New Research Foretells QE Domination

The title refers to a consensus-shattering paper that was unveiled at the University of Chicago last month before a Who’s Who of economists and central bankers.

Paul Krugman gave the keynote, but the meeting’s focus was on the paper’s authors—two Wall Street big shots, Morgan Stanley’s David Greenlaw and Bank of America Merrill Lynch’s Ethan Harris, and two academics, James Hamilton and Kenneth West. To keep it simple, I’ll call them GHHW.

The paper more or less shredded former Fed chief Ben Bernanke’s favorite defense of his quantitative easing (QE) programs—that QE lowered Treasury yields.

In fact, if you believe in the accuracy of the type of analysis GHHW conducted, QE may have actually increased Treasury yields. By parsing data and financial news more thoroughly than in prior studies, the authors found that yields rose, on average, when bond traders were presented with news about QE. (I recommend Hamilton’s blog write-up for a quick summary, although if you’re also looking for key charts, see Exhibits 4.11 and 4.12 on page 82 of the paper.)

But despite having the data to fully reverse the findings of other researchers, GHHW didn’t take it quite that far. (They were too polite for that.) Up against a strongly pro-QE crowd, they settled on the less ambitious conclusion that “the Fed’s balance sheet is a less reliable and effective tool than as perceived by many.” Between the lines, though, they painted a picture of QE being about as powerful as the host city’s passing game. (To save you the trouble of looking it up, Daaa Bears ranked last in the NFL.)

As far as pre-GHHW “perceptions,” the authors described a consensus that QE lowered 10-year Treasury yields by about 100 basis points, an amount they then refuted. That 100 basis point consensus is consistent with a few different literature reviews, as pointed out by GHHW, and also with claims by FOMC members. It went undisputed by the attendees in Chicago who published their comments. (Three Fed regional bank presidents, an ECB Executive Board member, and a few others delivered formal responses.)

The new research is important, in my opinion, not so much for academic reasons but because I think it foretells the future. Before I explain why, though, I need to insert a disclaimer about the likely accuracy of any study that attributes yield changes to QE news of one type or another.

That is, methods for establishing how much QE moved the bond market are essentially guesswork, even after GHHW’s improvements. Bond prices respond to traders and investors not only establishing new positions but also unwinding or rebuilding prior positions in combinations unknowable and for reasons derived from all past fundamental and technical information and ultimately also unknowable. Trades may occur because prices have gone up in the past, because they’ve gone down in the past, because the market is overbought or oversold, because a different market has become more or less attractive, because traders seek opportunities to lock in profits or cut losses, and for countless other reasons. As such, it’s easy to jump to the wrong conclusion by attaching a single fundamental cause to every price change—there’s no such thing as a sequence of single-cause price changes, and even if there were, we could only guess at the causes.

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Gary Anderson 11 months ago Contributor's comment

This article is a must read. Certainly bond yields go down because of demand for bonds in the private sector. The Fed did nothing to change the conundrum. But giant QE could pull yields into the negative. The ECB and BOJ own most of the bonds in those regions. That can't be healthy for economies in the long run. The alternative of runaway yields is worse.