13 - Joseph Gagnon on Quantitative Easing in the United States and Abroad

Episode Summary

Executive Summary: Joe Gagnon explains how he entered macroeconomics and the Fed, then argues that QE works mainly through portfolio rebalancing, with some signaling. He reviews evidence from QE1 and cross-country studies, explains why long rates have trended down for decades, and discusses policy limits in Europe, Japan, and the U.S., urging more aggressive easing, possibly higher inflation targets, and caution on negative rates.

Main Topics: Gagnon’s path into macroeconomics and the Fed (Priority: 3/5): He was drawn to big-picture current affairs, found economics intellectually interesting, and chose the Fed because of its large community of macro economists and policy work in Washington. How QE works and why it was adopted (Priority: 5/5): QE emerged as the Fed hit the zero lower bound and needed alternatives to the federal funds rate; staff explored long-term asset purchases, mortgage-backed securities, and liquidity facilities. Portfolio channel vs. signaling channel (Priority: 5/5): Gagnon defends the portfolio-balance view: buying long-term assets reduces their supply, forces investor rebalancing, and lowers term premiums, though he acknowledges some signaling effects from QE and forward guidance. Evidence from QE1 and the literature (Priority: 5/5): His paper on QE1 estimated sizable effects on long-term yields, and later cross-country work found QE effects in the U.S., U.K., euro area, Sweden, and Japan, with event studies typically showing larger effects than regressions. Why global long-term yields have fallen (Priority: 4/5): He attributes the secular decline in safe yields to demographics, weak productivity, and emerging markets shifting from net borrowers to net lenders; crisis-era risk aversion may also have intensified the decline. Japan, Europe, and the limits of unconventional policy (Priority: 4/5): He praises Abenomics’ early success but argues Japan needed a much bigger push and maybe equity purchases; he is cautiously optimistic on ECB QE, while warning that negative rates have practical and political limits. Implications for the U.S. and global economy (Priority: 4/5): Gagnon argues strong U.S. recovery, a stronger dollar, and weak foreign economies justify keeping U.S. rates low; he also sees Brexit and global slowdown as risks that reinforce the case for easing abroad.

Key Arguments: QE was a necessary response once the policy rate hit zero and the Fed needed other tools to ease financial conditions. The portfolio-balance channel is real: removing long-term safe assets from private portfolios lowers their yields and triggers broader rebalancing. Some of the QE effect may also work through signaling/commitment, but Gagnon thinks that channel cannot explain all observed yield changes. QE1 had a measurable impact on long-term rates, and the effect appears to persist outside crisis panic conditions. Cross-country evidence suggests QE lowers yields in multiple economies, not just the U.S., implying the mechanism is broadly valid. Long-term yields have been falling for decades due to structural forces, so QE is only one factor among many. Japan’s early QE was too timid because it largely bought assets too close to money; later Japanese QE was more effective because it targeted true long-duration bonds. Negative rates can help, but there is likely a practical lower bound near minus 1%, beyond which cash substitution becomes a serious problem. The U.S. recovery has been better than Europe’s partly because policy was more aggressive earlier, which later pushed U.S. yields back up relative to Europe. A higher inflation target, around 3% to 4%, may be needed if policymakers want more room to fight future recessions near the zero lower bound.

Data Points: QE1 size: about $1.75 trillion - Gagnon’s summary of the Fed’s first QE purchase program QE1 yield effect (event study): about 100 basis points - Estimated reduction in bond yields from QE1 announcement-window analysis QE1 yield effect (regression approach): about 50 basis points - Estimated reduction using government net supply of long-term bonds Time before Board staff research access: 6 to 9 months - Initial period at the Fed with relatively little assigned work Negative rate move in Japan: from +0.1% to -0.1% - Bank of Japan’s January move into negative rates Japan inflation change: from about -0.75% to +1.25% - Core inflation rise after aggressive Abenomics-era easing Inflation expectation / target: 2% - Official target discussed for Japan and implicitly for the Fed Core PCE inflation since mid-2009: about 1.5% average - Gagnon’s critique that U.S. inflation has remained below target Potential higher inflation needed for catch-up growth: 3% to 4% - His view of the inflation rate that might have been needed after the crisis U.S. dollar appreciation: over 20% - Rise in the dollar since mid-2014, linked to policy divergence Japan bond market comparison: larger bond market than others - Reason he thinks QE effects may be smaller in Japan unless scaled up

Pivotal Quotes: "I like macroeconomics because I really like the sort of broad focus on the big picture." — Joe Gagnon: Explaining why he gravitated toward macroeconomics "I think that the portfolio channel is part of it." — Joe Gagnon: Summing up his view of how QE affects rates "I think we need the Bank of Japan to step up to the plate now." — Joe Gagnon: Arguing Japan needs a more forceful policy response

Implications: Listeners should expect prolonged reliance on unconventional policy when rates are near zero. The transcript suggests QE can work, but its effectiveness depends on scale, communication, and the broader macro backdrop, with major implications for central bank strategy in the U.S., Europe, and Japan.