VoxEU Column Global crisis Monetary Policy

Lost in transmission

With the US economy still faltering, some are suggesting it may be time for a third round of quantitative easing. This column explores the transmission mechanism of monetary policy and how it has broken down in recent years. It argues that, in this climate, the Fed would be wise to avoid another bond-buying programme.

The past decade has been characterised by record-low interest rates, which has given rise to a whole new batch of economic literature on global imbalances, or the so-called saving glut. What has attracted much less attention is the fact that – while US Treasury yields have dropped to an all time low – the yield on equity capital has actually risen.

After a series of dismal economic data and the Eurozone crisis slowly but surely spinning out of control, the markets seem to be counting on the Fed to step up to the challenge yet again. Changes in the stance of US monetary policy are in principle transmitted to the real economy in three stages.

  • First, the Federal Reserve raises or lowers its federal funds rate target. Bank reserve provisions are then adjusted to push the actual federal funds rate to approximate the target.
  • Second, the change in the federal funds rate affects other interest rates, including LIBOR and commercial paper rates, Treasury bill and bond rates, and corporate bond yields, as well as the exchange value of the dollar and the valuation of corporate equities.
  • Third, changes in interest rates, the dollar, and the level of equity prices then affect the real economy.

The slew of recent data releases suggests that the US economy has slowed markedly in recent months. With its traditional policy instrument currently set as low as possible, the Fed has few instruments left to ease its monetary policy stance. The Fed may try to convince the markets through its communications that it will keep the federal funds rate at a record low for an extended period of time (Yellen 2011). The Fed may also endeavour to drive up inflation expectations by setting an explicit inflation target of, for instance, between 3% and 4%. Or the Fed may engage in yet another round of quantitative easing.

In 2008 and 2010 the Fed already rolled out 2 bond-buying programs, buying respectively for approximately 1.4 trillion US dollars government bonds, mortgage backed securities and bank debt in 2008/09 and for approximately 600 billion US dollars government bonds in 2010/11. This so-called quantitative easing implies that the Fed actually skips the first step of monetary policies’ transmission mechanism and proceeds directly to step 2 by driving up the price and driving down the yields of longer-term bonds. QE1 and QE2 have been estimated to lower yields by 30 to 100 basis points for the first round and around 20 basis points for the second (Gagnon 2010 and Krishnamurthy 2011).

As my recent research shows (Mees 2011b), the Fed’s easy monetary policy stance in the years leading up to the financial crisis has sparked the refinancing boom and ensuing spending spree. It was primarily through this transmission mechanism that the record-low federal funds rate (compared to pre-crisis years) affected the real economy in the years leading up to the financial crisis (Mees 2011a). Preliminary evidence suggests that the most recent spate of QE2 affected the real economy mainly through a weaker dollar, which reduced imports, and through higher stock market prices, which encouraged (high-end) consumer spending. QE1’s transmission mechanism was somewhat more diffuse, as the large-scale purchases of mortgage backed securities improved market liquidity and removed assets with high risk from private portfolios, which helped to further unfreeze financial markets.

Why the Fed’s accommodating monetary policy affected the real economy mainly through consumption, and less through investment, becomes self-explanatory if you compare the yield on long-term government bonds to the yield on capital, as shown in Figure 1.

Figure 1. Global ex ante earnings yield and real ex ante 10-year government bond yield

Source: Goldman Sachs

The fact that Treasury yields remained puzzlingly low in 2004 and 2005, in spite of the 200-basis points increase in the fed funds rate, has often been attributed to the saving glut (Bernanke 2005). However, the rising ex ante return on capital as shown in Figure 1 is not consistent with the saving glut theory. As Daly and Broadbent (2009) point out, the global increase in the forward yield on quoted equity together with the decline in bond yields implies a sharp increase in the global equity risk premium. Emerging economies’ savings have been heavily skewed towards fixed-income assets, either because emerging economies’ investors are genuinely more risk averse, and/or because they are institutionally constrained to invest in equity capital. Institutional constraints include emerging economies’ underdeveloped financial markets and the reluctance of most Western countries to allow emerging economies’ sovereign wealth funds to invest in equity capital of Western companies.

The rising yield on capital at a time that bond yields worldwide were falling, suggests that something went awry with monetary policy’s transmission mechanism. It may explain why monetary policy had limited traction in the 2000s. While bond yields and capital yields moved largely in sync during the period dubbed the Great Moderation (1982 to 2001), the opposite happened from 2002 onwards. Fuelled by the Fed’s easy monetary policy, the American spending spree in the early 2000s spurred economic growth and savings in China and oil-exporting nations (Mees 2011b).1 These countries subsequently invested a major part of the proceeds in fixed-income assets, driving down bond yields and driving up the global equity risk premium.

The higher equity risk premium does not only discourage investment in general, it also favours sectors in the economy that are characterised by relatively high debt-to-equity ratios (e.g. the financial sector). It may explain why – by the mid-2000s – bank profits accounted for 40% of S&P 500 companies’ profits combined. The “financialisation” of the economy is often attributed to deregulation. However, the combination of low bond yields and high equity risk premiums, which favoured the banks disproportionately, contributed to the financialisation as well. Another consequence of the high equity risk premium is that sectors with high debt-to-equity ratios – which are more profitable because of low finance costs and therefore can offer higher wages – impose a brain drain on sectors with lower debt-to-equity ratios (Philippon and Reshef 2008).

In light of the – at best – mixed results of almost a decade of monetary easing, the Fed would be wise to refrain from bond-buying programmes this time around. If anything, there is still an undue global zest for government bonds (with some notable exceptions, that is).

There is – unfortunately – no easy fix for the high global equity risk premium. The Fed buying stocks instead of bonds, skipping not only the first stage of the monetary policy’s transmission mechanism but part of the second stage as well, does not seem much of a solution. Even if the Fed would manage to drive down the average yield on existing stock, it is unlikely to drive down the marginal yield on capital, which drives investment. Also, the law actually prevents the Fed from buying stocks. And the US would end up looking an awful lot like China with all those state-owned enterprises.


Bernanke, Ben S. (2005), “The Global Saving Glut and the US Current Account Deficit,” The Sandridge Lecture.

Daly, Kevin and Ben Broadbent (2009), “The Savings Glut, the Return on Capital and the Rise in Risk Aversion,” Goldman Sachs Global Economics Paper 185.

Gagnon, Joseph, Matthew Raskin, Julie Remache and Brian Sack (2010), “Large-Scale Asset Purchases by the Federal Reserve: Did They Work?

Krishnamurthy, Arvind and Annette Vissing-Jorgensen (2011), “The Effects of Quantitative Easing on Interest Rates,”

Mees, Heleen (2011a), “US monetary policy and the saving glut”, VoxEU.org, 24 March.           

Mees, Heleen (2011b), “US Monetary Policy and the Interest Conundrum”, Working Paper.

Modigliani, Franco and Larry Cao (2004), “The Chinese Saving Puzzle and the Life-Cycle Hypothesis,” Journal of Economic Literature, Vol. XLII (March 2004) pp. 145–170.

Philippon, Thomas and Ariell Reshef (2008), “Wages and Human Capital in the U.S. Financial Industry: 1909-2006.”

Yellen, Janet L. (2011), “Unconventional Monetary Policy and Central Bank Communications

 1 Modigliani and Cao (2004) suggest that high household’s saving rates that characterise fast-growing emerging economies like China are largely consistent with the life cycle hypothesis.

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