©2014 by the Kellogg School of Management at Northwestern University. This case was developed with support from the June 2010 graduates of the Executive MBA Program (EMP-78). This case was prepared by Professor Arvind Krishnamurthy and Taft Foster ’13. The authors would like to thank Jonathan Palm Cohen for his research assistance. Cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. To order copies or request permission to reproduce materials, call 800-545-7685 (or 617-783-7600 outside the United States or Canada) or e-mail [email protected] No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise— without the permission of Kellogg Case Publishing.

ARVIND KRISHNAMURTHY AND TAFT FOSTER KEL782

Quantitative Easing in the Great Recession

On October 29, 2008, the Federal Open Market Committee (FOMC) concluded its eighth meeting since the start of the Great Recession eleven months earlier. Continuing its recent pattern, the FOMC voted to cut its target federal funds rate by another 50 basis points, to 1%. Yet despite the lowering of this rate from 4.25% since the start of the year (see Exhibit 1), a variety of economic indicators continued to paint a grim picture. Indeed, the situation appeared to be worsening.

The chairman of the U.S. Federal Reserve, Ben Bernanke, now faced a daunting prospect. As a professor of economics at Princeton, Bernanke had studied a set of tools that a central bank could employ if its policy rate were to be constrained by the zero lower bound. Prominent among these was a tool known as “quantitative easing,” or QE, a policy of making large purchases of financial assets. These purchases increased the quantity of money in the economy, hence the name quantitative easing. In his academic writings, Bernanke had advocated QE as a policy for Japan, where since the late 1990s the Bank of Japan (BoJ) had reduced its short-term interest rate to near zero.1 With the federal funds rate at 1%, the Federal Reserve likely would soon find itself in the same position as the BoJ, namely at the zero lower bound. Bernanke would get a chance to put his academic theories into practice.

The Great Recession and Financial Crisis

What would later be called the Great Recession began officially in December 2007 as a typical economic downturn associated with a spike in oil prices and a decline in home prices, but it quickly became a severe recession due to links between the housing and financial markets. As home prices across the United States and other countries fell in 2006 and 2007, foreclosure rates began to rise; this in turn rendered almost worthless many previously AAA-rated mortgage- backed securities (MBS) that derived their value from pools of mortgages (see Exhibit 2 and Exhibit 3). In turn, uncertainty about which financial institutions held worthless MBS—and which financial institutions insured the losses of those that did—caused what amounted to bank runs on several large financial institutions.

1 See Ben Bernanke, “Japanese Monetary Policy: A Case of Self-Induced Paralysis?” in Ryoichi Mikitani and Adam Simon Posen, eds., Japan’s Financial Crisis and Its Parallels to U.S. Experience (Washington, DC: Institute for International Economics, 2000).

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Early notable victims included Countrywide Financial, which reached a deal in January 2008 to be purchased by Bank of America, and Northern Rock, which was nationalized by the British government in February 2008. Both were heavily involved in mortgage lending and unable to obtain financing through credit markets. Then, on March 16, 2008, the FOMC held an emergency meeting in response to the imminent collapse of Bear Stearns, at that time the fifth largest investment bank in the United States. During that meeting, the Federal Reserve pledged financing for J.P. Morgan to purchase Bear Stearns at $2 per share, less than 7% of Bear Stearns’s market value two days earlier. Six months later, another large investment bank, Lehman Brothers, faced a similar crisis. This time, however, the Federal Reserve was unable or unwilling to provide a bailout, and no buyer could be found. As a result, Lehman Brothers, the fourth largest U.S. investment bank at the time, filed for Chapter 11 bankruptcy protection on September 15, 2008.

On the day of Lehman’s bankruptcy filing, the Dow Jones Industrial Average plummeted 500 points (-4.4%), its largest decline since the attacks of September 11, 2001. Lehman’s downfall created widespread panic in financial markets, as investors scrambled to move their funds out of other potentially at-risk institutions and investments. The multinational insurance giant AIG suffered a liquidity crisis the day after Lehman’s bankruptcy filing. This time, however, the Federal Reserve stepped in to prevent the collapse of AIG by providing a secured credit facility of up to $85 billion. This was followed a week later by the federal takeover of Fannie Mae and Freddie Mac, government-sponsored enterprises (GSEs) that securitized mortgages in the form of MBS. Exhibit 4 shows the magnitude of financial institution write-downs throughout this period.

By the time the FOMC met on October 29, the Dow Jones had dropped more than 2,300 points, or 20.6%, since Lehman’s bankruptcy. Meanwhile, the turmoil in the financial sector was also being felt in the real economy. According to the Federal Reserve’s October 2008 Senior Loan Officer Opinion Survey, credit standards were tightening sharply (see Exhibit 5). Real GDP fell 3.7% during the third quarter of 2008 and the unemployment rate, which was on a sharp upward trajectory, reached 6.5% in October, up from 5% at the start of the recession (see Exhibit 6).

Quantitative Easing

As the economic situation continued to deteriorate following the October 29 FOMC meeting, it became clear that the Federal Reserve would soon be forced to lower its target rate further. With the target rate already at 1%, however, the Federal Reserve did not have much room for further easing. Monetary policy would soon be constrained by the zero lower bound.

The Zero Lower Bound

One way to look at the zero lower bound is through the lens of the Taylor rule. Named after its creator, Stanford economist John Taylor, this mathematical formula indicates how much a central bank should adjust its policy rate in response to changes in inflation, output, or unemployment. More specifically, Taylor proposed the following equation:

∗ ∗

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Applying this equation to the United States, represents the federal funds rate, ∗ is the equilibrium real interest rate, is the inflation rate, ∗ is the Federal Reserve’s target inflation rate, is the logarithm of real GDP, and is the logarithm of potential output. The coefficients

and tell the Federal Reserve how much to adjust the federal funds rate in response to deviations in the inflation rate from its target and to deviations in real GDP from potential output.2

From 1988 to 2007, under first Alan Greenspan and then Ben Bernanke, the Federal Reserve had set the federal funds rate in a manner that could be described by a modified Taylor rule (see Exhibit 1). The main difference between Taylor’s rule and actual Federal Reserve policy was that Taylor proposed, in a paper published in 1993, that the Federal Reserve choose equal to one- half and equal to one-half, whereas the Federal Reserve appeared to choose to be closer to one.3

Beginning in late 2008, the Federal Reserve’s modified Taylor rule began to recommend a negative federal funds rate, something that was impossible to implement. This constraint on the federal funds rate is a consequence of the fact that investors can always earn at least a 0% nominal return by holding cash. As a result, banks will almost never be willing to lend reserves at a rate below 0%, that is, to pay to lend reserves. So, according to the modified Taylor rule, by late 2008, Federal Reserve policy was constrained by the zero lower bound.

Although new to the Federal Reserve, the zero lower bound was familiar territory for Japan’s central bank, the BoJ. In 1995 the BoJ had dropped its target rate below 1% in an attempt to combat deflation and a stagnant economy. This rate remained close to zero for several years, but Japan’s Lost Decade continued unabated. So in 2001, under pressure to do something more to stimulate the Japanese economy, the BoJ became the world’s first central bank to try quantitative easing. Among those calling for increased use of quantitative easing in Japan at that time was Ben Bernanke, then a Princeton economics professor.4 Seven years later, Bernanke had the opportunity to put his theories to the test in the United States.

QE1

On November 25, 2008, the Federal Reserve issued a press release announcing plans to purchase up to $600 billion in financial assets in what would later be referred to as QE1. Of these funds, $500 billion would be used to purchase MBS backed by Fannie Mae, Freddie Mac, and Ginnie Mae. The remaining $100 billion would go to purchase direct obligations (i.e., plain vanilla bonds rather than MBS) of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks.

Over the next four months, the Federal Reserve made four more announcements regarding quantitative easing. On December 1, Bernanke gave a speech in which he described “several

2 The Taylor rule is sometimes written in terms of unemployment gaps rather than GDP gaps, appealing to Okun’s law relating GDP gap deviations to unemployment deviations. In this case, the last term in the Taylor rule is modified from to

, where is the unemployment rate and is the natural rate of unemployment. 3 See John B. Taylor, “Discretion versus Policy Rules in Practice,” Carnegie-Rochester Conference Series on Public Policy 39 (1993): 195–214, and John B. Taylor, “A Historical Analysis of Monetary Policy Rules,” in Monetary Policy Rules (Chicago: University of Chicago Press, 1999), pp. 319–41. 4 See Ben Bernanke, “Japanese Monetary Policy: A Case of Self-Induced Paralysis?” in Ryoichi Mikitani and Adam Simon Posen, eds., Japan’s Financial Crisis and Its Parallels to U.S. Experience (Washington, DC: Institute for International Economics, 2000).

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means by which the Fed could influence financial conditions through the use of its balance sheet,” including purchases of “longer-term Treasury or agency securities on the open market in substantial quantities.”5 Then, on December 16, the FOMC lowered its target federal funds rate to 0%–0.25%, essentially hitting the zero lower bound. The press release for this meeting also stated that the Federal Reserve stood “ready to expand its purchases of agency debt and mortgage- backed securities as conditions warrant” and was “also evaluating the potential benefits of purchasing longer-term Treasury securities.”6 Similar comments were made after the subsequent FOMC meeting held on January 28.7 Finally, on March 18, the Federal Reserve expanded QE1 to include $1.25 trillion in MBS purchases and $300 billion in long-term Treasury purchases.

Although it is impossible to fully identify the effects of QE1 on the economy, some insight about its effects can be obtained using an event study methodology.8 With this approach, key variables are observed shortly before and after each of the five announcements described above. To the degree that these announcements represented the dominant news affecting the market on their respective dates, changes in certain variables around the announcements can shed light on the channels through which QE1 operated, as well as its overall impact. Intraday movements in 10-year Treasury yields and trading volume for each of the event dates provide evidence that the five announcements were indeed the major piece of news on their respective dates (see Exhibit 7). Further evidence for the effects of QE1 can be found in Table 1 below, which displays the two-day changes in the yields of several securities summed across the five event dates. Table 2 contains this same information for federal funds futures at various maturities; the average yield curve before and after the five announcements provide additional evidence (see Exhibit 8).

Table 1: Changes in Yields (in Basis Points) on Select Securities QE1 QE2

5-year Treasuries -74 -17

10-year Treasuries -107 -18

Agency MBS (10-year duration) -107 -12

Baa Corporate Yield -81 -7

Credit Default Swapa -40 2

10-year TIPS -187 -25

a The credit default swap yield in this table corresponds to an index of Baa corporates.

Table 2: Changes in Yields (in Basis Points) on Federal Funds Futures by Maturity QE1 QE2

3rd month -28 0

6th month -27 -1

12th month -33 -4

24th month -40 -11

5 Ben S. Bernanke, “Federal Reserve Policies in the Financial Crisis,” speech at the Greater Austin Chamber of Commerce, Austin, Texas, December 1, 2008, http://www.federalreserve.gov/newsevents/speech/bernanke20081201a.htm. 6 Board of Governors of the Federal Reserve System, press release, December 16, 2008, http://www.federalreserve.gov/newsevents/ press/monetary/20081216b.htm. 7 Board of Governors of the Federal Reserve System, press release, January 28, 2009, http://www.federalreserve.gov/newsevents/ press/monetary/20090128a.htm. 8 See Arvind Krishnamurthy and Annette Vissing-Jorgensen, “The Effects of Quantitative Easing on Interest Rates: Channels and Implications for Policy,” Brookings Papers on Economic Activity, Fall 2011.

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QE1 was executed over a period of sixteen months and concluded when the last of its purchases were made during March 2010. By that time, the U.S. economy was no longer in free fall, but the unemployment rate was 9.9% and the recovery appeared to be proceeding at a slow pace. Meanwhile, dark clouds were forming over Europe, which was showing early signs of a sovereign debt crisis. After months of sluggish recovery and talk of a “double-dip recession,” Wall Street began to speculate about QE2.

QE2

The first official hint of QE2 came on August 10, 2010, when the FOMC announced its plan to “keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities.”9 Prior to this announcement, markets had expected the Federal Reserve to gradually reduce its balance sheet. The announcement indicated a shift toward long-term Treasuries and away from MBS, which had been the focus of QE1. The next FOMC announcement on September 21 reaffirmed this position and added that the committee was “prepared to provide additional accommodation if needed to support the economic recovery.”10 This language was interpreted by many market participants as signaling a new round of asset purchases by the Federal Reserve. For example, Goldman Sachs economists forecasted that the Federal Reserve would purchase up to $1 trillion of Treasuries.11 As a result of these widespread expectations, markets were underwhelmed when, on November 3, the FOMC finally announced its plan to purchase $600 billion in long-term Treasuries.

Applying the event study approach to QE2, there are three possible dates to work with, but because the November 3 announcement was largely priced into the market beforehand, only the August 10 and September 21 announcements are included in the data provided here. Intraday movements in 10-year Treasury yields and trading volumes provide evidence that the QE2 announcements were the major news event on their respective release dates (see Exhibit 9). As with QE1, further evidence can be found in the changes in security yields and the yields on federal funds futures (see Tables 1 and 2), and the average yield curve before and after the announcements provide additional evidence (see Exhibit 10).

QE3

On September 13, 2012, the Federal Reserve launched QE3. It was announced that the Federal Reserve would purchase MBS at a pace of $40 billion per month, and it would purchase longer-term Treasury securities at a pace of $45 billion per month. The Treasury purchases were for the most part expected, but the announcement of MBS purchases took the market by surprise. It indicated a shift back toward MBS, unlike the exclusive focus on Treasury securities in QE2. Of further surprise was the Federal Reserve’s indication that purchases would continue until the

9 Board of Governors of the Federal Reserve System, press release, August 10, 2010, http://www.federalreserve.gov/newsevents/press/ monetary/20100810a.htm. 10 Board of Governors of the Federal Reserve System, press release, September 21, 2010, http://www.federalreserve.gov/newsevents/ press/monetary/20100921a.htm. 11 “FOMC Rate Decision—Fed Signals Willingness to Ease Further if Growth or Inflation Continue to Disappoint,” Goldman Sachs Newsletter, September 21, 2010.

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labor market improved, within the context of price stability. The press release stated, “If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.”12 The open-ended nature of this purchase commitment led some commentators to dub QE3 as “QE infinity.”13

Table 3: Changes in Yields (in Basis Points) on Select Securities QE3

5-year Treasuries -6

10-year Treasuries -3

Agency MBS (10-year duration) -15

Baa Corporate Yield 0

Credit Default Swapa 0

10-year TIPS -11

a The credit default swap yield in this table corresponds to an investment grade index.

Table 4: Changes in Yields (in Basis Points) on Federal Funds Futures by Maturity QE3

3rd month 0

6th month 0

12th month 0

24th month -3

The event study for QE3 involves only one clear-cut surprise date, the announcement date of September 13, 2012. Table 3 and Table 4 provide data on the one-day change in asset prices across the event date.14

The QE Debate

Although Bernanke had been a longtime proponent of quantitative easing and the majority of FOMC members agreed that QE1, QE2, and QE3 were merited, committee members held a wide range of views regarding the policy. Much of the debate surrounded the potential costs and benefits of the Federal Reserve’s actions.

12 Board of Governors of the Federal Reserve System, press release, September 13, 2012, http://www.federalreserve.gov/newsevents/ press/monetary/20120913a.htm. 13 Sam Jones, “Hedge Fund Sceptics Warn on ‘QE Infinity,’” Financial Times, September 25, 2012. 14 See Arvind Krishnamurthy and Annette Vissing-Jorgensen, “The Ins and Outs of Large Scale Asset Purchases,” Federal Reserve Bank of Kansas City Economic Symposium on the Global Dimensions of Unconventional Monetary Policy, Jackson Hole, Wyoming, August 2013.

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Potential Benefits of QE

Janet Yellen, former president of the Federal Reserve Bank of San Francisco and vice chairwoman of the Federal Reserve, was a vocal supporter of quantitative easing. In a January 2011 speech defending the Federal Reserve’s decision to proceed with QE2, she described the policy’s potential benefits:

Turning now to the macroeconomic effects of the Federal Reserve’s securities purchases, there are several distinct channels through which these purchases tend to influence aggregate demand, including a reduced cost of credit to consumers and businesses, a rise in asset prices that boosts household wealth and spending, and a moderate change in the foreign exchange value of the dollar that provides support to net exports.15

She also cited the results of the Federal Reserve’s forecasting model, which predicted that by 2012, “the full program of securities purchases will have raised private payroll employment by about 3 million jobs.”16

In an October 2010 speech, William Dudley, president of the Federal Reserve Bank of New York and another of the FOMC’s so-called inflation doves,17 emphasized the effects of quantitative easing through the mortgage-rate and business-lending channels:

Lower long-term rates would make housing more affordable and support consumption by enabling households to refinance their mortgages at lower rates. This would increase the amount of income left over for other spending. Of course, this channel can be made more powerful to the extent that further progress can be made in efficient mortgage debt restructurings that allow households with negative equity in their homes to take advantage of the drop in mortgage rates. In addition, lower long-term rates would reduce the cost of capital for businesses, thereby fostering higher levels of capital spending for any given economic outlook.18

In addition to the channels emphasized in these speeches, Chairman Bernanke also described the signaling channel of quantitative easing:

Large-scale asset purchases . . . can signal that the central bank intends to pursue a persistently more accommodative policy stance than previously thought, thereby lowering

15 Janet L. Yellen, “The Federal Reserve’s Asset Purchase Program,” speech at the The Brimmer Policy Forum, Allied Social Science Associations Annual Meeting, Denver, Colorado, January 8, 2011, http://www.federalreserve.gov/newsevents/speech/ yellen20110108a.htm. 16 Ibid. 17 The Federal Reserve has a dual mandate to create high employment and keep inflation low. The term “dove” is used to indicate a policymaker who places a greater weight on high employment in this dual mandate, while the term “hawk” is used to indicate a policymaker who places a greater weight on inflation. 18 William C. Dudley, “The Outlook, Policy Choices and Our Mandate,” speech at the Society of American Business Editors and Writers Fall Conference, City University of New York, Graduate School of Journalism, New York City, October 1, 2010, http://www.newyorkfed.org/newsevents/speeches/2010/dud101001.html.

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investors’ expectations for the future path of the federal funds rate and putting additional downward pressure on long-term interest rates, particularly in real terms.19

Furthermore, Bernanke pointed out that during periods of financial crisis like that of late 2008, “asset purchases may also improve the functioning of financial markets, thereby easing credit conditions in some sectors.”20

Potential Costs of QE

In a November 2010 speech, Richard Fisher, president of the Federal Reserve Bank of Dallas and one of the FOMC’s so-called inflation hawks, described the doubts he had about QE2:

I could not state with conviction that purchasing another several hundred billion dollars of Treasuries—on top of the amount we were already committed to buy in order to compensate for the run-off in our $1.25 trillion portfolio of mortgage-backed securities— would lead to job creation and final-demand-spurring behavior. But I could envision such action would lead to a declining dollar, encourage further speculation, provoke commodity hoarding, accelerate the transfer of wealth from the deliberate saver and the unfortunate, and possibly place at risk the stature and independence of the Fed.21

In February 2013, Federal Reserve Governor Jeremy Stein gave a speech on what he saw as overheating in the credit markets. Exhibit 11 and Exhibit 12, which are figures referred to in Stein’s speech, show that inflows into high-yield mutual funds, high-yield exchange traded funds (ETFs), and real-estate investment trus

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