eighteen months, the Fed has been letting its portfolio of assets deflate. This
initiative, prepared and communicated on long ago, rolled out automatically and
gradually, had not really caught the attention of the markets until recently.
It became a major source of anxiety at the end of 2018, much to the Fed’s
surprise, it would appear, as the latter considered it to be no more than a technical
adjustment. If we accept that QE has had positive effects -still a moot point-
we may fear that quantitative tightening (QT) will have a negative impact.
But making QT the key to market developments looks like a step too far.
Quantitative Tightening = Quantitative Frightening
Ben Bernanke, if not exactly the father of quantitative easing (QE)1, at any rate, its most enthusiastic supporter to overcome the impotence of zero interest rate policies, said on one occasion that “the problem with QE, is that it works in practice, but not in theory”2. This joke illustrates the ambiguities surrounding QE analysis, ambiguities that we find again today when it comes to analysing the inversion of QE, or to use the popular term quantitative tightening (QT).
To place the problem in its proper context, bear in mind that the portfolio of assets held by the Fed grew, through successive waves, from around $ 800bn (i.e. 6% of GDP) end-2007 to over $ 4,200bn in 2014 (24% of GDP). Then, the Fed did not sell any assets, but since the end of 2017, it has capped the reinvestment of maturing assets so that this portfolio is automatically shrinking. It represents $ 3,800bn.
Asset purchases were financed by creating central bank money, mainly in the form of bank reserves. When the Fed buys an asset from a bank, it credits its account for the same amount. In the end, the banking system holds reserves well above the legal requirement. One of the major unknowns at the moment is to set the desirable level of the Fed’s balance sheet, and therefore the pace and duration of its normalisation. This amount will depend on the system chosen to manage day-to-day liquidity. In any case, the deflation of the Fed’s balance sheet has often been presented in recent months as a decisive element in monetary tightening. We examine here whether this is indeed the case.
When the Fed first undertook QE, its main aim was to loosen monetary policy, having already exhausted all its room for manoeuvre with interest rates. The use of QE was therefore dictated by circumstance: an emergency response was needed to combat the effects of the financial crisis by inventing new means of intervention even though there was no guarantee that they would work.
Ten years later, the debate over the effects of QE and its transmission channels is still not entirely settled. To assess the risks posed by QT, it is therefore useful, in order to get a clear view of the situation, to provide a recap on the theories that circulated regarding asset purchase policies.
- QE and goods prices – It has perhaps been forgotten now, with many observers expressing fears over QT, but QE was initially vigorously criticised by a large section of the financial community. The initial theory on QE postulated that broad asset purchases by the central bank would debase the currency and trigger a huge inflation shock. In an economy that is at full employment, an increase in the money supply is supposed to have a one-for-one knock-on effect on prices. Neither the US, nor the other countries that implemented QE, were at full employment. In practice, the dollar did not collapse, and inflation did not accelerate following the Fed’s QE1 programme, quite the contrary, and the Fed had to implement QE2 and then QE3 – which some observers saw as having no limits, hence the expression “QE-infinity”. While QE had an effect on the prices of goods, this came about indirectly by showing that central banks were not restricted by the limit of zero interest rates and that, consequently, there was no reason to fear that future inflation would deviate from inflation targets for any length of time. As such, QE most certainly played a part in anchoring medium- and long-term inflation expectations.
- QE and the stock markets – As the direct impact of QE on goods prices seems to have been roughly zero, attention shifted to asset prices, and particularly equity prices. In 2012-2014, some observers attributed the rise of US stock market indexes to the expansion of the Fed’s balance sheet. At first sight, the relationship seemed to make sense (as is often the case between two rising data series, whatever they may be) but the link was completely broken from 2016 on, as the US stock market continued to rise whereas the Fed’s balance sheet was stable. This relationship between QE and the stock market, which is fragile to say the least, forms the basis for the anxiety relating to QT. With the Fed reducing its balance sheet, so the thinking goes, liquidity is bound to dry up, driving down stock market indexes. It is hard to be convinced by a theory that has no theoretical basis and which is not borne out empirically. The rise of the S&P500 cannot be explained by QE, nor can QT explain its fall.
- QE and long rates – According to financial asset theory, long-term interest rates reflect the intrinsic preferences of economic agents as regards the risk-reward balance in different states of nature. The fact that the central bank changes the size or composition of its assets does not change the risk-adjusted return on markets where transactions are free and frictionless. QE challenges this theory head-on since it assumes a “portfolio effect”. Indeed, it postulates that by buying certain assets, such as government bonds, the central bank would prompt investors to switch to other assets, such as private sector loans. This would result in a reduction in interest rates. For this portfolio effect to exist, the investment choices must depend on factors other than financial yields and the different assets must not be perfect substitutes. There are many empirical but contradictory works on the portfolio effect of QE. The impact on long-term interest rates is not clearly established, either in terms of its scope or its persistence.
- QE and forward guidance – The lack of a robust conclusion on the QE-long rate link probably stems from the fact that there have been three waves of QE, conducted in different contexts and with different objectives. The transmission channels for QE1 are not necessarily the same as those of QE2 or QE3 (flow effect vs stock effect, announcement vs implementation). That said, it is hard to deny that, at times, QE has had a decisive impact on interest rate markets. The taper tantrum episode of 2013 is the most striking example. It is no coincidence if the fastest upturn in US long rates post-crisis came as the Fed was adjusting its intentions as regards QE. This change, namely the scrapping of “QE infinity”, may have been interpreted as a signal for the direction of short rates. It is the QE-forward guidance link which is at issue here, then. Those that criticise QE, claiming that it has no influence on long rates, generally acknowledge that it is a tool to strengthen the central bank’s forward guidance. In all events, it is certainly risky to draw conclusions on the expansion (or contraction currently) of the Fed’s balance sheet separately from its intentions on key rates.
- QE and financial stability – The period when QE was implemented coincided with an environment when returns on financial assets were low. In reaching for yield, some investors may have taken on exposure to riskier markets. Against this backdrop, QE may be seen as a stabilising factor. This point was defended by Jeremy Stein when he was a member of the Fed’s board from 2011 to 2014. By saturating the supply of short term assets (creating reserves), the Fed may have also reduced the incentive of the private sector to finance itself in the short term, which is often a characteristic of financial excess. Now that the Fed is reducing its supply of bank reserves, there could, conversely, be an increase in risky financial behaviour.
From the above, we may conclude that QE has not, by any means, had the disastrous effects that some had feared at the outset, such as a collapse in the value of the dollar or widespread financial instability. On the contrary, it has had a positive influence, albeit indirectly and therefore not easily measurable with certainty, in the convalescence of the US economy after the Great Recession. The same reasoning can be attributed to all the other countries that have conducted QE on a large scale (Japan, eurozone, UK).
In the US, based on the works (already cited), we can establish a rough equivalence between QE and cuts in key rates: put simply, $ 300bn of asset purchases are estimated to have the same effect as a quarter-point reduction in the headline rate. The three QE programmes ($ 1.75tn + $ 600bn + $ 1.5tn) are estimated to have added around 300bp of rate cuts, taking the rate below the zero limit. That said, can we conclude from this an equivalence between QT and rate tightening? We have our doubts given the extent to which the context of monetary normalisation is fundamentally different from the financial crisis. However, assuming that this equivalence makes sense, the reduction in the asset portfolio since 2017 equates to a rate increase of 50bp and, at the expected pace of reinvestment in 2019, QT would add another 50bp of tightening. This is what is driving the market’s jitters about the Fed continuing to reduce its balance sheet. Not only is the Fed raising its key rates, but it is also reducing its balance sheet. It is too much!
It is clear that the governors of the Fed were surprised by this sudden swell of anxiety at the end of 2018 since for years the central bank has clearly laid out the ins and outs of its balance sheet policy, even if this has meant adjusting its plans over time. At the outset the principle was that the exiting from extraordinary measures would happen in reverse order to their implementation, as the economy moved further away from crisis/recession conditions. As such, in 2011 when the Fed established the general framework for its future normalisation, it planned to reduce its balance sheet before raising interest rates, which makes sense since, chronologically, QE was put in place after the zero rates policy. The taper tantrum in 2013, by showing how hyper-sensitive the markets are to quantitative measures, upset this order of priorities. The inversion of QE only began at end-2017, i.e. around two years after the first interest rate hike. Not without justification, the Fed considered that it had a better understanding of the mechanisms brought into play by the change to policy rates than those resulting from its balance sheet policy.
For the Fed, whilst the balance sheet policy is an element in the adjustment of its monetary policy, it is a secondary element compared with decisions regarding its policy rates. This is also why adjustments to the balance sheet are made without the need for discussion at each FOMC meeting. It is the automatic nature of this adjustment that must have panicked the markets after the meeting of 19 December 2018. Since then, Jerome Powell and the other members of the FOMC have indicated that they are ready to make adjustments if they prove necessary in order to avoid an overly brutal tightening. These comments cost the Fed nothing but helped to rekindle a degree of confidence. In any event, these setbacks show that the Fed has no strong opinions on the use of the balance sheet policy outside crisis periods. If the Fed were led to adjust QT in the future, it is unlikely that this adjustment will be made independently of any modification to its interest-rate policy (a prolonged pause or a cut in rates). This would therefore require a major change in economic conditions and forecasts for the US.
Bruno Cavalier – Chief Economist ODDO BHF
Fabien Bossy – Economist ODDO BHF