WASHINGTON — It is March 2009. The American economy is rapidly collapsing. The previous month, payroll jobs had dropped by a staggering 650,000. The grim outlook stokes gallows humor. Federal Reserve Chairman Ben Bernanke receives a call from a top Fed official.
"Do you want some good news?" the official asks.
"Please," Bernanke responds.
"Call somebody else."
In this desperate climate, the Fed unleashed a massive program — the ultimate cost approached $4 trillion — to buy U.S. Treasury securities and mortgage bonds. The aim was to ignite a recovery by driving down interest rates. The gamble worked. By mid-year, the economy hit bottom. Its subsequent growth reduced the monthly unemployment rate from a peak of 10 percent to nearly 4 percent by 2017.
The success of the bond-buying program — confusingly called "quantitative easing," or QE — has now become a standard part of the Great Recession narrative. But wait. A new paper by four respected economists challenges the conventional wisdom. It argues that previous studies have exaggerated how much the Fed reduced interest rates. If that conclusion stands, it would dramatically alter our view of the economic recovery.
The present view is straightforward. As the bond-buying program flooded the economy with money, investors who sold their bonds to the Fed were left with cash. They reinvested this money in new bonds, lowering interest rates. Scholarly studies suggest that interest rates dropped about one percentage point on 10-year U.S. Treasury securities. That's huge.
Although the new study didn't explicitly examine the effect on stocks, the same logic is widely believed to apply. Investors who sold bonds to the Fed wanted to reinvest their cash. Some of it was used to buy stocks, supporting the market rally.
Be skeptical, warns the new study.
"The impact of the Fed's [policy] appears to us to be substantially less certain than the current consensus," writes economist James Hamilton of the University of California at San Diego, one of the four authors, on his blog, Econbrowser. "The effect could be substantially smaller than is often believed." However, the study doesn't provide a precise estimate of the impact on interest rates. (The other authors are David Greenlaw of Morgan Stanley, Ethan Harris of Bank of America Merrill Lynch and Kenneth West of the University of Wisconsin.)
This controversial view — if accepted, which is hardly a sure thing — would have two significant implications.
First, it would suggest that the course of interest rates over recent years has been heavily driven by "market forces" — not Fed policy — such as low inflation, weak demand for investment funds or high consumer savings. The same would be true of the stock market boom. It would be driven less by the Fed's easy money policy than by market forces.
Second, it would imply that resuming a bond-buying program as an antidote to the next recession would provide only limited "stimulus" to the economy. Former Fed chairs Ben Bernanke and Janet Yellen have both said that the Fed could initiate a new bond-buying program if the economy falters. Indeed, referring to the Great Recession, Bernanke indicated that bond buying was "the most powerful step we could take."
The disagreement over the bond-buying program involves so-called "event studies." When the Fed makes a policy announcement that might affect interest rates, economists examine financial markets to see what happened that day. Did rates go up or down, as predicted? Many early event studies seemed to find a close correlation between policy pronouncements and rates, leading to the conclusion that "quantitative easing" was a success.
The weakness of this approach is that financial markets — the collective opinion of investors — can change the next day. The new study covered a longer period than earlier studies and found that the connection between policy announcements and interest rates weakened. There's a danger, Hamilton warns, of scholars picking events that confirm their biases.
Granted, this dispute is highly technical. But the underlying question it poses is profoundly important: How powerful is the Fed?