Unemployment, Small Business, Quantitative Easing, and More

The Fed’s quantitative easing programs did indeed lower interest rates, but more so for Treasuries and mortgage-backed securities than for other kinds of debt. Small businesses are overrated as job creators. Extended unemployment insurance does increase unemployment rates, but not that much.

Those are just a few of the findings from papers presented today at the Brookings Institution’s twice-yearly conference, Brookings Papers on Economic Activity.

Courtesy of a Brookings release, here are brief summaries of five papers discussed today:

In Recession and the Costs of Lost Jobs, authors Steve Davis of the University of Chicago and Til von Wachter of Columbia University find that when mass-layoffs occur in good economic times, men with 3 or more years of job tenure suffer a $65,000 loss in the lifetime value of their earnings (a fall of about 10%), relative to otherwise similar workers who retain their jobs. But in a recession, a similar shock causes workers to lose $112,000 in the lifetime value of their future earnings (or about 19%).  The authors also track worker perceptions about layoff risks, job-finding prospects, and the likelihood of wage cuts, finding a tremendous increase in worker anxieties about their labor market prospects after the financial crisis of 2008.  This heightened anxiety continues today, they find.  Davis and von Wachter also show that prior economic employment models have been unable to address the facts about the earnings losses associated with job loss, yet those earnings impacts appear to be one of the main reasons that individuals and policymakers are so concerned with recessions and unemployment.  Finally, they note that pro-growth policies may be the most efficient and cost-effective means available to policymakers to alleviate the hardships experienced by displaced workers.

In What Do Small Businesses Do authors Erik Hurst and Benjamin Wild Pugsley of the University of Chicago overturn the conventional wisdom about the role of small business, finding that they aren’t the job engine most believe them to be. Most small business owners neither expect nor desire to grow or innovate, but rather intend to provide an existing service to an existing customer base.  Analyzing new survey data, the authors find that, instead, it is non-financial reasons — such as work flexibility and the desire to be one’s own boss – that are the most common reason that entrepreneurs start their own business. Hurst and Pugsley note this behavior is consistent with the industry characteristics of the majority of small businesses, which are concentrated among skilled craftsmen, lawyers, real estate agents, doctors, small shopkeepers, and restaurateurs.  They conclude that standard theories of entrepreneurship may be misguided and result in sub-optimal public policy, suggesting that subsidies for small businesses may be better spent if they are targeted to businesses that expect to grow and innovate, rather than small businesses in general.  They laud the partnership between the US Small Business Administration and venture capital firms as an example of strong targeted public policy.

In Unemployment Insurance and Job Search in the Great Recession, Jesse Rothstein of the University of California, Berkeley finds that recent extensions to the period in which the unemployed can draw unemployment benefits had a significant but small negative effect on the probability that eligible unemployed would exit unemployment, and that the effect is mainly concentrated among the long-term unemployed. Rothstein calculates that without those extensions, the unemployment rate would have been about 0.2-0.6 percentage points lower—a much smaller impact than implied by previous analyses, and that the long-term unemployment rate would have been even lower. He finds that half or more of these impacts are due to the unemployed remaining in the labor force rather than reductions in the chances of finding employment. As a result, Rothstein suggests that a generous extension of UI benefit in deep recessions should last until the labor market is strong again, thus giving displaced workers a realistic chance of finding new employment before their benefits expire.

In The Effects of Quantitative Easing on Interest Rates, Arvind Krishnamurthy and Annette Vissing-Jorgensen of Northwestern University show that the Federal Reserve’s recent quantitative easing (QE) programs (“QE1” and “QE2”) did in fact significantly lower interest rates on Treasury securities, as well as GSE bonds and highly rated corporate bonds.  They also find that such programs affect interest rates differently depending on which assets are purchased: QE1, which involved the purchase of mortgage-backed securities (MBS) in addition to Treasury securities, significantly lowered MBS rates, whereas QE2, which focused exclusively on Treasury securities, had little effect on MBS rates.  The authors identify several channels through which QE affects interest rates: first, QE increases the premium paid for assets with low-default risk (and thus lowers rates on these assets), by reducing the supply of such assets available to investors; second, QE drives down interest rates broadly by signaling a commitment by the Federal Reserve to keep interest rates low for a long period; and third, when QE involves purchases of mortgage-related assets, it lowers rates on such assets by affecting the price of mortgage-specific risk.  Because QE does not affect all long-term interest rates equally, examining the impact of a QE policy that focuses on purchases of Treasury securities on long-term Treasury rates is likely to overstate the program’s impact on the long-term corporate and mortgage interest rates that all relevant to investment and housing demand.  Interestingly, the results about having the Fed use its communication channel alone – that is, signaling its intentions – might be having a significant impact on rates without having the Fed actually take on the risks associated with increasing its balance sheet. The authors also conclude that expected inflation increased substantially due to QE1 and modestly due to QE2, implying that reductions in real rates were larger than reductions in nominal rates. 

In Practical Monetary Policy: Examples from Sweden and the United States, Lars E.O. Svensson, the Deputy Governor of the Swedish Central Bank (Sveriges Riksbank) analyzes the actions of the U.S. Federal Reserve and the Swedish Riksbank during and after the summer of 2010, looking for evidence that perhaps central banks make mistakes. In that time period, both the Fed and Riksbank forecasts for inflation were below their target and their forecasts for unemployment were above the sustainable unemployment rate, suggesting that more expansionary policy was warranted. However, the Riksbank tightened policy while the Federal Reserve held rates steady. Although the Swedish economy developed better than expected, and the U.S. economy developed worse than anticipated, Svensson argues that these developments were the result of external factors — not, in fact, the nations’ respective monetary policies. The Riksbank benefited from higher-than-anticipated domestic and export demand, upward revisions of GDP data, and a lack of structural problems. On the other hand, the Fed had to contend with fiscal policy problems, a slower housing market recovery, and substantial downward revisions of GDP data. The author concludes that the Riksbank’s decision to tighten policy is difficult to justify, while the Federal Reserve’s decision not to tighten was appropriate, although there is also a case to be made that they should have eased more.

Fedspeak on Quantitative Accommodation

In case you haven’t heard of him, let me introduce Brian Sack. As Executive Vice President at the New York Fed, he’s the guy in charge of implementing the Federal Reserves’s monetary policy efforts including all the purchases of agency securities and Treasury bonds in QE1 and QE2  (LSAP1 and LSAP2 in Fedspeak, where they are known as large-scale asset purchases).

Sack gave an interesting speech last week on the Fed’s $2.654 trillion portfolio. Among other things, he reiterated the Fed view that the impact of the portfolio comes from the owning, not just the buying:

Lastly, I should note that the market seems to have adjusted fairly well so far to the end of the purchase program. The pace of the Desk’s purchases fell back sharply at the end of June, as we moved from expanding the portfolio to simply reinvesting principal payments. In particular, our purchases slowed from an average pace of about $100 billion per month through June to an anticipated pace of about $15 billion per month going forward. We do not expect this adjustment to our purchases to produce significant upward pressure on interest rates or a tightening of broader financial conditions, given our view that the effects of the program arise primarily from the stock of our holdings rather than the flow of our purchases. While there has been considerable volatility in Treasury yields over the past several weeks, we attribute those movements primarily to incoming economic data and to broader risk events. However, we will continue to watch the markets and assess their adjustment to the end of the purchase program.

As noted earlier, the current directive from the FOMC is to reinvest principal payments on the securities we hold in order to maintain the level of domestic assets in the SOMA portfolio. This approach can be interpreted as keeping monetary policy on hold. Indeed, one can generally think of the stance of monetary policy in terms of two tools—the level of the federal funds rate, and the amount and type of assets held on the Federal Reserve’s balance sheet. The FOMC has decided to keep both of these tools basically unchanged for now. (Emphasis added)

In short, quantitative easing is over, but quantitative accommodation is still boosting the economy.

Sack also offered a rule of thumb equating each $250 billion in asset purchases to a 25 basis point reduction in the federal funds rate. By that metric, the $1.6 trillion in asset purchases has been the equivalent of lowering short-term rates by about 1.6 percentage points. (Over at Econbrowser, however, James Hamilton suggests that impact may be significantly smaller.)

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.

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:

  1. Cutting rates (easing)
  2. Keeping rates low (accommodation)
  3. Raising rates (tightening)
The Fed’s asset purchases will go through three stages as well:
  1. Buying assets (quantitative easing)
  2. Owning assets (quantitative accommodation)
  3. 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.

Federal Reserve Earned $81 Billion in 2010

The Federal Reserve system is doing its part to cut the budget deficit. The central bank earned $81 billion in fiscal 2010, of which a bit more than $78 billion will be remitted to the Treasury. That’s $31 billion more than last year.

According to the Fed’s news release yesterday, the following items drove profits:

$76.2 billion in income on securities acquired through open market operations (federal agency and government-sponsored enterprise (GSE) mortgage-backed securities, U.S. Treasury securities, and GSE debt securities) [In short, the Fed is making money on its “quantitative easing” / “credit easing” activities. At least for now.];

$7.1 billion in net income from consolidated limited liability companies (LLCs), which were created in response to the financial crisis [Profits on the Maiden Lane partnerships, etc.];

$2.1 billion in interest income from credit extended to American International Group, Inc.;

$1.3 billion of dividends on preferred interests in AIA Aurora LLC and ALICO Holdings LLC [also related to AIG]; and

$0.8 billion in interest income on loans extended under the Term Asset-Backed Securities Loan Facility (TALF) and loans to depository institutions.

Additional earnings were derived primarily from revenue of $0.6 billion from the provision of priced services to depository institutions.

Those $88 billion in gross earnings were slightly offset by the following expenses:

$2.7 billion [of interest expense] on depository institutions’ reserve balances and term deposits;

[$4.3 billion] of operating expenses of the Reserve Banks, including $1.0 billion for Board expenditures and the cost of new currency.

The resulting $81 billion in net profits were then distributed as follows: $78.4 billion to the Treasury, $1.6 billion as dividends to member banks, and $0.6 billion retained to “equate surplus with paid-in capital.”

Is Housing Messing Up Inflation Measures? Yes, But …

Here’s the simplest argument in favor of the Fed’s decision to restart quantitative easing:

  1. The economy remains very weak. Unemployment, for example, is still almost 10%, and the underemployment rate is close to 17%.
  2. Key inflation measures are exceptionally low. The core consumer price index (CPI), for example, is up only 0.6% over the past year.
  3. It’s unlikely that Congress and the White House will do anything to stimulate the economy.

In short, the economy is struggling, inflation appears tame, and the Fed is the only game in (Washington) town.

Items (1) and (3) are, I suspect, not controversial. Moderate economic growth is moving us in the right direction, but has done little to create jobs or reduce the yawning output gap. And given the Republican’s election gains, it’s hard to imagine a new round of fiscal stimulus (except an extension of the expiring tax cuts — a form of anti-anti-stimulus).

Item (2), however, is highly controversial. Some commentators argue, for example, that it’s not appropriate to focus on core measures of inflation, which exclude volatile food and energy prices. Others argue that the government systematically (and, perhaps, intentionally) understates inflation.

I will leave those old debates to the side today and focus on a third, more contemporary question: Is housing messing up inflation measures?

Although the housing bubble popped several years ago, America is still adjusting to its aftermath. Falling house prices don’t directly show up in the CPI, but over time they do result in lower rents and lower estimates of the rental equivalent for owning a home. My question is how big an effect those falling housing prices are having on measured inflation.

To start, note that the core CPI really is running at exceptionally low levels:

Indeed, core inflation is well below the levels that inspired the previous round of deflation worries back in 2003.

Now let’s look at what’s happening with the shelter component of the CPI, which tracks the cost of owning or renting a home:

The CPI for shelter has fallen off a cliff. Shelter price inflation averaged about 3% from 1995 through 2007. Over the past year, however, it’s negative.

Shelter makes up almost a third of overall consumer spending, so you might expect that weak shelter prices are having a big effect on measured inflation. They do:

If you strip out shelter from the core CPI, you find that the remaining consumer prices have risen at a moderate pace over the past year (1.3%) – low, but not exceptionally low. Indeed, the economy came much closer to deflation back in 2003, by this measure, than it has so far today.

In short, the ongoing weakness in housing is a key reason why measured inflation is so low. But — and this is an important but — inflation still appears quite moderate even when you adjust for this effect. At 1.3% over the past year, the core CPI less shelter certainly doesn’t inspire concern about inflationary pressures. And if you look more recently, you find that this measure of inflation has been falling (e.g., the pace of inflation was about 1% annually over the past six months).

Bottom line: Housing weakness has indeed pushed measured inflation down a great deal, but it’s not the only factor at work.

Note 1: BLS tracks four costs of shelter: rent of primary residence (for renters), owners’ equivalent rent of residences (for homeowners), lodging away from home, and tenants and household insurance. Lodging and insurance account for only 3.5% of shelter, so it didn’t seem worth the trouble to strip them out to get a housing-only measure. You will sometimes see analysts do this comparison using the BLS measure of housing costs. Housing is about one-third larger than shelter because it includes household energy and utilities purchases, furnishings, and other household operations. For that reason, I think shelter is a better measure for exploring the relationship between the housing market and measured inflation.

Note 2: According to BLS, food comprises about 14% of consumer expenditures, energy about 9%, and shelter about 32%. So the core CPI less shelter covers about 45% of consumer expenditures. So use it with care.

Quantitative Easing, Trading, and the Viral Bunnies

When Ben Bernanke and his colleagues at the Federal Reserve announced their plan for $600 billion in new quantitative easing, I am sure they expected criticism. Angela Merkel? No surprise. Hu Jintao? Ditto. Domestic inflation hawks? Ditto again.

But could the Fed have anticipated that its most vocal critics would be a pair of talking bunnies?

If your email, Facebook, and Twitter feeds are anything like mine, you know the video: two bunny-like creatures (I’ve also heard them called smurfs and dogs) discussing “the quantitative easing” of “the Ben Bernank.” It’s hilariously effective but, as Jim Hamilton helpfully points out, also quite wrong in places.

In case you’ve missed it, here’s the video:

The folks at Xtranormal have been offering the ability to make such movies for a couple of years now, but the idea appears to have gone viral in the economics and finance space in the last week. Indeed, YouTube already has a bunch of rebuttal videos to the quantitative easing one.

So far, the funniest video I have seen (ht: Jack B) features a bunny interviewing for a Wall Street trading job. I usually keep things G-rated here, but I’ll make an exception today. Be forewarned, some of the language may be NSFW — unless, of course, you are a trader:

How Blurry is the Line between Monetary and Fiscal Policy?

Economists have traditionally drawn a sharp distinction between monetary and fiscal policy. Monetary policy should try to promote growth and limit inflation by setting short-term interest rates, managing the money supply, and providing liquidity during times of financial stress. Fiscal policy should also encourage growth and, more broadly, promote the general welfare through careful choices about spending, taxes, and borrowing. The Federal Reserve has responsibility for monetary policy, while Congress and the President handle fiscal policy.

That clean distinction was one of many casualties of the financial crisis. As credit markets froze, the Fed pursued unconventional policies that blurred the line between fiscal and monetary policy. For example, it purchased more than $1 trillion in mortgage-backed securities (MBS) issued by Fannie Mae and Freddie Mac, created new lending facilities for commercial paper and asset-backed securities, and provided special support for such key financial institutions as AIG, Bank of America, and Citigroup.

Those actions differed from conventional monetary policy in two ways. First, they exposed the Fed to more financial risk. Short-term Treasury securities, the Fed’s usual fare, carry no credit risk and almost no interest rate risk. In contrast, the Fed’s new portfolio has healthy doses of both. Second, in several cases the Fed offered to purchase financial assets at above-market prices or, equivalently, to make loans at below-market interest rates. In effect, the Fed chose to subsidize some specific financial activities.

Both changes increased the Fed’s fiscal importance.

Most visibly, Fed profits have jumped as its portfolio expanded and it acquired higher-yielding assets. Indeed, the Congressional Budget Office (CBO) projects that Fed profits will hit $77 billion in 2010, up from $32 billion in 2008. That makes them the fourth largest source of federal revenues, after personal income, social insurance, and corporate income taxes, but ahead of estate and excise taxes. Actual returns could be higher or lower, however, depending on how well its investments perform.

Also important, though less visible, are subsidies implicit in some of the Fed’s financing programs. The Term Asset-Backed Securities Loan Facility (TALF), for example, offered favorable long-term funding to investors who wanted to finance investments in securities backed by auto loans, student loans, and certain other types of debt. Similar programs provided favorable funding to support commercial paper markets and to assist AIG, Bank of America, and Citigroup. CBO recently pegged the initial cost of the resulting subsidies at $21 billion.

Not all programs created subsidies, however. CBO concluded, for example, that the MBS purchase program did not involve subsidies because the Fed made its purchases at market prices.

To be sure, the Fed’s fiscal initiatives were dwarfed by the explicitly fiscal actions taken by Congress and Presidents Bush and Obama. The Troubled Asset Relief Program (TARP), for example, was originally estimated to involve subsidies of $189 billion (a figure that has fallen as financial markets have healed), and support to Fannie Mae and Freddie Mac has added tens of billions more. Still, CBO’s estimates do highlight the Fed’s move into fiscal territory as it battled the financial crisis.

Those steps were appropriate given the severity and suddenness of the crisis, but have fueled concerns about the Fed’s scope of authority. Some members of Congress, for example, have questioned whether the Fed should be able to engage in even moderate amounts of fiscal policy without congressional oversight. Their increased interest in Fed oversight, in turn, has raised concerns about defending the Fed’s traditional independence in making monetary policy.

As Chairman Ben Bernanke argued in a speech last week, maintaining the Fed’s independence in monetary policy would be easier if policymakers would “further clarify the dividing line between monetary and fiscal responsibilities.” Let’s hope such guidance comes along before the next financial crisis strikes.

This post first appeared on TaxVox, the blog of the Urban-Brookings Tax Policy Center.