Fed Watch: Dodged That Bullet

I was reading Robin Harding’s take on the possible nomination of Federal Reserve Vice Chair Janet Yellen for the top job at the Fed, and a chill went down my spine when he reminded me of this:

Mr Bernanke’s own appointment in 2005 was a case in point. There were several candidates that year. According to people involved, then-President George W. Bush leaned towards Martin Feldstein, a former economic adviser to Ronald Reagan.

But fate intervened:

But Mr Feldstein was a director of the insurance company AIG, which restated five years of financial results that May after an accounting scandal. Then in October, Mr Bush ran into a huge backlash after nominating his lawyer Harriet Miers, who later withdrew, to the Supreme Court.

I think we dodged a bullet there.  Indeed, it might be proof of a higher power.   Martin Feldstein could have been Fed chair during the worst financial crisis since the Great Depression.  Consider that in light of May 9, 2013 Wall Street Journal op-ed in which he professes that raising equity prices is the ONLY mechanism by which quantitative easing impacts the economy:

Quantitative easing, or what the Fed prefers to call long-term asset purchases, is supposed to stimulate the economy by increasing share prices, leading to higher household wealth and therefore to increased consumer spending. Fed Chairman Ben Bernanke has described this as the “portfolio-balance” effect of the Fed’s purchase of long-term government securities instead of the traditional open-market operations that were restricted to buying and selling short-term government obligations.

Here’s how it is supposed to work. When the Fed buys long-term government bonds and mortgage-backed securities, private investors are no longer able to buy those long-term assets. Investors who want long-term securities therefore have to buy equities. That drives up the price of equities, leading to more consumer spending.

As might be expected, Feldstein finds this channel lacking:

…Although it is impossible to know what would happen without the central bank’s asset purchases, the data imply that very little increase in GDP can be attributed to the so-called portfolio-balance effect of the Fed’s actions.

Even if all of the rise in the value of household equities since quantitative easing began could be attributed to the Fed policy, the implied increase in consumer spending would be quite small. According to the Federal Reserve’s Flow of Funds data, the total value of household stocks and mutual funds rose by $3.6 trillion between the end of 2009 and the end of 2012. Since past experience implies that each dollar of increased wealth raises consumer spending by about four cents, the $3.6 trillion rise in the value of equities would raise the level of consumer spending by about $144 billion over three years, equivalent to an annual increase of $48 billion or 0.3% of nominal GDP.

This 0.3% overstates the potential contribution of quantitative easing to the annual growth of GDP, since some of the increase in the value of household equities resulted from new saving and the resulting portfolio investment rather than from the rise in share prices. More important, the rise in equity prices also reflected a general increase in earnings per share and an increase in investor confidence after 2009 that the economy would not slide back into recession.

Oh my.  Can Feldstein really believe that only the wealth effect channel is in operation?  What about other channels that could boost activity and drive the improvements in earnings and confidence?  And does Bernanke believe quantitative easing has an impact only through the wealth effect?  I don’t think that is the conclusion you reach if you read his speeches.  Bernanke’s description of the portfolio-balance impact is a bit more sophisticated than Feldstein’s interpretation.  From last year’s Jackson Hole speech:

One mechanism through which such purchases are believed to affect the economy is the so-called portfolio balance channel, which is based on the ideas of a number of well-known monetary economists, including James Tobin, Milton Friedman, Franco Modigliani, Karl Brunner, and Allan Meltzer. The key premise underlying this channel is that, for a variety of reasons, different classes of financial assets are not perfect substitutes in investors’ portfolios….Thus, Federal Reserve purchases of mortgage-backed securities (MBS), for example, should raise the prices and lower the yields of those securities; moreover, as investors rebalance their portfolios by replacing the MBS sold to the Federal Reserve with other assets, the prices of the assets they buy should rise and their yields decline as well. Declining yields and rising asset prices ease overall financial conditions and stimulate economic activity through channels similar to those for conventional monetary policy.

Quantitative easing acts through a variety of channels – interest rate, credit, exchange rate, etc. – just like traditional interest rate policy.  And other channels as well:

Large-scale asset purchases can influence financial conditions and the broader economy through other channels as well. For instance, they can signal that the central bank intends to pursue a persistently more accommodative policy stance than previously thought, thereby lowering investors’ expectations for the future path of the federal funds rate and putting additional downward pressure on long-term interest rates, particularly in real terms. Such signaling can also increase household and business confidence by helping to diminish concerns about “tail” risks such as deflation. During stressful periods, asset purchases may also improve the functioning of financial markets, thereby easing credit conditions in some sectors.

So, no, Bernanke does not view quantitative easing as acting only through equity price and related wealth effects, and no, Feldstein shouldn’t either.  But somehow he does, or wants to trick you into believing that Bernanke’s only objective is boosting equity prices. Either way, I don’t think this is the intellectual approach we should be looking for in a Fed chair.

With regards to Feldstein’s claim that it is impossible to know what would have happened in the absence of quantitative easing, I think Bernanke would have something like this to say:

 If we are willing to take as a working assumption that the effects of easier financial conditions on the economy are similar to those observed historically, then econometric models can be used to estimate the effects of LSAPs on the economy. Model simulations conducted at the Federal Reserve generally find that the securities purchase programs have provided significant help for the economy. For example, a study using the Board’s FRB/US model of the economy found that, as of 2012, the first two rounds of LSAPs may have raised the level of output by almost 3 percent and increased private payroll employment by more than 2 million jobs, relative to what otherwise would have occurred….Overall, however, a balanced reading of the evidence supports the conclusion that central bank securities purchases have provided meaningful support to the economic recovery while mitigating deflationary risks.

Yes, like it or not, quantitative easing has been a successful policy.

I understand that in the midst of the crisis there was a significant confusion about what monetary policymakers were doing and why.  But we are well past that stage.  We would hope that any potential Fed chair would by now have come to an understanding about what quantitative easing is and how it works.  And we should be relieved that any candidate that has not made that leap did not get the pick for the top job at the Federal Reserve.