QE as Stimulus, and more
A macroeconomics textbook staple has central banks lowering interest rates to stimulate an economy, presumably meaning lower unemployment and increased output. We can probably take the intention at face value. Whether and when lower rates stimulate and how the rate tools work are more ambiguous, and interesting. Central banks don’t just move a dial that says “rates” that’s connected by a big gear to growth and employment. In the case of QE, the post great recession tool of choice, central banks became a massive buyer of both distressed commercial and highly rated government medium-term interest-bearing assets. The reliable laws of supply (decreasing as assets were retired to central bank balance sheets) and demand (increased liquidity as purchases were made) meant those assets’ value increased, and their yields (realized interest rates) decreased. So far, nothing new.
Digging deeper, one question is what asset sellers did with the QE proceeds. This is a hard question, but the short answer is they bought other assets, thereby at the margin increasing prices and decreasing yields in those markets. And the sellers of those assets bought other assets, and so forth until we really don’t the full extent of asset markets affected. We are pretty sure that QE increased asset values and decreased yields in the distressed and medium-term government debt markets where it was mainly executed. It was supposed to. Economists thankfully still agree on supply and demand. They don’t agree on the degree that QE driven asset inflation spread outside its target markets. Evidence varies, but it almost certainly did.
To that extent QE succeeded. The yield curve flattened, medium and longer-term rates dropped as asset values increased. The economy also recovered simultaneous with the QE program: growth returned, and unemployment dropped. The bigger question is, did QE and the resulting lower rates drive the recovery and if so, how, how much, and perhaps how not? Empirical analysis as always can only establish correlation since we can’t know the counterfactuals. In the rest of the post, I look at some channels that QE-driven low interest rates can take through an economy, and admittedly, speculate heavily on the effects that these rates can have or not as they move through those channels.
Channel 1: lower interest rates can spur consumption, the main component of GDP. For the channel to work consumers borrow and lenders lend for increased consumption. After a credit crisis, like in 2008, lenders may not be able (due to regulations or capital requirements) or willing (after getting burned) to lend, and consumers may be shedding debt. Policy rates may also not carry over into rates charged on consumer debt. Effects of this critical channel can be quickly muted, and after a credit crisis is perhaps not a prudent way to stimulate an economy anyway.
Channel 2: the wealth effect of higher asset prices can stimulate asset holders’ consumption. Portfolio values did increase as asset values rose across a wide range of markets, though how much QE as opposed to other factors affected which asset markets in uncertain. The wealth driven consumption effect is limited to those with sizable investment portfolios, but spending on high-value consumption goods and services can stimulate employment and further consumption (and increase GDP). All other things equal, wealth (but not income) inequality can increase if this channel is dominant and gains mainly go to those with large asset portfolios. The return of ostentatious spending post-crisis may lend some credence to the openness of this channel. At the same time, lower refinance mortgage rates helped a much larger segment of the population.
Channel 3: lower interest rates can lower the cost of and increase demand for investment, increasing GDP. This occurs in varying and sometimes opaque ways, and probably differently at different points in the recovery cycle. For recently lowered rates to work, an investment all other things equal must still yield a good return with businesses wanting to expand, which is less likely in a weak economy when low interest rates prevail. Investors will need to adjust their WACC to the new rates, though evidence indicates they may not. Banks’ ability and willingness to lend, as with consumer lending, may be complicated by post-recession bank and regulatory policies. More clearly, lower rates can increase existing companies’ profits as interest costs fall, assuming they still qualify for loans. Whether companies distribute (higher impact) or retain (lower impact if not invested) profits will influence the final effects. Many companies post-2008 retained profits or even borrowed at low rates to buy back their shares. The latter can have a wealth effect like Channel 2 if stock prices rise.
Reduced investment hurdles can be a double-edged sword that we will get back to. At the margin lower rates can help both in funding and maintaining high debt businesses that would otherwise not get funded or go bankrupt if rates were higher. These businesses employ people and their production contributes to GDP, or their not failing can keep GDP from falling. But, if their survival is based on QE driven low rates, dangers may loom. The collapse of the risk premium is perhaps more a factor than QE, though the two are almost certainly related. The drop in risk premia seems to happen later in recoveries as investors seek yield in a low rate environment and reembrace risk, though much more substantiation is needed.
Channel 4: lower interest rates can lead to higher saving and decreased consumption in some cohorts, lowering GDP (unless there is a shortage of investment capital). Lower interest rates decrease income from fixed assets, decreasing their compounding and anticipated retirement income, incentivizing people to consume less both in retirement and while saving for it. The channel mainly affects older consumers (say 50+), who are an increasing percentage of the population, and/or those reliant on insurance/annuity products with payouts at risk from low rates. The effect may also incentivize retirees to put off retirement, potentially putting downward pressure on wages and consumption in other parts of the economy. Lower interest rates can drive prices upwards in a range of fixed assets, particularly housing, small business purchases, and small business leases. Effects are complex, but higher costs can lead to more saving and less consumption to reach the hurdles required for acquisition.
There are other channels, some of which may be open at different times. The above is hopefully illustrative enough to make the point that “it’s complex,” when talking about how lower interest rates and particularly those driven by QE affect an economy. There are any number of partial conclusions, open questions, paths to follow, and points to make when looking at the complexity of this problem. I am only going into one more in this section.
It may well be that QE mainly affected asset markets, and by increasing the value and decreasing the yield of existing assets. It is questionable how much that helps stimulate an economy, but it can through the wealth effect (not without other consequences) and later by keeping marginal companies afloat and get new ones floating. I am searching for better data on the various stocks and flow in asset markets during the relevant period and leading up to the present one. QE would presumably have worked best in its stimulating capacity if new assets were created in response to the lower rates, rather than increased liquidity circulating around bidding up prices of existing assets. Given the weak investment response of major companies sitting on huge cash hoards, a lack of investment capital was probably not the reason the economy did not grow faster, sooner. It is also not clear that QE really was stimulating through other channels, though it may well have been.
We need to figure this out though. Partially so that QE or central bank policy can be better understood and executed more effectively in the future, or not executed at all. We also need to figure it out to better understand what will or will not likely happen as QE unwinds. That gets to the next entry in this series.