July 2011 – Page 2 – Donald Marron

How Will Quantitative Tightening Work?

The Fed’s second round of quantitative easing ended in late June. That means we are now in a period of quantitative accommodation. The Fed continues to hold a hefty portfolio of mortgage-backed securities and longer-term Treasuries — thus providing continued, unconventional monetary stimulus — but it’s not adding more.

At the FOMC’s June 21-22 meeting, the members discussed how it would someday exit from this unusual policy posture. In short, the Fed discussed the roadmap for quantitative tightening.

Here’s how it will work:

To begin the process of policy normalization, the Committee will likely first cease reinvesting some or all payments of principal on the securities holdings in the [System Open Market Account].

At the same time or sometime thereafter, the Committee will modify its forward guidance on the path of the federal funds rate and will initiate temporary reserve-draining operations aimed at supporting the implementation of increases in the federal funds rate when appropriate.

When economic conditions warrant, the Committee’s next step in the process of policy normalization will be to begin raising its target for the federal funds rate, and from that point on, changing the level or range of the federal funds rate target will be the primary means of adjusting the stance of monetary policy. During the normalization process, adjustments to the interest rate on excess reserves and to the level of reserves in the banking system will be used to bring the funds rate toward its target.

Sales of agency securities from the SOMA will likely commence sometime after the first increase in the target for the federal funds rate. The timing and pace of sales will be communicated to the public in advance; that pace is anticipated to be relatively gradual and steady, but it could be adjusted up or down in response to material changes in the economic outlook or financial conditions.

Once sales begin, the pace of sales is expected to be aimed at eliminating the SOMA’s holdings of agency securities over a period of three to five years, thereby minimizing the extent to which the SOMA portfolio might affect the allocation of credit across sectors of the economy. Sales at this pace would be expected to normalize the size of the SOMA securities portfolio over a period of two to three years. In particular, the size of the securities portfolio and the associated quantity of bank reserves are expected to be reduced to the smallest levels that would be consistent with the efficient implementation of monetary policy.

Bottom line: (1) stop reinvesting principal on securities (both MBS and Treasuries, presumably), (2) modify guidance about federal funds rate, (3) raise federal funds rate (and interest on reserves), (4) sell agency securities. If I am reading this correctly, selling Treasuries is not part of the exit strategy. The Fed’s Treasury portfolio will thus decline soley as principal payments are made.

A Big Error in the Senate Republicans’ Balanced Budget Amendment

Senate Republicans made a striking error in the balanced budget amendment they introduced last week. As written, the amendment would limit federal spending far more than those senators realize or, I suspect, desire.

The Republicans want the budget to be balanced by keeping spending down rather than by raising tax revenues. They thus propose limiting spending to no more than 18% of gross domestic product (GDP). That’s in line with average tax revenues over the past four decades, but well below average spending, which has been just short of 21% of GDP.

So what’s the problem? The way the amendment would implement the spending limit:

Total outlays for any fiscal year shall not exceed 18 percent of the gross domestic product of the United States for the calendar year ending before the beginning of such fiscal year, unless two-thirds of the duly chosen and sworn Members of each House of Congress shall provide by law for a specific amount in excess of such 18 percent by a roll call vote.

The amendment compares spending in one period (the upcoming fiscal year) to the size of the economy in an earlier period (the last complete calendar year). If the amendment were in force today, for example, spending in fiscal 2012, which starts in October, would be limited to 18 percent of GDP in calendar 2010. That’s a gap of 21 months.

As Bruce Bartlett pointed out in analyzing an earlier version of this amendment, that time lag can add up to big money. Why? Because both real economic growth and inflation will expand the economy during those 21 months.

The Congressional Budget Office projects, for example, that nominal GDP will grow about 4.5% annually in the latter part of this decade (the earliest the amendment could go into effect). Over 21 months, that works out to roughly 8% growth. The amendment would thus limit federal spending in those years to about 16.7% of each year’s GDP (16.7% = 18% / 1.08) not the advertised 18%. In 2020 alone that amounts to a difference of more than $300 billion in spending.

That’s a big error.

I doubt that Senate Republicans really want to limit spending to only 18% of GDP. Even the House Republican budget calls for spending of more than 20% of GDP for at least two decades. But if the Senate Republicans are serious, their first step should be to fix the drafting error in their amendment.

The Cost of Sunshine: Hugo Chavez Edition

Campaign systems often rely on disclosure (e.g., of campaign contributions and petition signing) to limit corruption and inform the voting public. Such sunshine provides important benefits, but, as I’ve noted before (here and here), it can also have costs. For example, disclosure makes it easier for politicians to identify their supporters and opponents and, if they are so inclined, to mete out rewards and punishments accordingly.

A recent paper in the American Economic Journal: Applied Economics reports a striking example of this in Venezuela. Chang-Tai Hsieh, Edward Miguel, Daniel Ortega, and Francisco Rodriguez document (here; ungated version here) what happened to Venezuelans who signed at least one of three petitions in 2002-03 calling for a recall vote against President Hugo Chavez. The third petition was successful, but Chavez survived the vote.

He then got his hands on the list of Venezuelans who signed the third petition. Using household survey data, the authors were able to track what happened to those signers, Here’s their abstract:

In 2004, the Hugo Chávez regime in Venezuela distributed the list of several million voters who had attempted to remove him from office throughout the government bureaucracy, allegedly to identify and punish these voters. We match the list of petition signers distributed by the government to household survey respondents to measure the economic effects of being identified as a Chávez political opponent. We find that voters who were identified as Chávez opponents experienced a 5 percent drop in earnings and a 1.3 percentage point drop in employment rates after the voter list was released.

In short, a notable fraction of the opponents lost their jobs, were unable to get new jobs, or had their pay cut.

Individuals who signed the first or second petition, but not the third, did not experience any decline in earnings or employment.

Why the difference? Because only information about the third petition appeared in the computerized data sets that Chavez distributed.

So it wasn’t disclosure alone that allowed the punishment, but disclosure coupled with easy-to-access dissemination.

If QE2 Is Over, Does That Mean QA2 Just Started?

Everyone has been writing epitaphs for the “end” of QE2, the Federal Reserve’s program to buy $600 billion in Treasury bonds.

In a narrow sense, they are right: the Fed just completed those purchases. What most coverage misses, however, is that the effects of “quantitive easing” depend at least as much on the Fed’s owning the bonds as buying them. The stock matters at least as much as the flow.*

The epitaphs apply only to the buying. The stock–Fed ownership of $600 billion in Treasury bonds–is still with us.

Which brings us to today’s question: What should we call that? To say that QE2 is over leaves the impression that the program is over. It’s not.

One answer would be to expand the definition of QE2 to include the owning as well as the buying. In that case, we’d simply say that QE2 is still in place.

That strikes me as the cleanest solution except for one thing: almost everyone seems to want to believe that QE2 is over. So we need a new name.

To get some inspiration, consider the three stages of traditional monetary policy. You know, the kind where the Federal Reserve moves short-term interest rates up and down:

Cutting rates (easing)
Keeping rates low (accommodation)
Raising rates (tightening)

The Fed’s asset purchases will go through three stages as well:

Buying assets (quantitative easing)
Owning assets (quantitative accommodation)
Selling assets (quantitative tightening)

Stage 1, quantitative easing, just ended. When the Fed someday starts selling, that will clearly be quantitative tightening.

But what about stage 2? The best I can come up with is quantitative accommodation, QA for short.

That doesn’t really flow off the tongue, and better suggestions would be welcome.

For now, though, here’s my recommendation: If you insist on saying that QE2 is over, you should also be saying that QA2 just began.

* For example, here’s Chairman Bernanke discussing stocks and flows at his inaugural press conferencein April:

[W]e subscribe generally to what we call here the stock view of the effects of securities purchases, which—by which I mean that what matters primarily for interest rates, stock prices, and so on is not the pace of ongoing purchase, but rather the size of the portfolio that the Federal Reserve holds. And so, when we complete the program, as you noted, we are going to continue to reinvest maturing securities, both Treasuries and MBS, and so the amount of securities that we hold will remain approximately constant. Therefore, we shouldn’t expect any major effect of that. Put another way, the amount of ease, monetary policy easing, should essentially remain constant going forward from—from June.