Eugene Fama On QE

Eugene Fama was on CNBC today (US time) (video here) and he argued that QE is a non-event.

Since he was on CNBC, I presume he has prices of financial assets in mind when he says it is a “non-event” – the logic being that the Federal Reserve and the Treasury together have effectively issued short-term debt and reduced the supply of long term debt.

Of course while this it is true that there is reduction of the supply of long term debt and increase in short term debt (compared to the counter-factual), it doesn’t mean it has no effect whatsoever. Of course Fama says it may have minor effect and the description of QE as a non-event is just a quick way of communicating his point, even if he is true, it is not that simple.

But first, it is great to see Fama doesn’t say this has led to a rise in prices of goods and services!

The U.S. Federal Reserve has purchased long term bonds – such as US Treasury securities and agency mortgage-backed securities by settling the purchase by issuing settlement balances to banks’ accounts at the Federal Reserve (in either case when a bank or a non-bank is a buyer).

This is however different from any other operation changing the composition of the bonds held by the private sector because in QE, banks have been holding balances at the Federal Reserve which they may not have held otherwise. As a counterpart to this the money stock compared to the counter-factual is also higher. Because of this, the non-bank private sector will “re-balance” its portfolio and this will clear via a higher price of assets such as bonds and equities.

In general investors – both residents and nonresidents – are also interested in international assets and this will lead to a price rise of equities in other countries as well because of capital inflows (from their perspective). Of course, one may argue that a capital flow in one direction is compensated by an outflow in the other direction but this needn’t mean there is no effect because this “clearing” occurs via changes in prices – such as exchange rates and prices of assets in the resident issuer’s currency.

There are two effects here. Prices of financial assets may change purely because of rise in expectations and also due to a rise in demand for the asset when expectations are held constant. In general both will have an effect because these two cannot be cleanly separated.

There are some who try to argue that as if it is only the expectations that matter – as if the rise is purely due to a change in investor sentiment and not due to a change in asset demand. From the point of view of asset allocation theory however, both matter.

Another thing is how much effect a billion of “asset purchase” by the Federal Reserve has. That is a slightly different question. In modelspeak it is that depends on the various parameters of the portfolio preferences. However there are people who say this is difficult to measure empirically. True but exactly for the same reason, it is also difficult to empirically say what effect this will have when if the Federal Reserve “tapers” QE.

At any rate, the point is that saying that the large scale asset purchases of the Federal Reserve or QE is just like another debt management operation is not a good argument because in QE, banks hold the short term debt of the official sector which is not the case in ordinary debt management operations and the counterpart to this is the rise in the money stock than otherwise leading to portfolio re-balancing by the non-bank private sector and the overseas sector.

There are some who think that Tobin’s asset allocation ideas (which was what Ben Bernanke had in mind when he started QE) are incorrect. Recently emerging market currencies saw sharp depreciation when it was thought the Federal Reserve may taper. Whether this was due to incorrect sentiments or due to whether the asset allocation theory applies is another question – the Federal Reserve Open Market Committee (FOMC) still has to consider these things when taking a decision on tapering because even if the asset allocation theory on which it has based its LSAP is wrong, investor sentiment may itself can have negative effects on financial markets.

Looking at the matter more academically, the thinking that “there is no portfolio rebalance” is equivalent to thinking that money (as in deposits) are held non-volitionally by the non-bank sector – something which doesn’t sound right.

In the above I avoided arguing how much effect QE has had on asset prices because as I mention it is difficult to empirically conclude. In my opinion it is quite strong. But irrespective of this, the fact that it is difficult to know empirically (but with some data from depreciation of currencies of “emerging markets”) also means that it is difficult to say what happens if there is “taper”. You could argue that there was no effect to begin with and hence there is no trouble withdrawing it but there is a risk that you may be wrong!

Personally I think QE is a waste of time but for different reasons. It somehow misleads policy makers – the ones making fiscal decisions to wishfully think something good is going to happen. Financial markets however seem to be worried at the mere mention of “taper” so the best way for the Federal Reserve would be to convince that this is silly – slowing down is not to be worried about.

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