The U.S. central bank’s bond buying is a less potent tool for stimulating growth than policy makers believe, two economists said in a paper released today at a Federal Reserve conference.
The paper scrutinizes the stance of some Fed officials that so-called quantitative easing works through a “portfolio-balance channel” in which Fed asset purchases induce investors to rebalance their investments to boost a wide range of financial assets. The research was presented at an annual Kansas City Fed symposium in Jackson Hole, Wyoming.
“The portfolio balance channel of QE works largely through narrow channels that affect the prices of purchased assets, with spillovers depending on particulars of the assets and economic conditions,” Northwestern University finance professor Arvind Krishnamurthy and University of California-Berkeley professor Annette Vissing-Jorgensen wrote in the paper. “It does not, as the Fed proposes, work through broad channels such as affecting the term premium on all long-term bonds.”
The work of Krishnamurthy and Vissing-Jorgensen has influenced the debate at the Fed before, with a previous paper of theirs cited by Fed Chairman Ben S. Bernanke in his speech last year in Jackson Hole that made the case for a third round of bond purchases, known as QE3.
Fed officials are debating when to wind down their bond purchases. Minutes of the Federal Open Market Committee’s July 30-31 meeting, released Aug. 21 in Washington, showed that Fed policy makers were “broadly comfortable” with Bernanke’s plan to slow the pace of purchases later this year and end them in mid-2014 if the economy performs as the Fed forecasts.
Despite working through narrower channels, the Fed’s buying of mortgage-backed securities in QE3 has been more effective at boosting the economy through its effect on mortgage rates, according to the paper.
“The Fed’s cessation of MBS purchases or sale of MBS are likely to be more economically important for the private sector than a sale of Treasury bonds, which by itself will affect mainly government borrowing costs,” according to the paper. “There is little evidence for the operation of a broad channel through which large-scale asset purchases lower the yield on all long-term bonds.”
The authors also argued that the Fed should rethink its current “exit strategy” to return its record $3.65 trillion balance sheet to normal.
A Fed exit strategy outlined in June 2011 said that after ending purchases the Fed would first allow maturing assets to roll off its balance sheet, then raise interest rates, and then sell its holdings of mortgage-backed securities. In June this year, Bernanke said officials no longer expect to sell their holdings of MBS.
Krishnamurthy and Vissing-Jorgensen propose that the Fed should first cease buying Treasury bonds and then sell down its holdings of government debt. Then, the Fed should sell mortgage-backed securities with high coupons.
“The last step in this sequence is that the Fed should cease its purchases of current-coupon MBS as this tool is currently the most beneficial source of economic stimulus,” the authors said.