Will It Work?

The short answer is “I don’t know.” But I presume you’d like a bit more analysis. So here’s the best I can do.

There are three questions embedded in the simple phrase ‘will it work?’

1. Will it help the economy relative to the no-QE alternative?
2. Is the announced policy likely to help more than the policy expected right before the announcement?
3. Is it adequate to meet the Fed’s implicit policy goals?

I believe the answer to the first question is clearly yes, the second question is “probably yes,” and the answer to the third question is clearly no.

It’s pretty obvious that the stock, bond and foreign exchange markets responded strongly to rumors of Fed easing over the past 6 weeks. So let’s focus on the next question, how did the markets respond to the 2:15pm announcement?

When the announcement is a big surprise, it is easy to infer the market response. In this case the policy was close to expectations, yet the various market responses suggest the move was slightly more expansionary than expected. Let’s start with the T-bond market, where I collected bond yield data at 2:00pm and 3:30pm:

Maturity	2:00 yield	3:30 yield
3 month	0.12	0.12
1 year	0.20	0.20
3 year	0.49	0.47
5 year	1.15	1.11
7 year	1.84	1.85
10 year	2.53	2.62
30 year	3.87	4.07

The longer term bond yields clearly rose, which could indicate either a expansionary or a contractionary surprise, depending on whether the liquidity or the Fisher effect was dominant. Because the Fisher effect is more powerful at longer maturities, it was probably an expansionary surprise. Further evidence comes from the 3 to 7 year maturities, where yields actually fell slightly (presumably due to the liquidity effect.) I don’t know why T-bill yields were unchanged; perhaps interest on reserves puts a floor on the very short term rates. Now let’s look at the response in the TIPS market:

Maturity	2.00pm	3:30pm
5 year	-0.46	-0.54
10 year	0.40	0.44
30 year	1.30	1.42

And the TIPS spreads (inflation expectations):

Maturity	2.00pm	3:30pm
5 year	1.61	1.65
10 year	2.13	2.18
30 year	2.57	2.65

This points to slightly higher inflation expectations, which is also consistent with the view that the policy was a bit easier than expected. I’m not sure why real rates rose over longer maturities—perhaps it reflected the expectation that the economy would recover slightly more rapidly, and thus real rates would return to normal at a slightly faster pace. That was the thesis in my recent post about why a little bit of inflation might actually help savers. (Not quite so far-fetched as many assumed.) On the other hand, the 5 year bond shows clear signs of a liquidity effect, even for real rates. But in a way this is good, as it suggests that we can be confident that the fall in the 5 year nominal yield reflected monetary ease, not lower inflation expectations.

The foreign exchange markets tell a similar story:

Currency	2:00pm	3:30pm
euro	1.401	1.4105	(euro appreciates)
yen	81.375	81.275	(yen appreciates)
pound	1.6075	1.6085	(pound appreciates)

The dollar fell significantly against the euro, and slightly against the other two (note the yen rate is reported “backwards.”)

Unfortunately, the stock market was a complete mess. This is no surprise, as the market often gyrates wildly when the “news” is not a single number, but a report full of nuance that must be digested by experts. In the end, stocks rose slightly from pre-announcement levels, but nothing statistically significant.

I was hoping for something much more shocking, so that we could really sink our teeth into the market responses. Unfortunately (as with the election) the pundits had already provided fairly accurate predictions, taking all the fun out of the actual event.

In the end, the market movements over the last few weeks seem to be telling us that QE2 is likely to provide a modest boost to the economy, and that a double dip recession is less likely than in August. But overall the future still looks bleak. The Fed’s action fell pitifully short of what was needed. At a minimum, I would have liked to have seen enough stimulus to raise 5 year TIPS spreads to 2.0%, instead they merely rose from 1.61% to 1.65%. We didn’t need more QE, but rather the three-pronged attack I suggested earlier (including lower IOR and level targeting.)

Of course markets are often wrong, and the economy may do better than expected or worse than expected. But for those of us who favor a Svenssonian policy of targeting the forecast, the verdict is already in; the policy is better than nothing, but not nearly enough. My hunch is that unemployment will remain high for quite some time, and the Fed will be forced to do even more in 2011. Of course this is a policy that should have been adopted in 2008, when it was already clear that AD would fall far short of the Fed’s implicit goals.

A few months ago I listed the March 2009 market response to QE1 as one of things I had been wrong about. I could not explain why the announcement reduced long term bond yields. At least this time the bond market responded in the “correct” fashion. I thank all the bond traders for not humiliating me a second straight time. Perhaps they have begun reading TheMoneyIllusion.com, :) and learned that stimulus should make long term bond yields increase.

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