Quantitative Easing in the 1930s October 2018 Christopher Hanes Department of Economics State University of New York at Binghamton P.O. Box 6000 Binghamton, NY 13902 (607) 777-2572 [email protected] Abstract: During the 1934-39 recovery from the U.S. Great Depression, overnight interest rates were usually at a lower bound while American monetary authorities followed policies related to today's debates on quantitative easing (QE): they tried to stabilize Treasury yields with open market operations; they created rapid growth in high-powered money; and they allowed transitory factors to affect high-powered money. I find relationships between these policies and bond yields that reveal a portfolio effect of short- duration asset supply on term premiums, and help explain why trend high-powered money growth was associated with recovery of real activity over 1934-39. JEL codes: E43, E52, G12, N12, N22 Acknowledgements. For comments and suggestions, thanks to William English, John Fernald, James D. Hamilton, Barry Jones, Edward Nelson, Gary Richardson, Eric Swanson, Susan Wolcott and Wei Xiao; to participants in the Federal Reserve Bank of San Francisco conference “The Past and Future of Monetary Policy,” March 2013; the Yale Economic History workshop; NBER DAE Summer 2014; Federal Reserve Bank of Cleveland workshop; Rutgers University Economic History Workshop. During the post-2009 recovery from the Great Recession, the Federal Reserve tried "quantitative easing" (QE) to influence bond yields while short-term rates appeared to be near a lower bound. In QE a central bank acquires long-term bonds, usually Treasury bonds, in exchange for newly-created reserve balances. One immediate effect is to shorten the average duration of bonds left in the hands of the public. Another is to increase the supply of high-powered (base) money at a time when the usual channel from money-supply changes to financial conditions, through changes in overnight rates, is ineffective. Policymakers' goal was to reduce yields on bonds issued by private borrowers, such as corporate bonds, to spur spending and real activity. QE might lower yields through expectations of future overnight rates, by convincing market participants that policymakers will hold overnight rates low for longer. This is called the “signalling channel.” But many advocates of QE claim QE squeezes down premiums that keep long-term rates above expected future overnight rates, through "portfolio-balance" effects. Portfolio-balance effects are controversial (e.g. Greenlaw et. al. 2018). Event studies find statistically significant changes in yields around announcements of coming QE operations, but it is hard to rule out the possibility these were due to the signalling channel (Bernanke, Reinhart and Sack, 2004; Krishnamurthy and Vissing-Jorgensen, 2011 and discussion; Gagnon et. al. 2011; Wright, 2012; Woodford 2013; Bauer and Rudebusch 2014). To disentangle portfolio effects from signalling, studies estimate time- series models of overnight-rate determination and factors other than QE that could affect term premiums (Gagnon et. al. 2011; Hamilton and Wu 2012; D'Amico et. al. 2012). But their conclusions depend on debatable assumptions about the process determining the overnight rate (Woodford 2013; Bauer and Rudebusch, 2014). As a matter of theory, portfolio effects do not exist in standard representative-agent asset-pricing models (Eggertsson and Woodford 2003). In current literature many arguments for portfolio effects (e.g. Krishnamurthy and Vissing-Jorgensen, 2011; Gagnon et. al. 2011; D'Amico et. al. 2012) refer instead to the "preferred habitat" theory of Modigliani and Sutch (1966) as formalized in a model by Vayanos and Vila (2009). In that model, an operation like QE can reduce term premiums because it reduces the average duration of bonds held by risk-averse investors, and hence reduces the extra return they require to bear duration risk. During the post-1933 recovery from the Great Depression, American short-term rates also appeared to be near a lower bound. American monetary authorities did not buy bonds to drive down long-term interest rates. But they did follow policies that increased high-powered money. And they often tried to influence bond yields by buying and selling Treasury bonds in the open market. Their goal was to stabilize Treasury yields - to stop sudden increases or decreases in bond prices. In this paper I examine effects of those policies, guided by current views of portfolio effects. I help solve an old puzzle about the 1934-39 era. I also find relatively unambiguous evidence for portfolio effects and for central banks' ability to influence long-term yields, including corporate yields, through QE. To apply current views of portfolio effects to 1934-39 I must account for the extremity of financial- market conditions in that era. After 2009 overnight lending markets remained active (though at diminished volume) with positive (though low) interest rates that varied from day to day (Gagnon and Sack 2014). Through most of 1934-39, on the other hand, the return to safe overnight lending was simply zero. Under this condition, I show, a model following Vayanos and Vila (2009) implies that term premiums can be lowered by an increase in high-powered money, whether or not the increase is accompanied by a change in bond supply. That is because the public’s willingness to hold money - a safe asset paying no interest - is governed by a tradeoff of its relatively low return against its freedom from duration risk. Thus demand for such money is negatively related to the expected return to holding bonds; an increase in the outside supply of money lowers term premiums. For 1934-39, this implies that an increase (decrease) in high-powered money could cause a decrease (increase) in medium- and long-term bond yields. Such a mechanism would help solve an old puzzle about 1934-39: trend growth in high-powered money appears to have affected real activity even though it had little if any effect on short-term nominal interest rates. Due to policies on international gold inflows and sterilization, trend high-powered money growth was rapid over 1934 through December 1936, about zero from December 1936 to late 1937, and rapid again after that. Trend growth in real activity followed the same trajectory after the usual lag of about six months in real effects of monetary-policy innovations (e.g. Christiano, Eichenbaum and Evans 2005): 3 output and employment grew rapidly after 1933 until the downturn of a recession in June 1937; real growth resumed in July 1938. To explain the coincidence it has been argued that high-powered money growth, or policies resulting in high-powered money growth, boosted real activity by creating expectations of future inflation which lowered long-term real interest rates (e.g. Bernanke, Reinhart and Sack 2004:18-19; Eggertsson and Pugsley 2006; Eggertsson 2008). According to Romer (1992: 775-76) "nominal interest rates were already so low that there was little scope for a monetary expansion to lower nominal rates further. Therefore, the main way that the monetary expansion could stimulate the economy was by generating expectations of inflation and thus causing a reduction in real interest rates." I show trend high- powered money growth was in fact accompanied by substantial declines in medium- and long-term nominal yields consistent with a portfolio effect of high-powered money growth on term premiums. Thus, whether or not trend high-powered money growth boosted expected inflation, it could have stimulated real activity simply by reducing longer-term nominal interest rates. But was this mechanism actually present in the 1930s? To test that, I examine effects of factors causing short-term fluctuations in high-powered money. Throughout 1934-39, payment flows between the banking system and the Treasury’s Federal Reserve accounts (like the 1990s Treasury-payment shocks studied by Hamilton [1997]) created shocks to high-powered money that were essentially transitory and exogenous to financial-market conditions. Through portfolio effects, these shocks should have tended to affect bond yields. At the same time, also through portfolio effects, monetary authorities’ yield-stabilizing operations should have tended to counteract effects of these high-powered money shocks on yields. Yield- stabilizing operations were rare prior to July 1936. They became routine after that. Thus, if my hypothesis is correct, high-powered money shocks due to Treasury payments should be observed to affect bond yields from 1934 up to July 1936. Their effects should be weaker or absent after that. I examine weekly data on yields and high-powered money-supply factors and find this was indeed the case, for both Treasury and corporate yields. This is relatively unambiguous evidence for portfolio effects because the apparent relationship between yields and high-powered money shocks up to July 1936 cannot be accounted for by 4 the signalling channel. Within 1934-36, high-powered money shocks due to Treasury payments signalled nothing about future monetary policy or overnight rates. Finally, I check whether their apparent relationship to yields over 1934-36 was due to portfolio effects of correlated changes in bond supply, rather than shocks to high-powered money. To do this I use newly constructed weekly series on Treasury debt issuance. I find distinct evidence of a high-powered money effect. To begin, I review current literature on portfolio effects of QE. Then I use a version of the Vayanos and Vila (2009) model to illustrate the portfolio effect of high-powered money on bond yields that exists when there is no return to safe overnight lending. In the third section I review the history of monetary policy, short-term interest rates and bond yields in the 1930s, and explain how a high-powered money portfolio effect helps account for the relationship between trends in high-powered money growth and real activity over 1934-39.