Wednesday, September 1, 2010

What assets to purchase in QE?

Even as double-dip looms large and fiscal policy paralysis continues in the US and other developed economies, much of the attention in recent weeks has focused on efforts to get monetary policy to stimulate demand.

In his speech at the annual Federal Reserve Bank of Kansas City’s Annual Economic Symposium in Jackson Hole, Wyomoing, last week, Fed Chairman Ben Bernanke signaled his commitment to doing everything to keep the economy from falling into a deflationary spiral. He pointed towards four options - purchase more government debt and long-term securities; communicate intent to keep short-term rates low for even longer than the markets currently expect; lower interest paid on reserves (funds held at the Fed); and raise medium-term target for inflation - of which, he felt only the last was unviable.

The last meeting of the FOMC had also reiterated that the prevailing economic conditions "warrant exceptionally low levels of the federal funds rate for an extended period". It also affirmed a continuation with the quantitative policies (QE),

"To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve's holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities. The Committee will continue to roll over the Federal Reserve's holdings of Treasury securities as they mature."


This commitment to continue with unconventional monetary policy responses by way of asset purchases naturally raises the question about which assets to buy. Nick Rowe advocates that the Fed buy pro-cyclical assets - whose prices rise if enough people believed that the US economy was moving back onto its desired long-run equilibrium path.

In so far as asset prices are forward looking, reflecting expectations of future value, he sees a possible Tinkerbell principle (of self-fulfilling prophecy) at work, with varying outcomes for pro-cyclical and counter-cyclical assets. In case of the former, the causal chain from policy to outcomes works with Tinkerbell, while for the later, it works against her. He writes,

"If the Fed buys an asset, the direct effect of the purchase will be to raise the price of that asset. The increased price of that asset, plus the increase in the money supply used to purchase that asset, will have a direct effect on the economy. But there's also an indirect effect, via Tinkerbell's credibility...

Suppose the Fed buys a counter-cyclical asset. If the price rises, people may interpret that rise as a sign that monetary policy is having the desired effect. Or they may interpret it as a sign the economy is getting weaker. Depending on how people interpret the rise in price of the counter-cyclical asset, and the relative strengths of the direct causal effect and the Tinkerbell effect, the net effect on the economy is ambiguous. Also, if people thought that monetary policy was having the desired effect, and was not impotent, any increased optimism about the future path of the economy would tend to lower the price of the counter-cyclical asset, which would tend to make monetary policy look less effective, and snuff out that optimism.

Suppose the Fed buys a pro-cyclical asset. If the price rises, people will interpret that as a sign that monetary policy is having the desired effect. Or they may interpret it as a sign the economy is getting stronger. Both effects work in the same, desired, direction. Also, if people thought that monetary policy was having the desired effect, and was not impotent, any increased optimism about the future path of the economy would tend to raise the price of the pro-cyclical asset still further, which would tend to make monetary policy look more effective, and reinforce that optimism."


I have three issues here.

1. Government bonds (whose yields will rise, and therefore prices fall, as economy recovers and nominal interest rates go up from the present zero-bound), are most certainly counter-cyclical. However as Nick Rowe acknowledges, the net impact of the increase in bond prices depend on the relative strengths of the direct impact on the real economy of lower real interest rates (and expectations for a long period and other related consequences) and Tinkerbell effect (people thinking that rising prices of counter-cyclical asset bodes ill for future).

In this context, I am inclined to the argument that whatever the attenuating role of expectations (and they are undeniably important), in a balance sheet recession (as is the case now, with firm and household balance sheets badly bruised) the primary objective should be to repair them. And higher bond prices, and lower resultant yields and long-term interest rate expectations that come with it, can accelerate the restoration process.

2. Though real estate and equities are among the major standard pro-cyclical assets, it may be too much of a stretch, especially given their role in the sub-prime crisis, to expect the Fed to indulge in massive purchases of those assets to inflate a rally (with potential risk of resource mis-allocation and an ultimate bubble) in those assets.

3. Are there any truly pro- and counter-cyclical assets? Both equities (in March-May) and bonds (for sometime now) have exhibited similar characteristics even as the prospects of the real economy has remained bleak.

No comments: