The Fed’s decision to implement quantitative easing and other unconventional monetary policy in December 2008 sparked a blaze of heated discussion amongst economists that has been burning to this day. The questions of if and how these new measures affect economic growth have become the focus of countless blog posts and editorials, and have become an integral part of many university Econ courses. The beginning of QE tapering in December 2013 added even more fuel to the fire, but it also gave many traditional economists a sense of relief. It finally looked like there was an end in sight to these unfamiliar and controversial policies. To the dismay of these traditionalists, however, recent research by the Brookings Institution (paper #1 and paper #2) suggests that there are significant benefits of pursuing unconventional monetary policy in the long term. A recent Economist article, “Staying Unconventional,” emphasizes some of the most important results of this research and raises a provocative question: Can QE and forward guidance, or some alternate forms of these policies, be combined to create an effective long term policy?
Based on my reading of the research papers that the article cites, I am inclined to say yes. It may not be the QE policy currently being rolled back, but I can see an alternate form of such a policy (hence the * in the title) being effective in the long term. Not only does unconventional monetary policy not cause riskier financial behavior, but it also provides a substantial boost to economic growth. In this blog post, my goal is to defend the bolded argument by highlighting some of the key findings of the research papers I mentioned earlier.
1. Unconventional Monetary Policy Does NOT Cause Financial Instability
The argument commonly used to refute long-term implementation of QE is that it encourages individuals and financial institutions to pursue riskier investments, thereby reducing financial stability. The prediction is that long periods of low interest rates incentivize investors to ‘reach for yield’ and take on more credit risk, duration risk, and/or leverage. The research by Gabriel Chodorow-Reich of Harvard University confirms this prediction but emphasizes that the story is not so cut and dry. Although the Fed’s low interest rate policy has caused financial institutions to take on some riskier investments, it has also boosted the value of these institutions’ portfolios, making them less risky and strengthening the stability of the U.S. economy. Most importantly, Chodorow-Reich’s analysis shows that the stabilizing effect of QE has been stronger than the destabilizing effect caused by ‘reaching for yield.’
Chodrow-Reich determined the magnitude of each effect by evaluating the effect of the Fed’s policies on four categories of financial institutions: life insurers, commercial banks, money market funds, and defined benefit pension funds. Together, these institutions manage $24 trillion in assets. The effects are nicely summarized in the graphic provided in the abstract of the paper:
As Chodrow-Reich states, “In the present environment, there does not seem to be a trade-off between expansionary [monetary] policy and the health or stability of the financial institutions studied.”
If the biggest argument against long-term use of QE (investors reaching for yield) is nullified, perhaps the Fed should think twice about continuing to taper. There is, however, the problem of surprising the market with such a change in policy. A possible solution to this is to continue the taper, but then start buying a constant level of bonds again after the taper is complete. If the Fed warns the public of such a long term policy change in advance, it could dampen the volatility the move would create in the markets.
2. Unconventional Monetary Policy Boosts Immediate Economic Growth and May Have Substantial Long-Term Growth Benefits As Well
The research conducted by Joshua K. Hausman (University of Michigan) and Johannes F. Wieland (University of California, San Diego) examines the success Abenomics has had in boosting Japanese GDP and gives insight into how such unconventional monetary policy can sustain amplified GDP growth in the long term.
Named after Japanese Prime Minister Shinzo Abe, ‘Abenomics’ is the name used to refer to Japan’s current three-pronged economic stimulus policy, which consists of a combination of monetary policy expansion, fiscal stimulus, and structural reform. It is the only real and current example of long-term unconventional monetary policy, and is thus viewed by economists as an important test of its validity.
So far, Abenomics has stood up to the challenge. The Japanese stock market has risen, the exchange rate has depreciated, and Japan’s GDP has jumped by up to 1.7%. Hausman and Weiland claim that one percent of this GDP growth has been directly caused by the monetary policy shift. Furthermore, Abenomics’ effect on the Japanese money supply has been much more effective than that of previous QE policies. The below graphic from the Economist article provides a nice summary of the effects of Abenomics:
Hausman and Weiland attribute the superior effectiveness of Abenomics to the change in inflation expectations it has caused. Japan has set a new 2 percent inflation target and because Abenomics was announced to the public as a permanent change in policy rather than a temporary measure to boost GDP, inflation expectations increased for both the short and long terms. Both short and long-term borrowing appeared cheaper as a result. This, in turn, caused borrowing to increase across the board, stimulating increased consumer spending.
One should not go all-in on Abenomics quite yet, though. Both the article and research paper emphasize that Abenomics is still in its initial stages and has yet to prove itself as an effective catalyst for long term growth. When discussing the long-run outlook of Abenomics, Haussman and Weiland assert:
“The research shows that the Bank of Japan is achieving its intermediate objective of higher expected inflation, but that the inflation target itself ‘remains imperfectly credible,’ with long-run inflation expectations below 1.5 percent. Thus the modest estimates of Abenomics’ effects reflect in part that the Bank of Japan has not yet fully convinced the public that inflation will be two percent.”
If the Bank of Japan could somehow more strongly convince the public of a future two percent inflation rate (perhaps through a public announcement reinforcing its intention to pursue the policies of Abenomics), the effects could be substantial. Hausman and Weiland estimate that “the output effects of Abenomics could as much double if inflation expectations rose to the 2 percent level.”
In summary, based on the results presented by Gabriel Chodorow-Reich about the positive effects of QE on financial stability, and Hausman and Weiland’s estimates of past and future Japanese output growth as a result of Abenomics, I am convinced that unconventional monetary policy can be used effectively in the long term. If the Fed can convince the public that inflation will be steady at two percent and interest rates will remain low, whilst continuing to purchase assets and pursuing fiscal stimulus, it can achieve both strong economic growth and increased financial stability.