Does QE Lower or Raise Interest Rates: the Evidence
There is a widespread presumption — rooted, I think, in basic principles of supply and demand — that quantitative easing lowers interest rates. The central bank buys bonds, which creates a price ceiling for them. Ceteris paribus, the price is lower than it would otherwise.
This is part of a larger presumption that central bank policy is lowering interest rates. There are deeply ingrained assumptions in many schools of economics that positive time preference dictates a moderately positive real interest rate. But, I think, interest rates are a measure more than anything else of the cost of capital. If there is lots and lots capital sitting slack, interest rates will go very low for long periods of time. In other words, I think it is much more likely that low interest rates are a symptom of a lack of demand for capital rather than “central bank manipulation”.
And this presumption that central banks are lowering interest rates is at odds with the evidence. This graph via Matt O’Brien from last year shows that each time the Federal Reserve has commenced a program of quantitative easing interest rates have actually risen. Of course, since that graph’s time series ended, interest rates have driven higher again in the context of another quantitative easing program.:
And each time the Federal Reserve has tapered its bond-buying programs, interest rates have fallen back lower.
Considering the Federal Reserve’s explanation for why it is conducting quantitative easing, this is a perfectly predictable outcome. The Federal Reserve intends to force bondholders out of low-yielding bonds and into lower-yielding cash, in order to force them to reach for yield in productive assets like equities. This is what Ben Bernanke has called the portfolio balance channel of monetary policy.
By forcing investors into productive assets — something which has clearly occurred, given the growth in the price of equities — central banks are driving up demand for capital in the economy, thus raising interest rates. In other words, things aren’t quite ceteris paribus and the “central bank manipulation” is actually pushing interest rates higher.
Another explanation along these lines would be that quantitative easing changes investors expectations — that they see that the central bank will do “whatever it takes” to engender a recovery, and this raises demand for capital, pushing interest rates higher. I am quite wary of this kind of explanation, because I don’t think investors generally even begin to understand what quantitative easing is, or what the Fed is doing.
Another expectations-based explanation is simply that investors are front-running the Fed, piling into government bonds during the periods when the Fed is not doing quantitative easing on the expectation that they will in future, and selling them on an expectation of a taper.
These kinds of explanations might have more traction if we were not seeing the boost in equities prices, and the strong recovery in gross private domestic investment. As it is, it appears as if quantitative easing is having effects on demand for capital — pushing it up, not down — by forcing investors into productive assets.
So have Bernanke and Yellen broken through the zero lower bound of monetary policy effectiveness? I think we should wait and see. Clearly, if quantitative easing pushes rates higher, both the QE1 and QE2 programs — which were time-limited — tapered far too quickly, as rates fell back again once the programs were completed. The higher rates we saw were not self-sustaining. Similar things can be seen with Japan’s quantitative easing programs.
This round of quantitative easing, of course, is not time-limited. That is, it can continue until inflation rises, and even longer if deemed necessary or appropriate. (In fact, I would say that the most appropriate ending point for this round of quantitative easing is when the market starts to demand that it end because inflation is rising). Of course, based on past occurrences there is much likelihood that the taper will come too soon. Central bankers generally (and their “quantitative easing is like heroin!” critics) have proven far more worried about the potential occurrence of future inflation, than the present occurrence of unemployment. Whether we even get a chance to see if Bernanke and Yellen’s unconventional monetary policy has truly broken through the zero lower bound depends on their — as yet unproven — ability to let the program continue until inflation begins to rise.