QE Didn’t Quite Cut It, So Now What?

Looking to the past may not help Yellen on rates.

Oil Painting: Braulio Amado; Images: Bloomberg mages (4)

Members of the Federal Reserve Board of Governors don’t usually share their differences in public. On Oct. 11 the board’s vice chairman, Stanley Fischer, said in Lima that he expects a hike in the Fed’s main rate “later this year,” confirming what Chair Janet Yellen had said in September. Within two days, Lael Brainard and Daniel Tarullo, both on the board, said the Fed should wait because there wasn’t yet any sign of inflation. That disagreement shows the dilemma Yellen faces: Raise rates soon and risk smothering a tepid recovery, or wait until next year and risk igniting inflation.

Congress gave the Fed two jobs: Keep inflation predictable and unemployment low. In the past, as unemployment went down, inflation went up. Fed hawks argue that, with unemployment at 5.2 percent, inflation is on its way. Doves say that relationship isn’t what it used to be. There’s a third argument: We don’t really know how well the last seven years of Fed policy have worked. And if the central bank can’t be sure of what happened in the past, it will find it hard to decide on the future.

The Fed can’t tell banks how to lend. Instead, it relies on something measurable that it can control: the rate of interest. Since 2008, the Fed has kept short-term rates near zero and brought long-term rates down through “quantitative easing.” That required the central bank to buy a lot of long-term U.S. government debt. By lowering long-term rates, QE would encourage people to buy houses, and businesses to borrow for expansion.

While QE succeeded in bringing down long-term rates, lending didn’t increase as much as anticipated. The Fed hit its interest rate target square on. It’s hard to measure how much easing has benefited Main Street. Some economists are skeptical. “We no longer believe that QE can fix everything,” says Michala Marcussen, global head of economics at Société Générale.

“We have very good estimates of how quantitative easing affected interest rates,” says Amir Sufi, a professor at the University of Chicago Booth School of Business. “We don’t know how to translate that into how it affected the real economy.” Sufi’s lecture in June at the Bank for International Settlements in Basel, Switzerland, asked whether monetary policy was as effective as economists had believed. Central banks, he concluded, failed to take into account that people behave differently under the same policy. Economists call those differences in behavior “heterogeneity.”

Sufi cited two recent papers that show that when rates fell in the U.S., households with higher debt burdens—generally the poor—were more likely to spend. His own research shows that for every dollar rise in a home’s value, the poorest households borrowed and spent 25¢. The richest 10 percent took out no new loans. And while Yellen’s low interest rates made mortgages cheaper to refinance, that didn’t necessarily mean more spending.

The same is true for credit card loans. In theory, low rates make it cheaper for banks to borrow and encourage them to increase credit limits. In a working paper for the National Bureau of Economic Research, a group of researchers looked at 8.5 million credit card accounts. They found that for every 1 percentage point reduction in what it costs banks to borrow, banks extended $127 in credit to families with credit scores below 660. Those families spent 58¢ for every new dollar in credit.

Under the same conditions, families with credit scores above 740 got $2,203 in extra credit. But they didn’t spend a penny of it. Says Johannes Stroebel of the NYU Stern School of Business, one of the authors: “The targeting of these credit expansions is potentially to the wrong people, to the people that don’t want to borrow more.”

A report prepared for the Lima meeting by the Group of Thirty, a body of central bankers, regulators, and economists, reached similar conclusions. Among developed economies, according to the report, the rich have gotten richer, their homes and investments have increased in value, and they’re the least likely to spend more. “How far down do you have to get interest rates,” Sufi asks, “before you get someone like Bill Gates saying, ‘Well, now I’m going to spend my money’?”

At his Basel speech, Sufi urged central banks to change their models to account for heterogeneity. The Fed has already started. A 2015 paper by its research division looks at how the unconventional monetary policy of the past seven years has affected U.S. unemployment. The paper assumes that households differ in the way they respond to lower rates and in their view of the future, with most households planning no more than five years ahead. For those with such a short-term perspective, the Fed’s success in bringing down rates on loans that mature in 10 years is irrelevant. The paper concluded, however, that loose monetary policy at its peak in early 2015 subtracted an extra 1.25 percentage points from the unemployment rate.

In 2012, Ben Bernanke, Yellen’s predecessor, told economists at the annual gathering of central bankers in Jackson Hole, Wyo., that the Fed’s actions had lowered long-term interest rates and improved financial conditions. “Obtaining precise estimates of the effects of these operations on the broader economy is difficult,” he said. As Yellen considers her next move, that’s true for her, too.

The bottom line: Researchers on Fed policy are discovering that rate cuts affect rich and poor consumers differently.