The Fed's Asset Purchases Don't Work So The Question Is: "when will the Fed first raise the interest rate paid on reserves?"

First up Casey Research:

Federal Reserve Policy Failures Are Mounting

The Fed's capabilities to engineer changes in economic growth and inflation are asymmetric. It has been historically documented that central bank tools are well suited to fight excess demand and rampant inflation; the Fed showed great resolve in containing the fast price increases in the aftermath of World Wars I and II and the Korean War. In the late 1970s and early 1980s, rampant inflation was again brought under control by a determined and persistent Federal Reserve.

However, when an economy is excessively over-indebted and disinflationary factors force central banks to cut overnight interest rates to as close to zero as possible, central bank policy is powerless to further move inflation or growth metrics. The periods between 1927 and 1939 in the U.S. (and elsewhere), and from 1989 to the present in Japan, are clear examples of the impotence of central bank policy actions during periods of over-indebtedness. 

Four considerations suggest the Fed will continue to be unsuccessful in engineering increasing growth and higher inflation with their continuation of the current program of Large Scale Asset Purchases (LSAP):

• First, the Fed's forecasts have consistently been too optimistic, which indicates that their knowledge of how LSAP operates is flawed. LSAP obviously is not working in the way they had hoped, and they are unable to make needed course corrections.
• Second, debt levels in the U.S. are so excessive that monetary policy's traditional transmission mechanism is broken.
• Third, recent scholarly studies, all employing different rigorous analytical methods, indicate LSAP is ineffective.
• Fourth, the velocity of money has slumped, and that trend will continue—which deprives the Fed of the ability to have a measurable influence on aggregate economic activity and is an alternative way of confirming the validity of the aforementioned academic studies.

1. The Fed does not understand how LSAP operates
If the Fed were consistently getting the economy right, then we could conclude that their understanding of current economic conditions is sound. However, if they regularly err, then it is valid to argue that they are misunderstanding the way their actions affect the economy.

During the current expansion, the Fed's forecasts for real GDP and inflation have been consistently above the actual numbers. Late last year, the midpoint of the Fed's central tendency forecast projected an increase in real GDP of 2.7% for 2013—the way it looks now, this estimate could miss the mark by nearly 50%.

One possible reason why the Fed have consistently erred on the high side in their growth forecasts is that they assume higher stock prices will lead to higher spending via the so-called wealth effect. The Fed's ad hoc analysis on this subject has been wrong and is in conflict with econometric studies. The studies suggest that when wealth rises or falls, consumer spending does not generally respond, or if it does respond, it does so feebly. During the run-up of stock and home prices over the past three years, the year-over-year growth in consumer spending has actually slowed sharply from over 5% in early 2011 to just 2.9% in the four quarters ending Q2.

Reliance on the wealth effect played a major role in the Fed's poor economic forecasts. LSAP has not been able to spur growth and achieve the Fed's forecasts to date, and it certainly undermines the Fed's continued assurances that this time will truly be different....MORE

... 3. Academic studies indicate the Fed's efforts are ineffectual
Another piece of evidence that points toward monetary ineffectiveness is the academic research indicating that LSAP is a losing proposition. The United States now has had five years to evaluate the efficacy of LSAP, during which time the Fed's balance sheet has increased a record fourfold.

It is undeniable that the Fed has conducted an all-out effort to restore normal economic conditions. However, while monetary policy works with a lag, the LSAP has been in place since 2008 with no measurable benefit. This lapse of time is now far greater than even the longest of the lags measured in the extensive body of scholarly work regarding monetary policy.

Three different studies by respected academicians have independently concluded that indeed these efforts have failed. These studies, employing various approaches, have demonstrated that LSAP cannot shift the Aggregate Demand (AD) Curve. The AD curve intersects the Aggregate Supply Curve to determine the aggregate price level and real GDP and thus nominal GDP. The AD curve is not responding to monetary actions, therefore the price level and real GDP, and thus nominal GDP, are stuck—making the actions of the Fed irrelevant....

And From EconBrowser:

Estimates of the effects of the Fed's large-scale asset purchases

I attended a conference this weekend on lessons from the financial crisis for monetary policy. Among many interesting presentations, Federal Reserve Bank of San Francisco President John Williams provided updated estimates on the effectiveness of large-scale asset purchases and forward guidance.

President Williams's analysis included a survey of academic studies of what effects the Fed's large-scale asset purchases seem to have had. The table below summarizes estimates that have been arrived at using a number of alternative data sets and methodologies for what we could expect to be the consequences for the 10-year Treasury rate of an additional $600 billion in Fed purchases....MORE

Using the above table as a guide, that suggests a difference of perhaps 2.5-5 basis points (that is, less than 0.05 percentage points difference in the annual yield) on a 10-year Treasury. Even if you double or triple that by adding in the consequences of MBS purchases, it's hard to see this as the #1 news event with which financial markets should be gripped.

The real question is not when will the Fed begin to reduce the rate at which it purchases Treasury securities, but instead should be, when will the Fed first raise the interest rate paid on reserves? That, rather than a change in large-scale asset purchases, is the key date to be watching for.