TheTreasury and the Fed are at Loggerheads over QE

In my last post on QE, I quoted a paper by James Hamilton and Cynthia Wu that provides some empirical evidence for the importance of the asset composition of the Fed's balance sheet and its effect on the term structure of interest rates. They have posted their data online and it makes for interesting bedtime reading. 

Hamilton and Wu combined their data with evidence from the yield curve. They found that qualitative easing can be effective at the lower bound and that

... buying $400 billion in long-term maturities outright with newly created reserves, ... could reduce the 10-year rate by 13 basis points without raising short-term yields.

To construct these estimates, they used a theoretical model developed by Vayanos and Vila which assumes that there are investors who have a 'preferred habitat'.

The Hamilton Wu results are important. I ran some regressions of term premiums on bond supply by maturity, using their data, and I found the same orders of magnitude in the response of interest rates that they found. But there is an interesting sub-text to their analysis discussed in Section 8 of their paper. The Fed and the Treasury have been following conflicting policies. David Beckworth on his blog in 2012 makes the same point.

Quantitative Easing took place in three phases. QE1 from 11/08 to 03/10, QE2 from 11/10 to 06/11 and QE3 which is ongoing. Along with monetary expansion, the Fed attempted to refinance its portfolio by selling at the short end and buying at the long end of the yield curve. But at the same time, the Treasury was refinancing its own portfolio. The end result was that the Treasury restructuring completely swamped any effect of Fed operations at the long end of the yield curve.  

Figure 1

In Figure 1 I have broken down the System Open Market Account (SOMA) of Fed holdings of Treasuries by maturity as a percentage of all outstanding Treasuries, using the Hamilton Wu data set. The two vertical red lines are the beginning and end of the last recession and the vertical black line marks the collapse of Lehman Brothers.

The Greenspan Put and the Yellen Call

In today's Guardian, I make the case for a more aggressive financial stabilization policy,  "No more boom and bust? The financial policy committee has time on its side". I argue that the Bank of England's FPC should buy shares in the stock market when the PE ratio is low, and sell them when it is high.

Kimdriver makes the following comment.

The Greenspan put with real teeth ?

My worry is that, while CAPE has historically been a good predictor of future returns, the level that the FPC should be ready to intervene would have to be set so low that it might be fairly useless. Otherwise the safety net would just encourage increased irrational exuberance.

My response ...

I am not arguing just for a Greenspan Put: but also for a Yellen Call. It is just as dangerous to allow market bubbles as it is to allow them to crash.

Read more here...

Why Death Matters for Central Bank Policy

Noah Smith raises the question: can the Fed influence the interest rate? Although the answer may seem obvious, the question itself reflects a conundrum for neoclassical theory. It is representative of a related but more comprehensive question: does the asset composition of the central bank balance sheet matter?

Let me set aside, for now, the deep question: what is money? I will take for granted the fact that the liabilities of the central bank are special. Perhaps this is due to legal restrictions, as Neil Wallace has suggested, or perhaps it is a matter of social convention. My focus here is not on central bank liabilities; but on their assets.