Academic studies indicate the Fed's efforts are ineffectualAnother piece of evidence that points toward monetary ineffectiveness is the academic research indicating that LSAP [the Federal Reserve's program of Large Scale Asset Purchases] is a losing proposition. The United States now has had five years to evaluate the efficacy of LSAP, during which time the Fed's balance sheet has increased a record fourfold.
It is undeniable that the Fed has conducted an all-out effort to restore normal economic conditions. However, while monetary policy works with a lag, the LSAP has been in place since 2008 with no measurable benefit. This lapse of time is now far greater than even the longest of the lags measured in the extensive body of scholarly work regarding monetary policy.
Three different studies by respected academicians have independently concluded that indeed these efforts have failed. These studies, employing various approaches, have demonstrated that LSAP cannot shift the Aggregate Demand (AD) Curve. The AD curve intersects the Aggregate Supply Curve to determine the aggregate price level and real GDP and thus nominal GDP. The AD curve is not responding to monetary actions, therefore the price level and real GDP, and thus nominal GDP, are stuck—making the actions of the Fed irrelevant.
The papers I am talking about were presented at the Jackson Hole Monetary Conference in August 2013. The first is by Robert E. Hall, one of the world's leading econometricians and a member of the prestigious NBER Cycle Dating Committee. He wrote, "The combination of low investment and low consumption resulted in an extraordinary decline in output demand, which called for a markedly negative real interest rate, one unattainable because the zero lower bound on the nominal interest rate coupled with low inflation put a lower bound on the real rate at only a slightly negative level."
Dr. Hall also wrote the following about the large increase in reserves to finance quantitative easing: "An expansion of reserves contracts the economy." In other words, not only have the Fed not improved matters, they have actually made economic conditions worse with their experiments. Additionally, Dr. Hall presented evidence that forward guidance and GDP targeting both have serious problems and that central bankers should focus on requiring more capital at banks and more rigorous stress testing.
The next paper is by Hyun Song Shin, another outstanding monetary theorist and econometrician and holder of an endowed chair at Princeton University. He looked at the weighted-average effective one-year rate for loans with moderate risk at all commercial banks, the effective Fed Funds rate, and the spread between the two in order to evaluate Dr. Hall's study. He also evaluated comparable figures in Europe. In both the U.S. and Europe these spreads increased, supporting Hall's analysis.
Dr. Shin also examined quantities such as total credit to U.S. non-financial businesses. He found that lending to non-corporate businesses, which rely on the banks, has been essentially stagnant. Dr. Shin states, "The trouble is that job creation is done most by new businesses, which tend to be small." Thus, he found "disturbing implications for the effectiveness of central bank asset purchases" and supported Hall's conclusions.
Dr. Shin argued that we should not forget how we got into this mess in the first place when he wrote, "Things were not right in the financial system before the crisis, leverage was too high [indeed], and the banking sector had become too large [exactly]." For us, this insight is highly relevant since aggregate debt levels relative to GDP are greater now than in 2007. Dr. Shin, like Dr. Hall, expressed extreme doubts that forward guidance was effective in bringing down longer-term interest rates.
The last paper is by Arvind Krishnamurthy of Northwestern University and Annette Vissing-Jorgensen of the University of California, Berkeley. They uncovered evidence that the Fed's LSAP program had little "portfolio balance" impact on other interest rates and was not macro-stimulus. A limited benefit did result from mortgage-backed securities purchases due to the announcement effects, but even this small plus may be erased once the still unknown exit costs are included.
Drs. Krishnamurthy and Vissing-Jorgensen also criticized the Fed for not having a clear policy rule or strategy for asset purchases. They argued that the absence of concrete guidance as to the goal of asset purchases, which has been vaguely defined as aimed toward substantial improvement in the outlook for the labor market, neutralizes their impact and complicates an eventual exit. Further, they wrote, "Without such a framework, investors do not know the conditions under which (asset buys) will occur or be unwound." For Krishnamurthy and Vissing-Jorgensen, this "undercuts the efficacy of policy targeted at long-term asset values."
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The Fed's relentless buying of massive amounts of securities has produced no positive economic developments, but has had significant negative, unintended consequences.
For example, banks have a limited amount of capital with which to take risks with their portfolio. With this capital, they have two broad options: First, they can confine their portfolio to their historical lower-risk role of commercial banking operations—the making of loans and standard investments. With interest rates at extremely low levels, however, the profit potential from such endeavors is minimal.
Second, they can allocate resources to their proprietary trading desks to engage in leveraged financial or commodity market speculation. By their very nature, these activities are potentially far more profitable but also much riskier. Therefore, when money is allocated to the riskier alternative in the face of limited bank capital, less money is available for traditional lending. This deprives the economy of the funds needed for economic growth, even though the banks may be able to temporarily improve their earnings by aggressive risk taking.
Perversely, confirming the point made by Dr. Hall, a rise in stock prices generated by excess reserves may sap, rather than supply, funds needed for economic growth.
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The money multiplier is 3.1. In 2008, prior to the Fed's massive expansion of the monetary base, the money multiplier stood at 9.3, meaning that $1 of base supported $9.30 of M2.
If reserves created by LSAP were spreading throughout the economy in the traditional manner, the money multiplier should be more stable. However, if those reserves were essentially funding speculative activity, the money would remain with the large banks and the money multiplier would fall. This is the current condition.
The September 2013 level of 3.1 is the lowest in the entire 100-year history of the Federal Reserve. Until the last five years, the money multiplier never dropped below the old historical low of 4.5 reached in late 1940. Thus, LSAP may have produced the unintended consequence of actually reducing economic growth. [Indeed, 81.5% of money created through quantitative easing is sitting there gathering dust, due to a conscious decision by the Fed to tie up the money and prevent it from being loaned out to Main Street.]
Stock market investors benefited, but this did not carry through to the broader economy. The net result is that LSAP worsened the gap between high- and low-income households. [Indeed, it's been known for some time that quantitative easing quantitative easing increases inequality (and see this and this.)]
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