Jan 17, 2022

Henry Curr on the Myths and Uncomfortable Truths about QE

QE remains effective in acute situations, but moving forward policymakers need to take better account of some uncomfortable truths such as the fiscal risks that QE brings.
David Beckworth Senior Research Fellow , Henry Curr

Hosted by David Beckworth of the Mercatus Center, Macro Musings is a new podcast which pulls back the curtain on the important macroeconomic issues of the past, present, and future.

Henry Curr is the economics editor for the Economist Magazine and a returning guest to the show. Henry has a new working paper out titled, *Money Printers Go Grrrr: Three Myths and Three Uncomfortable Truths about Quantitative Easing.* Henry joins us study to discuss these three myths and uncomfortable truths about QE. Specifically, David and Henry discuss the continued relevance of quantitative easing as a policy tool, QE’s relationship to financial markets and its effect on the banking sector, whether we can estimate the magnitude of its effect on interest rates, whether QE necessarily boosts the monetary base, and much more.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Henry, welcome back to the show.

Henry Curr: David, it's great to be back on. Thank you for having me.

Beckworth: Oh, this is a delight. And you are the economics editor, and we're going to talk about QE. But one thing I've always wondered about editors, especially like a magazine, like the Economist, which has a lot of pages, a lot of depth to it, do you actually read through all the articles? I mean, is there someone who reads the entire publication before it goes to print? Is that you?

Curr: So, in theory, that's the editor-in-chief, but in reality, there's a shift system, where the editor-in-chief or someone standing in for her would read everything before it went to print. I read anything in the paper that touches on economics. And although we're the Economist, the bulk of the content is politics and current affairs. But when someone is writing about the current account or monetary policy, or something, I will definitely read that, but it's not the whole thing.

Beckworth: Yeah. Well, sounds like you guys have some amazing reading skills to get through everything, to edit, to clean it up. So, I'm impressed. And I'm also impressed with this paper you've written. It's a real joy to read. And touches on some of the themes we've talked about on the show, and ones I think are worth revisiting. And I want to begin by maybe just asking you to motivate this by first defining what is QE and then why write this paper?

Why QE Remains an Important Issue

Curr: Sure. Well, what is QE? That's actually a harder question than it sounds. I'm going to go with the definition as it has been popularized, which is, let's say QE is the purchase of government debt with newly created central bank reserves. I know purists say that pure QE is only buying short term government debt, and that if you buy long term government debt, you're actually doing fiscal policy. But I think that definition has been somewhat overridden and the battle has been lost on that. And now QE means buying government debt of any sort. And the real question is whether buying something other than government debt is also QE. But for the purposes of my paper, I focus on government debt.

Curr: And why did I write it? Well, I'm a journalist. I write about economics. But I studied economics. I have a master's degree in economics. And for me, economics is about understanding mechanisms. It's about understanding why markets and incentives do what they do, and being interested in those mechanics of why things are happening as much as the fact that they are happening, so that when you explain why the world works, you're trying to be quite precise.

Curr: And over the past few years, as I've been reporting on QE, and I've been trying to understand economic policy, and QE has become more important economic policy making with interest rates around the zero lower bound, I got more and more into the QE literature. And I realized that I'd never come across an issue within economics where the gulf between popular perceptions – but also how the press writes about something, and sometimes how policymakers talk about something, and how the issue is discussed by macroeconomic theorists, I suppose – is so great. And so, I thought there were all these ways in which people talk about QE, which weren't particularly well grounded in economics, or at least not well grounded in economic theory. And I found that quite interesting. So, I got into it and decided to write the essay.

I realized that I'd never come across an issue within economics where the gulf between popular perceptions – but also how the press writes about something, and sometimes how policymakers talk about something, and how the issue is discussed by macroeconomic theorists, I suppose – is so great.

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Beckworth: Yeah, you highlight that there's this division among even central bankers as to what QE actually does and accomplishes. And of course, there's divisions among academics, journalists, people on the streets. So, it's great to tackle this question and try to get a better sense of what is going on. We've had now decades of QE, actually it's going back to 2008. We've had enough time, I guess, to look at this experiment and see what does it actually accomplish? We've had QE, the expansion of central bank balance sheets. We've also had some contraction briefly, 2017 to 2019. And of course, the pandemic, massive expansion. And there's now a talk of central banks dialing it back. The Fed in particular just recently announced it's going to do balance sheet runoff at some point in the near future, probably this year. So, very timely topic.

Beckworth: And again, one of the issues doesn't matter, will this balance sheet runoff matter. I was recently interviewed and they had several guests on. And one guest was a market participant. And this market participant was certain, it was going to create havoc by the end of the financial system. I exaggerated a little bit, where I came in a little more nuance, saying, "I'm not so sure what it's going to do, actually." I believe there's a signaling effect. There's signaling channel. But at the end of the day, I said, I think interest rates are going to matter more than the path of the balance sheet. So, let's jump into this. And you have, again, three myths and three uncomfortable truths. And Henry, we don't like uncomfortable truths, but we're going to work our way through it, anyways. Make us a little nervous, sweat over here, as we think through these. But your first myth, myth one, quantitative easing or QE props up financial markets. So, walk us through that.

Does QE Prop Up Financial Markets?

Curr: Sure. So, the first thing I'm going to do is ask you to park one sense in which this is true, which is important, but temporary, and that's in a big liquidity crunch like we saw in the spring of 2020, where central banks, most importantly the Fed come in with a big wall of QE and a help unplug the treasury mark or the market for government debt and stabilize everything. In that moment of crisis, quite clearly, QE is supporting financial markets. And it's very important that it does that. And that's not really up for debate. I'm also going to park one other thing, which is the specific role QE plays in Europe, where within the Euro zone, when the European Central Bank buys a bond, it is converting a liability of an individual country into a liability of the Euro zone as a whole through the ECB. And that's doing something which is also beyond the purview of my essay.

Curr: What I'm talking about is this broader sense in which people say, isn't it the case that a QE is distorting financial markets, that we've had a long period of asset price appreciation. The housing market at the moment is really, really strong. Isn't this to do with QE being some sort of unusual, weird monetary policy tool? And also the sense in which some people seem to argue that QE uniquely as an economic stimulus props up financial markets, but doesn't help the real economy, which is also a view you encounter in the financial press. And there was inquiry into QE by the British parliament recently, which also made that argument.

In a big liquidity crunch like we saw in the spring of 2020, where central banks, most importantly the Fed come in with a big wall of QE and a help unplug the treasury mark or the market for government debt and stabilize everything. In that moment of crisis, quite clearly, QE is supporting financial markets. And it's very important that it does that.

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Curr: And what I argue in the essays that this does not make a lot of sense when paired with the explanations for how QE works that economists have come up with. So, you mentioned the signaling theory of QE. So, this signaling theory says that QE works, because it reveals to financial markets, how central banks are going to move short term interest rates in future, because it reveals that if the central banks come in and done a lot of QE that shows that things must be really bad and interest rates going to stay low for a long time. And investors know that they should expect QE to be unwound before the interest rates rise, and that they provides stimulus in a forward guidance sense. But if that's the channel by which QE is operating, then QE isn't really doing anything special to financial markets, distinct from what conventional monetary policy expectations do to financial markets.

Curr: So obviously, it's true that all else equal or lower short term interest rate is going to lead to higher asset prices. But QE isn't more special than the central banks walking down the yield curve, except in so far as it's more effective. It's not some sort of nefarious thing that's doing something special in financial markets. So, that's one channel.

Beckworth: So Henry, is there any evidence for the signaling channel?

Curr: Yes. So, when I talk to financial market participants and many economists, there are a lot of people out there who believe that signaling is the main way in which QE works. And some who believe it's the only way outside of the crisis time that I mentioned in the start. But I think that the best evidence is what happened during the taper tantrum in 2013, when cockish comments by Ben Bernanke about the future of the Fed's asset purchases at the time caused a big selloff in bond markets. But when you crunch down analyze what happened, it's fairly clear that that was about repricing of what was going to happen to the short rate, more than anything else.

Curr: So, what the taper tantrum was about, was about the Fed shifting expectations for conventional monetary policy, not something specifically to do with the direct effect of its assets purchases. And that's probably the best evidence. But you can also appeal to other things. For instance, in the US, in the commentary on what the effects of balance sheet runoff are going to be, I know the focus is all on tapering and the Fed coming out and saying, it's going to change its taper schedule slightly, will move financial markets. But of course, other central banks operate QE in a different way.

Curr: The Bank of England just comes out and says, it's going to have a stock target. It doesn't engage in the same open-ended purchases. And then gradual tape down that the Fed does. And yet the end of its purchase programs don't lead to some kind of enormous cliff edge in which markets suddenly implore because you don't have a flow of purchases going on anymore.

Obviously, it's true that all else equal or lower short term interest rate is going to lead to higher asset prices. But QE isn't more special than the central banks walking down the yield curve, except in so far as it's more effective. It's not some sort of nefarious thing that's doing something special in financial markets.

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Curr: And the reason I would argue you that tapering is so important or changes in the pace of tapering are so important in the US, it's precisely because financial markets have been guided during first signals about the future path of short rates from the tapering schedule. And if you look at what happened during the pandemic, the massive, great interventions in bond markets in the pandemic happened early in 2020. And there was a sort of implicit tapering, if you like, as everything settled down and the Fed moved to a more steady pace of purchases that was announced. But as you move to that lower flow, it didn't disrupt bond markets, but to the contrary, the Fed was able to move to that lower flow because the period of crisis was subsiding. So, just from a high-level inspection of the trends in bond markets, as well as the more rigorous evidence from the taper tantrum, I would say there's quite solid evidence that the signaling channel [of QE] is operating. And the question is whether other channels are operating too.

Beckworth: Okay. And what was the other main channel that comes up in thinking about QE?

Curr: So, the other channel is the portfolio balance mechanism. And this is the idea that is somewhat in one sense, it's more intuitive, because it's more just like a kind of simple supply and demand model that you might have in your head, that central banks come into financial markets, they buy assets, and the price of those assets goes up. So, the Fed is able to influence long term bond yields by coming into financial markets and buying the 10 year treasury, and then the 10 year treasury yield falls. But in actual fact, making that work in economic theory is quite difficult, because asset prices are supposed to be determined by fundamentals, not by these changes and supply, and demand.

Curr: And so, the theoretical motivation for portfolio balance is quite complex and involved. And it basically relies on the idea that there are these so-called preferred habitat investors. And these are people who really, really like to hold government bonds, or specifically government bonds of a given maturity. And they keep buying those bonds regardless of price. Their demand is inelastic. And that creates this opening for the central bank to move government bond yields in a way that isn't anticipated by the more basic financial theory. And this motivates a lot of central bank thinking about how QE works.

Curr: But there is this paradox at the heart of it that I point to in the essay, which is that in order to get the central bank, this power to move financial markets, as I say, you have to assume these preferred habitat investors like pension funds who really like government bonds. But in order for the government bond rate, which the central bank is influencing to be significant to other financial markets and indeed the economy at large, you need there to be a link between the government bond rate and the price of other financial assets. You need there to be a spillover.

Curr: So, you need segmentation in order for the central bank to be able to move the bond yield, but you need tight links in order for that bond yield to have spillover effect on other financial markets. And the portfolio balance theory is trying to do both those things at once. And it gets there with some quite strange assumptions, you might say. For instance, you assume that some investors in the bond market only buy or really like to buy a given maturity and won't go down the yield curve, but they will switch into real estate if necessary. And you have these motivating assumptions, which are definitely open to debate. So, this is at best not open and shut. And it's potentially quite wobbly. And it's certainly not strong enough, I would argue to form the basis of a view that says QE is really what's driving asset prices higher, certainly going beyond bond markets and into housing markets and all the rest of it.

Beckworth: Yeah. And this conversation is important for many of the critiques, I think from the left, who say QE is dangerous because it's furthering inequality, at least wealth inequality that people holding stocks, they're doing great. And then QE is the not affecting the real economy. But I want to go back to the portfolio balanced channel, because I share your skepticism, or at least recognize this tension. It's kind of a, the central banks want to have their cake and eat it too. On one hand, they need segmented markets. On the other hand, they need to have spillover effects. And you go back and read some of Ben Bernanke's explanations in the speeches on how it works, he tells this story, right? It spills over from the Fed buys the treasuries. Then those investors go out and buy the next closest asset to it. And there's this chain effect going on.

Just from a high-level inspection of the trends in bond markets, as well as the more rigorous evidence from the taper tantrum, I would say there's quite solid evidence that the signaling channel [of QE] is operating. And the question is whether other channels are operating too.

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Beckworth: Another way this is often framed is, well, it's simple, David, the Fed just is taking duration risk off of the market from the private sector. But as you point out and Michael Woodford talks about a lot in his work, all that is happening is you're taking duration risk from private bondholders and transferring that risk to tax payers. And so, the bondholders are tax payers and at the end of the day ends up with tax, but you're just transferring it around. And at the end of the day, the public still holds the same amount of risk in the aggregate.

Beckworth: To make this work, the central bank has to be some kind of special, super powerful financial intermediary that can do magic that other financial intermediaries can't do. And that to me has always been a problem. Is the Fed merely substituting and doing what would've been done anyways? And I think in normal circumstances, like you say, I think you can make that argument, that rates would be where they are in the absence of the Fed intervening, the way that it has been. What are your thoughts on that?

Curr: Yeah, I think that's right. I think that argument about the central bank ultimately being owned by the private sector and the central bank's liabilities in some sense being on the books of the private sector, when you consider the private sector to be taxpayers, is interesting. And it reminds me of Ricardian equivalence arguments for the inefficacy of fiscal stimulus. Now, I'm aware that there are lots of good reasons to doubt with Ricardian equivalence. So, I wouldn't put all my eggs in the basket of saying that that risk is owned by the private sector, so QE doesn't work, but it's another important point to consider, I think.

Beckworth: Yeah. And to be clear in going back to what you said earlier, QE does work, or this argument does work when the markets are crashing in a panic. Middle of a crisis, you can make this argument convincingly that the Fed is a special financial intermediary. It does have balance sheet capacity that no one else has at the time. But in normal times, outside of those panics, so outside of 2008, 2009, outside of March 2020, and around there, QE has been really in my view, just again, signaling. I think it's signaling more than this portfolio balance channel.

Beckworth: And this goes back, as I mentioned, just stuff that Michael Woodford has written. We can go back even farther to Neil Wallace, Wallace neutrality, or the Wallace irrelevance proposition. And I find that argument very compelling that how the government finances itself doesn't really affect the price level or the allocation of real activity. It's a special case or application of the Modigliani-Miller theorem, but to public finance. And that theorem says how a corporation is valued, does not depend on how it is financed. Now, there's a bunch of strong assumptions it makes. And you got to make similar strong assumptions with QE. But I think in general, it's a good first approximation. And yet that is, I don't know, a view or a point that I don't think is well articulated or well known among the public, even among the financial press, commentators, even among economists, I mean, the academics. Do you get that sense too, that this Wallace neutrality critique isn't widely held or shared?

Curr: Oh, absolutely yes. I mean, I encountered it in Michael Woodford's paper and through some conversations with him and others as well. And it's a subtle point. And another reason I wrote this essay I suppose, is I thought I had all these thoughts that were at a level that was slightly too academic or technical for the pages of the Economist, because it's precisely the kind of argument that if I took to my editor and said, "Look, QE doesn't work because of Wallace neutrality and because the private sector owns the central bank." I don't think I'd get a receptive audience within the opinion pages of The Economist, because it's a subtle argument. And it's also not quite clear how you should assess that. And that goes for QE more broadly as well. I mean, the empirical tools that economists have to assess these theoretical arguments, and whether or not QE works are limited, basically limited to event studies, which have their own problems. So, it is a somewhat abstract argument, but ultimately if it's right, then it's extremely important. So, it's definitely worth highlighting.

Beckworth: Yeah. And just to flesh this point out a little bit more, Michael Woodford has a paper where he lists two assumptions. I think it's in his 2011 paper he gave to Jackson Hole, but I know he's put it somewhere else as well. But he said, you need just two assumptions for this kind of irrelevance proposition to work. One, the assets are held for pecuniary reasons. So, you hold the bonds because it pays an interest payment to you. And secondly, anyone can buy and sell unlimited amounts. Now, those two assumptions become particularly binding when you hit the zero lower bound. So, when money and bonds, or treasury bills at least are equivalent, you really are just substituting one government liability for another. And you get to this Wallace neutrality point, I think is particularly binding. And I think that's the contribution that Michael Woodford and Grant Atkinson was making. Wallace neutrality is particularly binding when you get to zero lower bound. You're just substituting Federal Reserve liabilities for treasury liabilities.

Curr: Yes. I think that's right. That only seems intuitively correct to me.

Beckworth: All right. So, let me go back and just restate the times where QE does work. And we've mentioned this already. So, the first one is in a crisis. So, we saw that again, March 2020, 2000 and 2009. But let me throw in another potential way or context where it would make a difference, a meaningful difference in terms of the real economy, asset prices inflation. And that is when QE is done alongside a helicopter drop or is part of a helicopter drop, which in normal times it is. I think the point is in normal times, it's not a helicopter drop, but in the midst of a crisis. And I think what we saw maybe over the pandemic, we saw something close to a helicopter drop, if not a helicopter drop. And the way I would define a helicopter drop is that there's going to be an increase in government liabilities, whether it's bonds or whether it's reserves, but an increase in government liabilities that's expected to be permanent and more than the public wants to hold. So, they're going to shuffle them and spend them until the price level adjusting goes up. What are your thoughts on that?

Curr: Well, I think I would agree. I'd need to think about whether I agree with your definition of a helicopter drop. I am very interested in this idea that it was the combination of QE and fiscal stimulus during the pandemic that made the stimulus so powerful, and that you need both parts of it for it to work. And I think the right way to think about that, and I'd really be interested to know your views on it David, is, what would the world have looked like if we had done the fiscal stimulus, but much less QE? Or rather we'd done QE during the period crisis, say early in 2020, but then central banks had unwound it much more quickly, but you'd continued and had the same level of fiscal stimulus. You would've had the Biden stimulus.

Curr: I think if you are committed to this view that it's the helicopter drop, the combination of the two that is so important, then you do have to tell a story for why fiscal stimulus on its own would've been less effective. And I'm not sure I fully buy that. I think that if you'd had that big fiscal stimulus, we probably would still have strong growth in the US and inflation. I think that you have to tell a story where that gets crowded out by the long term interest rate in the absence of QE. And I'm not sure I believe that, but what are your thoughts?

I am very interested in this idea that it was the combination of QE and fiscal stimulus during the pandemic that made the stimulus so powerful, and that you need both parts of it for it to work. And I think the right way to think about that...is what would the world have looked like if we had done the fiscal stimulus, but much less QE?

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Beckworth: No, I think you're right. I think they both had to be done. It was a complimentary action. And I think maybe another way of saying this is, what they did together was to provide nominal income to the households, to businesses, to keep them afloat. And I actually made the case for doing this at the onset of the pandemic, have a little policy brief out. And I actually have a kiddo policy journal. Now, I'm thinking about out where I made the case, when we're at the zero lower bound in a midst up a crisis, you should have something like a nominal GDP level target, but it's complimented by fiscal policy doing some kind of helicopter drop. That's how you're going to restore nominal incomes and preserve the economy.

Beckworth: Let's go back to 2001, 2006 in Japan, they did something very similar. They ran large budget deficits for many years. They also had the original QE, but it didn't make any difference. At the end of the day, they still had deflation. So, what's the difference? And the difference there, and this is the point Michael Woodford made in this 2011 paper, is that the public and everyone expected them to dial that back, to pull it out when it was done. It was a temporary fix. It wasn't something permanent. And if you look at, for example, the monetary base, it does go up, then it comes right back down to this trend path.

Beckworth: So, I do think there's got to be this expectation that's going to be permanent. So, where does permanence come in 2020, 2021? I think the Fed's new framework. The Fed's new framework is a level target of sorts. And it says, maybe it's not very clear, but it says we are going to effectively allow that helicopter drop to stay with us and we're not going to offset it in the future. And in fact, we see this, the price levels up, dollar sizes up.

Curr: Sure. But I think that's an interesting question there, which is, do you need QE for any of that to work, right? The Fed can switch to its new framework, its new average inflation targeting framework. You can have an increase in liabilities, just have them be bonds, not central bank services. And you can do all that without QE. So, if it is permanence, I think maybe you are back to signaling in some sense. You're back to saying that people don't believe it's permanent unless the central bank is involved via QE. And that's where you're getting the traction. But I'm not sure I believe that. I think that you could have done those things, the Fed's new targets and the expansionary policy in terms of aggregate liabilities of the government without QE. I don't have a high degree of confidence there. What do you think?

Beckworth: Well, I think it does come down to this question. What is the transaction asset that's going to facilitate exchange? I mean, ultimately you need some increase of a liability whether is treasuries or reserves. And they're going to be used somehow to increase spending, which affects then the price level and the size of the economy. And could you do that just with treasuries? I guess it's possible if the financial system takes them, uses them as collateral and increases spending. And there's an endogenous broader money creation. That you could probably tell that story. I think you could also tell the story, if you go back to the, I think the Greenbacks during the Civil War, those were originally treasury bills. They were to be redeemed, but they ended up turning it into money. So, I think you could tell that story too.

Curr: Isn't there another story involving distribution, which would be that if the US government borrows a lot of money and gives it to poor people with high marginal propensity to consume, you boost aggregate demand in a way that might have the economic effects. So again, in a counterfactual where you don't have QE, but you do have the US government sending checks to everyone. I still think you'd probably get quite a big boost to aggregate demand there, just as a result of providing a lot of cash to liquidity constrained households. And so, that's the way in which I would see the aggregate demand boost happening during the pandemic, even if we hadn't done as much QE.

Beckworth: Henry, I think that's a great question and something we could probably continue discussing on the show for a long time, but we have some other points in your paper I want to get to. So, we did myth number one. Now, let's go to uncomfortable truth number one. Nobody knows how much QE affects interest rates.

Do We Truly Know QE’s Effect on Interest Rates?

Curr: Yes. So, we covered this a little bit already, I suppose, but because of the uncertainty in the mechanism and the limited extent to which economists are able to estimate what happens when QE is announced, which basically based on event studies that look at the immediate reaction of financial markets and an immediate reaction, which may be unwound over time, or which may be biased by the state of financial markets at a point of which QE is announced, because of those uncertainties, it's quite difficult to know what QE is doing. And you've had various rules of thumb estimated from reviews of these event studies. So, Joseph Gagnon has one, where he says that, or rather he finds that in the literature, the median effect of asset purchases worth 10% of GDP to reduce 10 year government bond yields by about half a percentage point.

Curr: But it's very clearly the case that central bankers are to a certain extent flying blind when they use QE and when they determine how much to buy, it's not as precise as when they're determining what interest rate to set. You can't write down a Taylor rule for QE in the same way you can write down a Taylor rule for interest rates. And that is uncomfortable because central banks obviously want to look like they're in command of the situation, but they're using an experimental tool whose effects are uncertain. And also when you apply these rules of thumb from the pre-pandemic era to the quantities of QE that have been done during the pandemic, you end up with quite a large effect on 10 year bond yield. So, I think if you take the stock of Fed purchases to date now, you are in excess of 200 basis points by those rules of thumb on the 10 year bond deal.

Curr: And I'm not sure anyone really believes that portfolio balance effects are holding down to 10 year by 200 basis points. If that's true, that's failure sort of astonishing. And it's linked to the counter fact, we were discussing just now, what would've happened without QE. But central banks are doing it, I think because they want to throw everything at the wall and see what sticks, but the bang for buck of QE is really uncertain. And to the extent it's working by signaling effects, it depends on what you're saying about how QE interacts with monetary policy, and also how it interacts with the fiscal policy. So, it's not a tool that is going to have a very clear effect if you're a policymaker, trying to determine how much to buy.

Beckworth: So, one of the papers you cite in this discussion about how big the effects are, is a really clever paper that recently came out. I believe it came out in 2021. And the title of the paper is, “50 Shades of QE: Comparing Findings of Central Bankers and Academics.” And obviously, that's a play the movie and in the book with a similar name, 50 Shades of Gray. So what did this paper find that really plays into this discussion about these size of the effect of QE?

It's very clearly the case that central bankers are to a certain extent flying blind when they use QE and when they determine how much to buy, it's not as precise as when they're determining what interest rate to set. You can't write down a Taylor rule for QE in the same way you can write down a Taylor rule for interest rates. And that is uncomfortable because central banks obviously want to look like they're in command of the situation, but they're using an experimental tool whose effects are uncertain.

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Curr: Well, they essentially found that central bankers seem to do better in terms of getting more promotions, if they find positive effects of QE in their studies. And that central bankers are also much more likely to find positive effects of QE or rather say stimulatory effects of QE than academics are. And that is consistent with a view of the world in which when central banks do QE, there's a little bit of empire building perhaps going on. There's a little bit of wanting to say they haven't run out of ammunition to stimulate the economy when they're at the zero lower bound.

Curr: And so, there might be a kind of institutional incentive for people in the central bank to find that QE works. And it's a provocative paper for sure. And it's also consistent, like I say, with my experience, which is central bankers are more likely to emphasize certain portfolio little balance channel of QE than academic cell. Although, that's by no means a blanket statement. It's by no means true of everyone. I wouldn't like to allege that the central bankers I speak to are acting in bad faith, but this paper, certainly food for thoughts on the incentives that central bankers have.

Beckworth: Yeah. So, you can tell a story where they're not consciously trying to manipulate results or intentionally getting these findings. It's just the structure is set up. Incentives are set up such that they end at this point, maybe inadvertently or unconsciously. The key takeaway from this though, this section is, and I like what you say here, unsurprisingly, given its uncertain effects, central banks do not explain clearly how they decide what quantity of bonds to bond. Like you said, there's no tailor rule. You could maybe say there was a rule of thumb prior to the pandemic. You mentioned that the studies, Bernanke and then Joe Gagnon, who's been on the show a few times, but those rule of thumbs, and I took him to heart. I said, "Okay, this is a nice rule of thumb. I used them too." But I didn't think until I read your paper, man, if we apply them today, some huge, huge effects on the tenure treasury yield, for example. And that just doesn't seem plausible. So, we don't know. And central bankers don't know. And it's interesting just looking back, we don't see many people asking central bankers this question, or being forced to.

Beckworth: So, what exactly is QE accomplishing? Outside of the March 2020 period, what exactly is it accomplishing? And if it's just signaling, great. But why 120 billion a month? Why that magnitude? How did you guys come up with that magic number? I'm sure there's some internal documents where they motivated and justified it. All right. Let's move on to myth number two. We've done our first myth in our first uncomfortable truth. Myth number two, QE funds the government.

Does the QE Fund the Government?

Curr: Yeah. So, this is a particularly pervasive myth, I would say during the pandemic, especially in Britain, although to a certain extent everywhere, which is this idea that QE is doing something special to ease the government's finance and constraints. And again, I think you have to have the caveat that that may be true in a bond market crisis when there's a real risk off move. But the argument is that this happens in a broader, more sustained sense. And while it's true that loose monetary policy benefits the government in terms of easing the government's budget constraint, and to the extent QE does work in bringing down the yield curve, it is doing that.

Curr: QE is not contrary to what some people think making government liabilities disappear at all. It's just changing the makeup of those liabilities. It's replacing government bonds in the market with central bank reserves held by banks. Those central bank reserves bear interests and bear interest costs and where short term interest rates to rise, many central banks, the Fed. The Bank of England would implement that by raising the interest paid on reserves. And that would carry a cost of central bank fiscal cost. That would mean lower profits remitted to the government by the central bank. And in an extreme situation could mean the central bank making losses and eroding the central bank's equity.

Curr: So, what QE specifically is doing is reducing the government's funding costs in the same way that most governments could reduce their funding costs by issuing short term debt rather than long term debt. Because when you do that, you avoid the term premium. So, your average interest cost will go down. It'll be a profitable thing to do for the government in expectation, but that's not without a downside, which is of course, that if you assure your debt, at the short end, you're then more exposed to interest rates going up. You're not benefiting from the insurance you get from issuing long term debt, and you're saving on the insurance premium. So, it's not right to say that QE is really funding the government in any special sense. It may be making the government's funding costs lower for a while, but not in a way that the government can achieve on its own without central bank, if it issues short.

Beckworth: So, is it too cynical to say that the Federal Reserve is the largest fixed income hedge fund in the world?

Curr: I like that. That's fun.

Beckworth: That's fine now. Okay. More seriously though, so going back to this question of how the government is financed, the treasury could be issuing a lot more T-bills, which would be equivalent to reserves, depending on how close the interest rates were. But I guess the question is, isn't this like a political economy question at some level too? I mean, Congress has delegated the management of public debt to the treasury, not to the Fed. Right? And I think there's some pragmatic reasons to worry about this and then maybe some political ones as well. But pragmatic, I would think treasury does talk to the market, does issue bills, notes, and bonds based on what they think the demand is. So, the financial system may need more treasury bills at a point in time. And so, the treasury issues them or maybe they want longer bonds. And then the Fed comes in and messes up that mix.

Beckworth: So, I think on a pragmatic level, we need to be careful here. Then on a political matter, I think the Fed is really needs to be careful because it might be walking into a fire storm once interest rates do start to go up. It's managing, I think close to five and a half trillion in liabilities, both the reserves, as well as the funds park that the overnight reverse re-purchase facility. Think of those financial firms, mostly banks and then some financial firms that have parked at the overnight repo facility. But as interest rates go up, that means higher interest payments to these financial firms and banks, right? Now, they would be earning that probably the same amount were they holding treasuries instead, where the treasury being the main manager of debt. But it looks bad. It's bad optics, I think politically.

Beckworth: You can imagine Senator Elizabeth Warren, for example, having a letter to the Fed, having a speech saying, "Hey, why are we paying these big banks, these big financial firms so much? Are we subsidizing them?" So, there's a subsidy critique, which I don't think is right, theoretically, but politically I could see it being a very poignant, powerful argument. Do you see any danger in the central bank's big balance sheets on these fronts?

Curr: Yeah, I think that's absolutely correct. The optics of interest on reserves are bad. Some people say that you can circumvent this by implementing a tiering system, where you're only compensating a portion of the reserves. And during the House of Lord's inquiry, the British parliamentary inquiry to QE, I think this was discussed somewhat. My understanding is that would in effect be a sort of new tax on the banking system. So, it would be fiscal.

Curr: But in addition to that risk, I'd highlight the risk of the central bank getting drawn into funding particular projects with QE or changing its asset purchases to fulfill political desires, such as through green QE, using QE to find out only green projects, and QE becoming a tool to change the cost of capital. Now, that may be desirable in some broader policy making sense, but it's not what the central bank it's for. And it dilutes the central bank's mission. And it distracts from the core purpose of the central bank, if they're getting drawn doing that. So, I think, yeah, those twin risks of politicization of central banks because of the large balance sheets are present.

Beckworth: Yeah. I worry about that last point too. And it's what George Selgin would call fiscal QE, any QE that's done outside of addressing macroeconomic development in the business cycle. So, any kind of QE that goes beyond smoothing the business cycle out, he calls fiscal QE. And I think you're right, it looks like there's this piggy bank that has unlimited resources. You can tap into it. But really what you're doing is you're tapping into the fiscal space that belongs to the government, the treasury. And it's an off balance sheet way of tap tapping into that fiscal space. And that should be decided through elected officials, not through technocrats. That's my critique. And I think the Fed is opening itself up to, depending on who's in power, the Democrats are in power, their policy projects. If the Republicans are in power, it swings the other way. So, I do worry about that.

Beckworth: And just to go back, you mentioned about the tier system. I mean, this goes back to the operating system itself. This is a floor operating system where most central banks are doing some version of this or the tier system. But in the floor system, they've separated the size of the balance sheet from the stance of policy. And it gives them this flexibility, right? They can respond to liquidity shocks by expanding the balance sheet, while also having a certain stance for monetary policy. But it also comes at this political cost. If you separated the size of the balance sheet from the stance of policy, it makes it a very tempting target to tap into that central bank balance sheet for political purposes. So, I do worry about that. And I'm glad to see you raise that as well. All right. Let's go on to uncomfortable truth two, policymakers must choose between QE and locking in low rates.

Must Policymakers Choose between QE and Low Rates?

Curr: Yeah. So, this is the logical implication of our previous discussion that if QE is analogous to a debt charity operation, which replaces these long term debts with short term liabilities of the central bank, but those short term liabilities are ultimately short term liabilities of the taxpayer. The taxpayer is on the hook for interest on reserves. Then clearly there's a contradiction between the widespread operation of QE and the calls that you hear quite often, that what the government needs to do is lock in these low, long term interest rates. And we should do a lot more investments, financed at the long end. And the low 10 year yield is an indication that the markets are begging for government to do more investment.

Curr: And I think every time a prominent economist makes this call for locking in long term rates or taking advantage of long term rates, the unspoken implication is that you're doing a sort of not quite reverse QE, but your logic is contrary to QE there. And I find that contradiction interesting because it basically goes unacknowledged. It's both popular to make that argument. And QE is not questioned on the grounds that it's doing the opposite.

Beckworth: Okay. Let's move on to myth number three, QE boost only the monetary base.

Does QE Necessarily Boost the Monetary Base?

Curr: Yeah. So, after the global financial crisis, there had been a lot of QE. There was a lot of QE in the 2010s, but measures of broad money, measures of commercial bank deposits didn't rise commensurately. And so, it became popular to say that QE, it's affecting the monetary base, but it's not affecting broad money. In some sense, it gets stuck in the banks. And I think it's related to what you said earlier a little bit, people picture a commercial banks balance sheet and they think, well, if you've got a treasury bill there and it's a government liability with a low interest rate, and you just swap it for a bank reserve with a low interest rate, then you're not really doing very much.

Curr: And while I think in some context, that intuition is useful, in actual fact, QE does have a direct effect on broad money and on a commercial bank deposits at least in a partial equilibrium sense. And that's because if I'm the Federal Reserve or the Bank of England, and I go and buy a government bond from a non-bank, a pension fund or a hedge fund, or whomever, that will be intermediated by the banking system. The commercial bank will get the reserve. I will get the bond as the central bank, but the counterparty from which the central bank is buying the bond, the pension fund will get a newly created deposit at their bank.

Curr: So, it's not quite right to say that QE doesn't have a direct effect on broad money. What happened after the financial crisis of course, is that you had an enormous credit crunch. You had low demand for credit. You didn't have much credit creation. And so, you had lots of other things which were offsetting the effect on QE when bonds were purchased from non-banks. So, it's not that the central bank can necessarily steer broad money using QE, because it's set in equilibrium by all the forces that determine broad money, namely the demand for credit and the supplier of credit. But QE is having at least an effect on the margin. So, I think some of the discussion during the pandemic, which has emphasized fiscal policy as a thing that's been driving the big increase in broad money that's happened during the pandemic is at least partly mistaken because it is QE which is driven this big increase in the commercial banking system.

It's not that the central bank can necessarily steer broad money using QE, because it's set in equilibrium by all the forces that determine broad money, namely the demand for credit and the supplier of credit. But QE is having at least an effect on the margin. So, I think some of the discussion during the pandemic, which has emphasized fiscal policy as a thing that's been driving the big increase in broad money that's happened during the pandemic is at least partly mistaken.

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Beckworth: So, ceteris paribus, QE does affect broader monetary aggregates, but there are other things that are also affecting it after 2008, that was the credit contraction and banking system not wanting to make a bunch of new loans and therefore deposits.

Curr: Yes, that's my argument. Unless the central bank is only buying from banks. If the central bank is only buying from banks, then it is just that swap. But indeed I think that when the Bank of England started doing QE during the global financial crisis, it specifically said, "We're going to buy from non-banks in order to ensure that we're having this effect on broad money." And this point got a little bit lost when QE didn't lead to the inflation that some had predicted and people said, "Well, that's just because it's a narrow money policy. It's not a broad money policy." It is a broad money policy as well. It's just one that may not be effective in pinning down poor money, if you also have loads of other stuff going on.

Beckworth: I think some of this confusion also came about because we were told this. Ben Bernanke, I recall him saying in his speech, QE is not monetary easing, it's credit easing. He said, don't look at the liability side of the Fed's balance sheet, look at asset mix we're creating over there and all the magic that's going to do. And he said, don't compare us to Japan, 2001 and 2006. So, I think that the fact that the inflation didn't take off, at least didn't go off, people easily got lulled into this understanding.

Curr: Yeah, I think that's a reasonable point. Yeah.

Beckworth: Okay. Let's move into uncomfortable truth number three, QE swells the banking system.

Does QE Swell Up the Banking System?

Curr: Yes. So, this is the implication of the uncomfortable truth again, which is that if you have the central bank buying a lot of bonds from non-banks, as it has during the pandemic, and that's all intermediated by the banking system, you get a lot of new deposits created in the banking system. And that may be fine. But what we've discovered during the pandemic is that that can interact with regulatory rules in the banking system in a way that's uncomfortable, and notably the way in which it's been uncomfortable in the US, is its interaction with the supplementary leverage ratio, which constrains the size of bank's balance sheet, because they have to raise more capital, if they want to grow very large.

Curr: So, as the banking system has been swelled by these new deposits coming in as a result of QE that unlike after the global financial crisis were not offset by a credit crunch, you've had implications for the treasury market and you've had implications for regulation. And indeed you mentioned earlier, the Fed's overnight reverse repo facility, the Fed took the lid off the overnight reverse repo facility, I think to prevent problems in the treasury market caused by banks getting too large and having to offload treasuries in order to shrink their balance sheets. So, this has been less of a problem in Britain, where reserves are exempted from the leverage ratio, but in the US, that exemption was only temporary. It came back in. And so, instead you have the overnight reverse repo facility, where you now have astonishing amounts being parked at the Fed overnight to sap up all the liquidity that's been created in the banking system as a result of QE. And I don't know whether this is a desirable state of affairs or not. It seems to work, but it at least seems a little bit messy.

Beckworth: Yeah. I think it's incredibly messy. And I pointed to the UK is where we should be going. We should follow their lead on the supplemental leverage ratio. I've had Bill Nelson on the show a few times, and he's a former Fed staffer, the Board of Governors who worked in monetary affairs. And he highlights the fact that the supplemental leverage ratio when it was first written and introduced, I believe 2014, 2015, the expectation was the Fed's balance sheet would be in the billions. It'd be large, but it would be much, much smaller than it is today. They never intended for the supplemental leverage ratio to be a binding constraint. It's supposed to be a backup, right? A backup to make sure that banks have enough capital, but never is meant to be the binding constraint. It becomes a binding constraint in the worst possible time during a crisis when QE is being ramped up, right?

Beckworth: So, you use that balance sheet capacity of a bank during a crisis when that balance sheet space could be used for helping out the economy. So, it is I think a messy situation that we're in. But let's move forward. Now, we've looked at our three myths and uncomfortable truths. What next? Where should we be going or what will be happening next to QE?

What’s Next for QE?

Curr: Well, the question I suppose is to what extent is QE going to be the main tool of monetary policy in future recessions? If you believe the pricing and financial markets, the low rate world is here to stay, QE is going to continue to be the main tool that central banks have at their disposal to circumvents the zero low bound on interest rates. It's going to be important in future recessions.

Curr: But what I wonder, and this is the question really, I raise at the end of the essay, without coming to a firm conclusion about what should be done, whether policymaking wouldn't be better if it accounted for some of these uncomfortable truths a little bit more. And the example I give of this is that clearly QE has these implications for fiscal policy. They may make QE less desirable, or they may be costs worth paying for QE. But while you have the division between the debt management done by finance ministries and the stimulus done by central banks, I'm not really sure anyone's trading off the fiscal risk of QE against the stimulus risks. And I'm also not sure whether it would be impossible if QE mainly operates via signaling to come up with other ways that the central bank could credibly signal the path of future interest rates. So, those are the two things I think really should be considered.

While you have the division between the debt management done by finance ministries and the stimulus done by central banks, I'm not really sure anyone's trading off the fiscal risk of QE against the stimulus risks. And I'm also not sure whether it would be impossible if QE mainly operates via signaling to come up with other ways that the central bank could credibly signal the path of future interest rates.

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Curr: I know that a lot of central bankers are thinking about the long term future of QE. In Britain for a while, there was an argument made that the Bank of England needed to prioritize shrinking its balance sheets in order that it could act with force during another financial crisis. In Britain there's been an argument made that the central bank needs to preserve its QE ammunition, that it needs to get out of QE faster during normal times in order to be able to act with force during intermittent financial crises. I'm not sure, I really buy that argument, at least not yet, but it does strike me that we are dealing with a policy tool where the downside and the uncertainty surrounding it are not perhaps discussed in the public domain as much as they should be given the importance of the policy tool. And if QE isn't as effective as central bank say, then obviously, we're going to need to reach for alternatives too. And that's an important discussion.

Beckworth: I agree and I think an important context for this point is the zero lower bound environment or some might call it secular stagnation. So, a question is where will we be on the other side of the pandemic? Will we be back in the low rate world? Because this low rate world is really what drives QE, right? Normal monetary policy depends on some positive interest rate target. They can just down or up based on the conditions. If you lose that tool, then they resort to QE. So, I think one is, where will we be on the other side of the pandemic? I think we'll probably be back where we were before. What do you think? Do you think rates will continue to be low going forward or did the pandemic change everything?

Curr: No, no, I still buy the low for longer thesis in general. Sorry, can I say that again?

Beckworth: Yes.

Curr: I still buy the low-rate world thesis in general. I think there is a bit of a question as to whether we're going to be in in a low nominal rate world if the Fed is fighting more inflationary pressure. But from a real rate perspective, the analysis I've read about demographic pressures and inequality, and the other factors that drag down the equilibrium real rate of interest, I don't believe those forces are going away, but I think there's a bit more uncertainty on the nominal front, given the inflation outlook at the moment.

Beckworth: Yeah. So, let's assume that we are back in a zero lower bound, really low interest rate world moving forward in advanced economies. It does force the hand of the central bank to do QE. Or if we gave the central bank's new tools like negative interest rates. I know in the Europe, they've tried them. But negative interest rates or expand the number of assets that the central bank could buy. So, start buying private assets. And I know again, in Europe, there's more of this being done already.

Beckworth: So, if we want to get beyond QE, maybe expand the tool set of the central bank, that'd be one path. The other path is what we saw in 2020, that fiscal policy, monetary policy, they're going to work more closely together, just out of necessity. If we can't give the Fed or central banks more tools, I think there's not any much of a choice, but that there's be more coordination between fiscal and monetary policy.

I still buy the low-rate world thesis in general. I think there is a bit of a question as to whether we're going to be in in a low nominal rate world if the Fed is fighting more inflationary pressure. But from a real rate perspective, the analysis I've read about demographic pressures and inequality, and the other factors that drag down the equilibrium real rate of interest, I don't believe those forces are going away, but I think there's a bit more uncertainty on the nominal front, given the inflation outlook at the moment.

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Curr: So, I think I would agree with that to the extent that we're going to need more fiscal, if we can't give central banks new tools. And then the question becomes, how do you calibrate the fiscal policy? As we discussed earlier, I'm a bit less convinced of this idea that you necessarily need coordination. If QE isn't all that affected by portfolio balance effects and the central bank is able to signal that the short rate is going to stay low and it's going to accommodate the fiscal stimulus, then that probably gets you as far as you need to go in terms of coordination.

Curr: But there's a big question about how you make sure that the fiscal stimulus is the right size and whether politicians are necessarily going to deliver that. And you might want to consider whether you have some kind of technocratic input into the size of fiscal stimulus, whether you have fiscal policy councils that might advise on the degree of fiscal stimulus that's necessary to make up for the lack of monetary stimulus, or something like that. These are the kind of institutional questions that I think we have to consider. Because although I think on the whole, 2020 was something of a rebuke to the idea that politicians wouldn't deliver the fiscal stimulus that would be necessary when central banks ran out to ammunition. They came into enormous fiscal stimulus. I do think that there is a danger that we end up in a world where politicians overdo it, or indeed that the political conditions could change. And they don't reliably respond to downturns in the way that's necessary.

Curr: There's a reason that we delegated power to manage the business cycle to independent central banks. And that we didn't traditionally want politicians doing that job. So, if we're in a world where fiscal tools are the ones we need, then it's still an open question how we make sure that the fiscal stimulus is well calibrated.

Beckworth: Oh, I agree completely on that. I'm someone who would go even farther and say, we need rules based fiscal policy. So, we need some kind of guardrails, so that fiscal policy is automatically generating some outcome. And of course, I would advocate some nominal GDP level target, where fiscal policy goes towards that goal. But I think that's right. I mean, we need some kind of thoughtful consideration before we get to this point where we are forced to use and rely more exclusively on fiscal policy. Well, our time is up. Our guest today has been Henry Curr. Henry, thank you so much for coming on the show. Good to discuss QE.

Curr: David, thanks for having me. It's been a real pleasure.

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