QE and motivated reasoning

This post is mostly score settling. I don’t even bother to try to make it practically relevant to the current environment. You might want to skip it. There is now way you will get these three minutes back.

As a skeptic of the efficacy of QE, I found this study from the St. Louis Fed quite interesting.

They assess the effects of unconventional policy on the bond market and economy, and include in unconventional policy both formal rates guidance and QE.  Moreover, the effects of QE taken in isolation are said to work through both portfolio balance and implicit rates signaling, with the latter seeming to dominate quantitatively. So for them, unconventional policy is mostly rates guidance, direct and indirect. Progress!

But but but, they are part of tribe that really wants to retain some role for the portfolio balance channel and this is demonstrated hilariously in the way they discuss the “theoretical” underpinnings.  I thought this passage was the best:

Unconventional policy effects in macroeconomic models: In order to model the plausible macroeconomic effects of LSAPs and determine whether these effects improve welfare, theoretical models must provide some mechanism to affect either the expected future interest rate or the risk premium associated with various elements of the term premium. To do that, they introduce various financial frictions or assume that the government cannot commit to a fully credible path of future policy. Such mechanisms are needed in order to break the neutrality of such open market operations, which was first pointed out in a classic paper by Wallace (1981). In Wallace’s (1981) model, the size and/or composition of the central bank’s balance sheet, or, equivalently, the supply of assets in the hands of the public, has no effect on real or financial variables. Therefore, to model the effects of LSAPs, DSGE models must introduce frictions.

The literature has introduced several types of frictions, including heterogeneity in asset preferences, various forms of asset market segmentation, and other limits to arbitrage. Heterogeneity in preferences in assets and market segmentation make assets imperfect substitutes. With imperfect substitutability, LSAPs alters relative supplies and reduce risk/term premium through a portfolio balance channel. That is, LSAP-induced changes in relative supply of assets can then change equilibrium asset prices and macroeconomic quantities.

In other words QE works through the portfolio balance channel and it is up to researchers to come up with reasons that might be the case, which they have done. Science!

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Fed researcher shows results of latest study into QE

For slightly different reasons, this discussion of work from San Francisco Fed president John Williams, which they relegate to a footnote, is also awesome:

Williamson (2016) presents a micro-founded monetary model where collateral is scarce in the economy and long-term government debt is a worse collateral than short-term government debt. In this environment, QE, where the central bank swaps long-term government debt with short-term, is desirable as it relaxes collateral constraints. Moreover, such policy decreases long-term nominal yields. But somewhat differently from a New Keynesian model and from conventional thinking on empirical effects of QE, real yields actually increase and inflation decreases.

Seven years after QE was first implemented, Williams is saying that it works, but you know, by pushing up real interest rates and pushing down inflation. Probably just me, but that should not be in a footnote.

Along the way, they make a defense of event studies, which are the main tool of empirical work showing these effects of QE, whatever they are.  This passage is not funny, but is instead very straightforward:

Moreover, because financial markets adjust rapidly to new information, the asset price reaction to a policy over a course of minutes or hours or days should approximate the long-term reaction of the asset price to preclude an implausible profit opportunity in financial markets. Therefore, the efficient markets hypothesis implies that the short-term impact of some announcement is also expected to be approximately its long-term impact.

The only problem with this statement is that it is far from self-evidently true, and they provide no evidence to support it.