By Michael S. Derby
The Federal Reserve's signature bond buying stimulus program undertaken during and in the wake of the financial crisis was largely a dud for the economy, argues a new paper authored by a group of prominent economists.
The paper, which was to be presented Friday at a conference held in New York by the University of Chicago Booth School of Business, takes aim at the central bank's controversial purchases of long-term Treasury and mortgage debt.
In a series of campaigns between 2008 and 2014, the Fed bought Treasury and mortgage bonds to push down long-term interest rates, in a bid to spur activity in an economy mired in high unemployment and very low inflation. The Fed turned to asset purchases as a stimulus vehicle because its traditional policy tool, the short-term overnight rate target, had been lowered to zero at the start of the financial crisis, and couldn't be lowered further.
Given the unorthodox nature of the stimulus, arriving in an economy undergoing huge stress, central bankers and academics have long struggled to understand what the Fed got for a policy that took its portfolio of cash and bonds from a precrisis level of just over $800 billion in 2007 to a peak of $4.5 trillion.
Central bank research has suggested that the purchases likely lowered the benchmark 10-year borrowing rate by a percentage point from where they otherwise would have been. Meanwhile, a number of Fed officials have said substantial declines in unemployment, a return to growth and a recovery in the housing market were clear evidence that the overall stance of monetary policy was effective in putting the economy back on better footing.
The paper presented at the conference was written by David Greenlaw of Morgan Stanley, James Hamilton of the University of California San Diego, Ethan Harris of Bank of America Merrill Lynch and Kenneth West of the University of Wisconsin. It argues most of what people now believe of the asset purchases is likely wrong.
"We find that Fed actions and announcements were not a dominant determinant of 10-year yields and that whatever the initial impact of some Fed actions or announcements, the effects tended not to persist," the paper's authors wrote. Their findings were based on a study of Fed policy announcements referenced against market reactions.
William Dudley of the Federal Reserve Bank of New York and Eric Rosengren of the Federal Reserve Bank of Boston both said on a panel discussing the paper's findings that they agree it's hard to understand the exact impact of the bond buying. But they said there's nevertheless evidence the effort was helpful, and that the strategy should remain a part of the Fed's policy toolkit going forward.
Mr. Dudley, in particular, said that instead of looking at yield movements, it's more important to assess how asset buying affected so-called term premiums in the bond market. Term premiums are the compensation investors demand for taking on risk.
Mr. Dudley notes that term premiums clearly fell, apparently due to central bank bond buying. He also said the buying helps reinforce Fed commitments to keep interest rates at very low levels when this form of guidance is in play.
Mr. Dudley said asset buying is "useful to have in the tool kit."
Mr. Rosengren agreed and said bond buying is important as a "last resort" when short-term rates can be cut no further. He added there's a good chance the Fed will again have to use asset buying should another recession arise.
In the paper, the authors also say that the 2013 "taper tantrum" wasn't what most observers now believe it was. Then, comments by Federal Reserve Chairman Ben Bernanke signaling a looming end for bond buying sent the yields spiraling higher. That chapter seared into central bankers the importance of clearly communicating future policy changes, which in turn helped create a negligible market reaction to the actual wind down when it was announced.
Not so, says the paper. "Our procedure attributes most of the bond market selloff during the 2013 'taper tantrum' to better economic news rather than to changing expectations for the end of balance sheet expansion," the authors wrote.
The paper says the Fed's ongoing and slowly accelerating effort to shrink its balance sheet, started late last year, is further evidence Fed bondholding levels haven't been driving yield levels, given that the effort has had no apparent impact on the market. The authors would like to see the Fed pick up the pace of the shrinkage, noting that they expect Fed holdings to again grow in coming years.
In the future, the paper's authors want the Fed's short-term target rate to be the primary tool of monetary policy, a goal shared by current central bank officials. That is true even as they note that the Fed is unlikely to be able to raise rates as high in the past, meaning it won't have as much space to lower rates when trouble arrives.
"The size of the Fed's balance sheet is less potent in moving the bond market than as perceived by many and should not be viewed as a primary tool of monetary policy going forward," the paper said.
Write to Michael S. Derby at [email protected]