Gagnon: Michael Woodford’s Unjustified Skepticism

I'm not as skeptical as Michael Woodford about the ability of monetary policy to stimulate the economy, but I'm not as optimistic as many others. I think it can help some, and that the expected benefits exceed the expected costs, but it's not going to make a dramatic difference in the recovery (hence my continued calls for additional fiscal policy to provide an additional boost). One of the people who is more optimistic than I am is Joe Gagnon, and he takes on Woodford's "unjustified skepticism" about the ability of monetary policy to provide economic stimulus:

Michael Woodford’s Unjustified Skepticism on Portfolio Balance (A Seriously Wonky Rebuttal), by Joseph E. Gagnon: In his recent speech at the Federal Reserve’s annual Jackson Hole conference, Professor Michael Woodford of Columbia University attempted to pour cold water on the idea that the Fed’s purchases of long-term bonds (also known as quantitative easing) could lower bond yields.¹ His contention was that the portfolio balance effect of such purchases would be minimal at best. I disagree, as do the bulk of central bankers. This debate matters because, if Woodford is right, the Fed’s only tool for delivering more stimulus now is to commit to future policy actions that may be viewed as undesirable when they occur—such as promising not to raise interest rates when inflation returns. If the market were to doubt such a commitment from the Fed, the Fed would lose its ability to steer the economy. In reality, the portfolio balance channel gives the Fed a tool to guide the economy without unduly restricting future policy choices. This is not to deny, however, that Fed statements about future policy intentions may have important effects.

Woodford devotes several pages in his Jackson Hole remarks to discussing a paper I wrote two years ago with former Fed colleagues Matthew Raskin, Julie Remache, and Brian Sack. We showed that Fed purchases of long-term agency and government bonds in 2008 and 2009 lowered a range of long-term interest rates. We argued that most of those declines appeared to reflect a reduction in term premiums rather than a reduction in expected future short-term interest rates. We posited that those reductions in term premiums were required to induce investors to accept the shift in their portfolios engendered by the Fed’s purchases; this is what Nobel Laureate James Tobin and others have long referred to as the portfolio balance effect. Woodford asserts instead that most or perhaps all of the declines in bond yields might have been caused by the market’s interpretation of the Fed’s statements and actions as indicating that the path of future short-term interest rates would be lower than previously expected.

Our paper, and more recent papers, presented evidence that counters most of Woodford’s empirical claims (D’Amico and King 2010, Neely 2010, D’Amico, English, Lopez-Salido, and Nelson 2011, Hamilton and Wu 2012, and Li and Wei 2012).¹ The evidence shows that Fed purchases affected the prices of a broad range of assets at once, not just the prices of those bonds being purchased directly. Some Fed statements and actions clearly had no implications for the path of future short-term rates, and yet they still affected some asset prices. This evidence comes from a range of investigations, not solely from event studies, and the conclusion is not sensitive to changes in the underlying model used to identify movements in the term premium. These effects of Fed asset purchases are fully consistent with what would have been expected based on data from before the financial crisis, and with the portfolio balance view.

Readers are encouraged to check out the above papers for more on the empirical case for a portfolio balance effect as well as an Econbrowser post in response to Woodford by Jim Hamilton. In the remainder of this post, I focus on Woodford’s theoretical arguments against portfolio balance. I find them unpersuasive. For more theoretical arguments for and against portfolio balance, see a post by Cohen-Selton and Monnet on the Bruegel blog. ... [makes theoretical points] ...