Too Much Focus on Interest Rates

Though much needed, QE2 it is far from perfect. One problem with QE2 is that it is being marketed as a monetary stimulus program that works by lowering long-term interest rates. Dropping long-term rates, the story goes, will in turn spur interest-sensitive spending and jump-start the economy. This marketing strategy seems wrongheaded to me because it (1) ignores other important channels through which monetary policy can work and (2) creates the wrong expectation that QE2 will only be successful if it maintains long-term interest rates at a low level.

The emphasis on the so called “interest rate” channel through which monetary policy actions are transmitted to the economy is pervasive in QE2 discussions. For example, here is Greg Ip explaining how QE2 works:

Under QE, the Fed shifts its focus to long-term rates from short-term rates, and buys as much debt as it needs to get long term rates down. If it ever gets long-term rates to where it wants, it will stop buying. If it thinks long-term rates have gone too low, it could sell…Monetary policy stimulates demand by lowering the real interest rate…

It is understandable that journalists would invoke this monetary transmission channel when explaining QE2 since Fed officials are doing the same. Here is this channel being endorsed by Ben Bernanke:

[A] means of providing additional monetary stimulus, if warranted, would be to expand the Federal Reserve’s holdings of longer-term securities. Empirical evidence suggests that our previous program of securities purchases was successful in bringing down longer-term interest rates and thereby supporting the economic recovery.

This view is further reinforced in the FOMC minutes for the October 15 meeting. These minutes show that the FOMC considered targeting an long-term interest rate:

[P]articipants discussed the potential benefits and costs of setting a target for a term interest rate. Some noted that targeting the yield on a term security could be an effective way to reduce longer-term interest rates and thus provide additional stimulus to the economy.

This narrow emphasis on the interest rate channel ignores the fact that monetary policy can influence the economy through various transmission mechanisms. This New York Fed article, for example, notes that the transmission channels include the bank lending channel, the balance sheet channel, the wealth channel, the interest rate channel, the exchange rate channel, and the monetarist portfolio adjustment channel. I see the portfolio adjustment channel being much more important for QE2 than than interest rate channel for several reasons.

First, the portfolio channel acknowledges the reality that Fed purchases of government securities will affect the prices and yields of one’s entire portfolio of assets, not just treasuries. This includes real money balances and the demand for them as an asset. Thus, it is through this channel that the real issue behind the weak U.S. economy can be addressed: the excess money demand problem. Ironically, Ben Bernanke acknowledged the importance of this channel at his Jackson Hole speech back in August, 2010. Unfortunately, his other speeches and Fed statements more generally create the impression QE2 is all about the interest rate channel.

Second, the interest rate channel works through a lowering of interest rates that stimulates interest-sensitive spending. This cannot be an important channel, however, if QE2 actually works. For if QE2 is successful in stimulating economy activity it must be the case that (1) expected inflation picked up at some point and (2) real interest rates picked up at some point in response to the recovery of the real economy. In other words, nominal interest rates–the sum of the real interest rate and expected inflation–will increase if QE2 is successful. This channel, then, will at best be fleeting.

That the interest rate channel will be fleeting if QE2 works is another reason why the narrow emphasis on this channel is wrongheaded: it creates the wrong expectation that QE2 will only work if long-term interest rates remain low. Thus, QE2 is bound to be plagued by second guessing and criticism from observers who only see monetary policy through the prism of the interest rate channel. For example, imagine there is a sustained rise in interest rates. I would view this as a sign that QE2 is working. Many observers, however, would probably view such a development as failure of QE2. I fear the Fed is setting itself up for trouble by framing QE2 as working solely through the interest rate channel.

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