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Joe Gagnon Believes in Large Portfolio-Balance Effects of Quantitative Easing

Joe Gagnon: RealTime Economic Issues Watch | Michael Woodford’s Unjustified Skepticism on Portfolio Balance:

In his recent speech at the Federal Reserve’s annual Jackson Hole conference, Professor Michael Woodford of Columbia University attempted to pour cold water on the idea that the Fed’s purchases of long-term bonds (also known as quantitative easing) could lower bond yields. His contention was that the portfolio balance effect of such purchases would be minimal at best. I disagree, as do the bulk of central bankers.

This debate matters because, if Woodford is right, the Fed’s only tool for delivering more stimulus now is to commit to future policy actions that may be viewed as undesirable when they occur—such as promising not to raise interest rates when inflation returns. If the market were to doubt such a commitment from the Fed, the Fed would lose its ability to steer the economy. In reality, the portfolio balance channel gives the Fed a tool to guide the economy without unduly restricting future policy choices. This is not to deny, however, that Fed statements about future policy intentions may have important effects.

Woodford devotes several pages in his Jackson Hole remarks to discussing a paper I wrote two years ago with former Fed colleagues Matthew Raskin, Julie Remache, and Brian Sack. We showed that Fed purchases of long-term agency and government bonds in 2008 and 2009 lowered a range of long-term interest rates. We argued that most of those declines appeared to reflect a reduction in term premiums…. Woodford asserts instead that most or perhaps all of the declines in bond yields might have been caused by the market’s interpretation of the Fed’s statements and actions as indicating that the path of future short-term interest rates would be lower than previously expected.

Our paper, and more recent papers, presented evidence that counters most of Woodford’s empirical claims (D’Amico and King 2010, Neely 2010, D’Amico, English, Lopez-Salido, and Nelson 2011, Hamilton and Wu 2012, and Li and Wei 2012)…. Some Fed statements and actions clearly had no implications for the path of future short-term rates, and yet they still affected some asset prices. This evidence comes from a range of investigations, not solely from event studies, and the conclusion is not sensitive to changes in the underlying model used to identify movements in the term premium. These effects of Fed asset purchases are fully consistent with what would have been expected based on data from before the financial crisis, and with the portfolio balance view….

I focus on Woodford’s theoretical arguments against portfolio balance. I find them unpersuasive. For more theoretical arguments for and against portfolio balance, see a post by Jérémie Cohen-Setton and Éric Monnet on the Bruegel blog.

Woodford asserts that there can be no portfolio balance effect if two conditions hold: (1) the assets being bought and sold are valued only for their pecuniary returns, and (2) all investors can purchase and sell unlimited quantities of these assets. A third requirement he does not mention is that investors are rational, forward-looking, and fully informed…. These conditions are violated in clear and obvious ways in the real world. Indeed, Woodford acknowledges that money has a non-pecuniary return—transactions services—which is required for conventional monetary policy to work. There is no reason to assume that money is the only asset with a non-pecuniary return. The violation of Woodford’s second theoretical assumption is even clearer, as it requires that private agents have an unlimited ability to take short positions in the assets the Fed is buying. In fact, private agents seeking to borrow at any maturity face severe and binding collateral requirements and pay considerably higher interest rates than the Treasury. It is common in economics to make the benchmark assumption of rational, forward-looking, fully informed agents…. But it is one thing for investors to respond to a Fed announcement about imminent bond purchases and quite another for them to fully anticipate the implications of those purchases for their taxes and transfers in the distant future. Yet the case against portfolio balance requires precisely that knowledge…