If QE was Mostly Placebo, What about the Unwind?


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During the Great Depression, countries discovered their balance sheets.  Fiscal spending helped augment aggregate demand.  After the WWII, high income countries have typically run persistent deficits, resulting in the accumulation of debt.  During the Great Financial Crisis, central bank balance sheets were discovered.   Central banks bought a variety of assets, but especially their own government bonds.   The idea was that the proximity of the zero bound (zero policy rate) could be overcome through the purchase of bonds and the expansion of the central bank’s balance sheet.  

Some economists have argued that the bond buying by the Federal Reserve lowered the 10-year yield by as much as 85 bp.  We are skeptical.  The Fed did not simply buy long-term securities.  It is better to understand the asset purchases as an asset swap.  The Fed swapped reserves for the bonds.  It took duration out of the market, for sure, but this is not the same thing as getting beyond the zero bound.  Moreover, reducing the term premium of bonds is not the same as cutting the Fed funds rate.

This is important because the Fed has begun allowing its balance sheet to shrink, and some argue that this is tantamount to tightening of policy.  Indeed, Benn Steil and Benjamin Della Rocca at the Council on Foreign Relations warned that the Fed’s balance sheet reduction that has been announced is tantamount to a 100 bp hike in the Fed funds rate by the end of next year.

Steil and Rocca’s concern is that the markets and the Fed do not seem to be aware of this.  They note that neither the Fed’s forecasts (dot plot) nor the Fed funds futures strip through 2019 have reflected the impact of the balance sheet reduction.  They conclude:  “These facts suggest that they [Fed and investors] are largely ignoring-and therefore the greatly underestimating-the tightening impact of the balance-sheet reduction.”

Are the markets and Fed officials as naive as Steil and Rocca suggest?   We do not think that the $450 bln reduction of the Fed’s balance sheet (Oct 2017-Dec 2018) is the equivalent of hiking the Fed funds target rate by 100 bp.  Of course, it must be acknowledged up front that the unwinding the central banks’ balance sheet is unprecedented.

When the Fed announced its first rate hike in the current cycle in late 2015, many observers thought the central bank would have to conduct huge reverse repo operations to solidify its new target.    It didn’t.  It almost seems as if once the Fed lifts its target, market participants accepted it as given.

In a similar fashion, many observers see the QE as easing policy (rather than removing duration) because that is what Fed officials wanted them to believe.  The messaging from the Fed is different now.  The Fed says that the reduction of the balance sheet is a technical operation distinct from its monetary policy goals.    The Fed has been clear on this point.  The Fed funds target range, the upper end of which is the rate of interest it pays on reserves (not just excessive reserves, as is often mistakenly asserted in the media) is the main policy tool.

The power of the Fed’s asset purchases lies in the signaling effect.  In fact, the biggest impact of the asset purchases seemed to be on the announcement.  Yields seemed to rise during the actual purchases. Another example, of how official intentions matter is in Japan.  The Bank of Japan had been engaged in what it calls “rinban” operations for years. These are outright purchases of government bonds.  The BOJ did not call this quantitative easing, and they were not regarded as such by the market.  When BOJ Governor Kuroda announced Quantitative and Qualitative Easing, the outright bond purchases were then seen as part of the extraordinary monetary policy.

Also, we note that the impact of the Fed’s asset purchases is not thought to be constant over time.  Many observers argue that the first round of asset purchases had a greater impact than rounds two and three.  In a similar vein, some observers argue that the ECB’s asset purchases, which began several years after the Fed’s program, have been less effective because it had waited so long, and interest rates were already quite low.

Keynes’ taught that investing is like a beauty contest.  The challenge is not to pick who you think is the most beautiful but who others think is the most beautiful.  The argument we sketch here places a premium on central bank intentions, guidance, and signaling.  The Fed says the shrinking of its balance sheet is independent from the conduct of monetary policy.  As Steil and Rocca note, the Fed’s forecasts and the market pricing seems consistent with that understanding.  Our argument is also consistent with the apparent uneven impact of the asset purchases in the first place.

We are happy to revisit the issue in the middle of next year.  The Fed’s gradual approach to its balance sheet reduction gives investors plenty of time.  Steil and Rocca use an average of purchases for their calculations.  In contrast, we think it is important that this quarter the balance sheet is set to shrink by $30 bln, which is hardly even a rounding error.  In the Q1 18, the balance sheet is to shrink by $60 bln and in Q2 18 by $90 bln.

The Fed funds futures contracts settle at the average effective rate for the month.  The Fed says that three rate hikes next year are likely to be appropriate. The current effective average is 1.16%. The 25 bp rate hike that is nearly fully discounted for next month will lift the effective average to 1.295% in December (due to the meeting on December 13, and assuming a somewhat lower rate at the very end of the year as has been the case at end of quarters this side of the financial crisis).  The effective rate in January (FOMC meeting on last day of the month) implied by the January Fed funds futures contract is 1.39%.

The December 2018 Fed funds futures contract currently implies an effective average of 1.735%.   That seems to be pricing in one hike next year.  We agree with Steil and Rocca that the market is underestimating the extent of next year’s Fed tightening, but we see it through its monetary policy actions, not through its balance sheet.