A Retrospective Argument in Favor of QE2

The Board of Governors of the Federal Reserve (the Fed) launched its program of Large-Scale Asset Purchases (LSAP), referred to in the popular press as “Quantitative Easing,” on 25 November 2008, in response to the recession that began in December 2007. Through this program, the Fed planned to purchase $800 billion worth of bank debt, mortgage-backed securities, and Treasury bonds. By the end of the program, in June 2010, the Fed had actually purchased a total of $2.525 trillion of these securities and longer-term Treasury debt. The Fed initially ended this purchase program in June 2010 because the economy looked to be in recovery. In August 2010, the Fed began to purchase $30 billion in long-term Treasury debt per month because the recovery began to slow. This extraordinary monetary policy was deemed necessary because the Fed had already exhausted its normal policy tools, such as lowering the Federal Funds Rate (FFR), which was nearly zero (Amadeo, What Is Quantitative Easing?, 2013).

Figure 1: Ex-post Inflation in 2010

In November 2010, The Fed announced that it would buy $600 billion of Treasury debt, in order to keep its portfolio at approximately $2 trillion (Amadeo, Federal Reserve's QE2, 2012). The stated purpose of this additional LSAP (“QE2”) was to increase inflation, which had been falling steadily throughout 2010, and was threatening to fall below zero (Figure 1). With the announcement, inflation expectations (University of Michigan Inflation Expectation) immediately began to rise, with measured inflation (Core PCE) ceasing to fall, and beginning to rise in early 2011 (Figure 2). The growth rate of Real GDP, which had begun to fall off in the second quarter of 2010, has remained above one percent since the implementation of QE2 (Figure 3). While this is hardly encouraging, based on recent history (Figure 4), QE2 likely headed off another recession.

Figure 2: Recent Expected Inflation and Ex-post Inflation

Figure 3: Recent GDP Growth

In order to assess whether or not LSAP should have been discontinued in the fourth quarter of 2010, it is necessary to weigh the net benefits and costs of continued LSAP. The benefits include bolstered inflation and GDP, and reduced unemployment. The potential costs include runaway inflation and reduced purchasing power of the dollar internationally. I will weigh each of these, and demonstrate both that there existed no compelling reason to discontinue LSAP in 2010 and that no macroeconomic event since 2010 has altered this calculus.

Figure 4: Historical GDP Growth

The chief criticism of LSAP broadly is that it is likely to lead to a drop in value of the dollar (Macroeconomic Analysis). Bill Gross, manager of PIMCO, the world’s largest mutual fund, voiced this concern specifically in the run up to the announcement of QE2. "When a central bank prints trillions of dollars of checks, which is not necessarily what (a second round of quantitative easing) will do in terms of the amount, but if it gets into that territory --- that is a debasement of the dollar in terms of the supply of dollars on a global basis" (Ablan, 2010). The trade-weighted dollar index (major currencies and broad) was in the middle of a slight decline when QE2 was announced, and bottomed out six months later. It has risen for the most part since (Figure 5).

Figure 5: World Purchasing Power of the Dollar

Daniel Thornton, Vice President of the Federal Reserve Bank of St. Louis, warned in late 2010 that the then-recently announced QE2 posed a “danger [of] long-run inflation … well above” the 2% target (Thornton, 2010). Inflation expectations, as measured by the University of Michigan survey and the 5- and 10-year TIPS spreads, have been between 1.5 and 3.8 percent, while actual measured inflation, as noted above, has hardly risen above 2 percent (Figure 2). David Andolfatto recently noted that TIPS-spread-based measures of expected inflation have begun to move upward, but that the effect is more prominent on short-run expectations than on long-run (Andolfatto, 2014).

Figure 2: Recent Expected Inflation and Ex-post Inflation

Thornton also warned that “additional quantitative easing may have only modest effects on economic growth, employment, or inflation” (Thornton, 2010). In contrast, Cúrdia and Ferrero examined the effects of QE2 on GDP growth and inflation and found that QE2 led to a 0.13 percentage point increase real GDP growth and a 0.03 percentage point increase in inflation. This effect owes much to the effectiveness of “forward guidance,” or clearer communication of Fed policy intentions (Cúrdia & Ferrero, 2013). Matthew D. Raskin also found a positive economic effect of this move toward clearer communication (Raskin, 2013). The analysis by Cúrdia and Ferrero led them to conclude that a reduction of the FFR of 0.25 would have a more reliably positive impact on these metrics, but, as the FFR was near zero at this time, as it has been since late 2008, such a policy option was unavailable.

Figure 6: Recent Deviations From Potential

Another argument in favor of accommodative monetary policy is that the US economy has been operating significantly below potential since mid-2008 (Figure 6). Real GDP has not been below potential to this degree in thirty years (Figure 7). Reifschneider, Wascher, and Wilcox estimate (with a more pessimistic measure of potential GDP) that the US economy is currently 7% below potential as of 2013 (Reifschneider, Wascher, & Wilcox, 2013). The supply-side damage from the crisis includes labor-market inefficiency, reduced labor-force participation and capital stock, lower multifactor productivity. This is the source of their measure of potential GDP, which is below that of the Congressional Budget Office, but still markedly higher than real GDP.

Figure 7: Historical Deviations From Potential

In any macroeconomic analysis, counterfactuals are exceedingly difficult. True laboratory experiments are nearly always impossible. When available, natural experiments can prove very valuable. None of these methods are possible in the analysis of something as large, unprecedented, and deeply interwoven with both the wider macroeconomy and specific financial markets as LSAP. The analyses of Cúrdia & Ferrero, Raskin, and Reifschneider, et al. attempt to quantify specific effects of LSAP, and these analyses can form the basis for complex counterfactuals that will likely inform the papers of economic historians for decades to come.

Ultimately, the best technique to determine whether the Fed should have discontinued LSAP in late 2010 is simple benefit-cost analysis. Since the worst of the dire predictions about QE2 and beyond have not come to fruition, and show no sign of doing so going forward, and since the scaling back of asset purchases has not yet disrupted markets, and also shows no sign of doing so in the medium-term, and since there is still clearly much slack remaining in the economy, due in no small part to counterproductive fiscal policy due to political intransigence, it is impossible to conclude that it would have been wise for the Fed to discontinue LSAP in the fourth quarter of 2010.

Works Cited

Ablan, J. (2010, November 1). Fed easing may mean 20 percent dollar drop: Gross. Retrieved January 20, 2014, from Reuters: http://www.reuters.com/article/2010/11/01/us-pimco-gross-idUSTRE6A055R20101101

Amadeo, K. (2012, December 12). Federal Reserve's QE2. Retrieved January 20, 2014, from About.com: http://useconomy.about.com/od/Fed/g/QE2.htm

Amadeo, K. (2013, December 30). What Is Quantitative Easing? Retrieved January 20, 2014, from About.com: useconomy.about.com/od/glossary/g/Quantitative-Easing.htm

Andolfatto, D. (2014, January 17). U.S. Inflation Expectations: Low, But Rising. Retrieved January 20, 2014, from MacroMania: http://andolfatto.blogspot.com/2014/01/us-inflation-expectations-low-but-rising.html

Cúrdia, V., & Ferrero, A. (2013, August 12). How Stimulatory Are Large-Scale Asset Purchases? Retrieved January 20, 2014, from Federal Reserve Bank of San Francisco: http://www.frbsf.org/economic-research/publications/economic-letter/2013/august/large-scale-asset-purchase-stimulus-interest-rate/

Federal Reserve Bank of St. Louis. (2014, January 20). [All Figures]. Retrieved January 20, 2014, from Economic Research: http://research.stlouisfed.org/

Macroeconomic Analysis. (n.d.). Criticism of Quantitative Easing. Retrieved January 20, 2014, from Macroeconomic Analysis: http://macroeconomicanalysis.com/macroeconomics-wikipedia/criticism-quantitative-easing/

Raskin, M. D. (2013, May 9). The Effects of the Federal Reserve’s Date-Based Forward Guidance. Retrieved January 20, 2014, from Board of Governors of the Federal Reserve System: http://www.federalreserve.gov/pubs/feds/2013/201337/201337pap.pdf

Reifschneider, D., Wascher, W., & Wilcox, D. (2013, November 21). Aggregate Supply in the United States: Recent Developments and Implications for the Conduct of Monetary Policy. Retrieved January 20, 2014, from Board of Governors of the Federal Reserve System: http://www.federalreserve.gov/pubs/feds/2013/201377/201377pap.pdf

Thornton, D. L. (2010). The Downside of Quantitative Easing. Retrieved January 20, 2014, from Federal Reserve Bank of St. Louis - Economic Synopses: http://research.stlouisfed.org/publications/es/10/ES1034.pdf