interest rates to be lower to speed start the economic activity. As previously announced, Fed concluded its $600 billion bond purchasing program in June 2011. QE2 can be termed as the fund used to kick-start the economic recovery.

In September 2011, Fed came up with yet another program called operation twist, wherein Fed started selling short term treasury bills and notes, and buying long term treasury bonds, to lower the long term treasury yields. Total fund allocated for this program was $400 billion. This showed that Bernanke was shifting the central bank's focus from repairing the damage from the subprime mortgage crisis to supporting lending in general.

In September 2012, Fed announced QE3. It agreed to buy $40 billion in MBS, and continue Operation Twist, adding a total $85 billion of liquidity a month. In December 2012, Fed announced it would buy a total of $85 billion of long-term treasuries and MBS put together. It clarified its direction by promising to keep it until one of two conditions was met: either unemployment rate to fall below 6.5% or inflation rose about 2.0%.

Did QEs Work?

In hindsight it’s always easy to analyze things! But talking about whether Fed’s QEs worked or not, it is somewhat complicated to question to answer and those answers are divided. But many economists agree that Fed accomplished couple of its goals. It’s unimaginable to know what would have happened without Fed's QEs. In the beginning, Fed wanted to stop the financial crisis from getting worse. By buying mortgage securities, Fed prevented more banks from failing and eased the frozen lending and money markets. Also being far more proactive and expansionary in nature of Fed as compared to ECB of European region reflects in the present status of both the regions. Fed helped to stabilize the U.S. economy, providing the funds and the confidence to pull out of the recession.

But whether QEs achieved what they were intended to achieve? Whether they succeeded in creating more jobs, spurring up the economy, boosting the inflation to Fed expectation level? I think answer would be “No”.  

Why QEs didn’t create enough jobs or reduce unemployment rate to Fed’s normal acceptance level of 5%. Why unemployment rate, which rose to 10% in 2009 till today didn’t reduced to before the crisis level of 5%, even after six non-stop years money pumping from Fed. Because monetary policies can't do much to reduce unemployment as liquidity is not the problem. In other words, there is little that expansionary monetary policies can do to increase the job creation.

High unemployment rate is due to two factors: cyclical unemployment and structural unemployment. Cyclical unemployment is caused by the economic downturns and structural unemployment happens when the long-term unemployed people lose their skills, needed to compete in the job market. Even now many economists argue that, present decline in unemployment rate is substantially because of long-term unemployed people quitting the job searching process, which is reducing unemployment rate.

QE didn't achieve Fed's goal of making more credit available and boosting the inflation. It gave the money to banks, which basically sat on the funds instead of lending it out. Though Fed succeeded in lowering the cost for banks to make mortgages, the banks didn’t actually start making more mortgages. Since banks didn't lend out the money, inflation wasn't created in consumer goods. As a result, Fed's measurement of inflation, the CPI, stayed below Fed's target.

However, QE did create an asset bubble kind of situation, first in gold and other commodities, and then in stocks.  An gold price more than doubled, rising from $869.75/ounce in 2008 to $1,895/ounce in 2011. Oil prices more than tripled from around $40/barrel in 2008 to around $120/barrel in 2011. After that, investors shifted to stocks. S&P 500 more than doubled from 700 levels in 2009 to 2000 levels in 2014.

QE could have been better designed. There could have been a better balancing act between monetary and fiscal policies. In retrospect far too much faith was put in the banks to channel the money to where it was needed. Edward Hadas of Reuters Breakingviews once nicely said, QE could have been worse, and it should have been better.