Endogeneity and Quantitative Easing

February 7, 2014

The Federal Reserve's use of quantitative easing and stimulus are becoming less and less effective, says John Makin, a resident scholar at the American Enterprise Institute.

Makin identifies "endogeneity" -- a practice of taking measures that can be predicted in advance -- as the culprit behind the decline in the Fed's efficacy. As an illustration, he compares the Federal Reserve's fiscal policy with antibiotics.

  • In biology, endogeneity explains why antibiotics become less effective after repeated use: enzymes evolve to protect the bacteria, resulting in an antibiotic-resistant bacterial gene that can survive against future doses of antibiotics.
  • This dynamic can actually be applied to economic systems. The Federal Reserve uses the Taylor Rule, linking its interest rate with the difference between actual and target inflation and growth rates. Those who can forecast growth and inflation correctly already know in advance what the Fed's response will be to such growth and inflation and they act accordingly. Because these firms have already responded in advance of the Fed's actions, the government's actions do not produce as great of an impact as they might otherwise have.
  • As the Fed continues to respond to economic changes, more and more individuals and businesses can anticipate its responses. As such, changing the interest rate -- just like issuing another round of antibiotics -- does very little, as economic actors have already anticipated the Federal Reserve's actions.

Endogeneity is therefore what ultimately made the Fed's repeated quantitative easing (QE) program ineffective, leading to suggestions that the Fed would "taper" -- that is, ease its QE policy by reducing its bond buying.

Exogenous measures, on the other hand, are those that are not anticipated, Makin explains. And because they are surprises, exogenous events actually do have a perceptible impact on the economy. The 2008 collapse of Lehman Brothers, for example, was an exogenous shock.

Paradoxically, the result of this endogeneity is that it can produce a stronger economy with weaker stocks, or a weak economy with high stock prices. When the Fed initiated QE3 in September of 2012, it encouraged investors to take risks in order to earn higher returns, and this kept stock prices rising. But as the economy grows stronger and investors anticipate a withdrawal of Fed stimulus, investors will drop stocks in exchange for bonds. Oddly, a stronger economy in 2014 might actually be paired with lower stock prices, much like a weak economy increased stock prices last year.

Source: John H. Makin, "Endogeneity: Why Policy and Antibiotics Fail," American Enterprise Institute, January 30, 2014.

 

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