Cleaning Up After the Party is Over: How the Fed Will End Quantitative Easing

With tapering in the air along with holiday cheer, we are getting a lot of questions about how the Fed will end its Quantitative Easing program. This note quickly reviews the QE program and then discusses how the Fed’s asset purchase program will be unwound. Our expected scenario is that sometime in the next few months the Fed will likely slightly reduce the amount of bonds it is buying. Assuming the economy grows at its 2013 pace or stronger, the Fed will likely cease buying new bonds in the second half of 2014. We do not expect major dislocations to the market or the real economy as a result of the Fed’s ultimate termination of QE.

The Fed is currently in the third part of its process of expanding its balance sheet. The Fed intends to buy $85B a month (split between Agency Mortgage Backed Securities and Treasuries), as long as inflation expectations stay anchored and the labor market continues to languish well below potential. Curious readers might want to review the speech incoming Fed Chair Janet Yellen gave about Large Scale Asset Purchase (known on the street as Quantitative Easing) shortly after the expansion of the program was announced.

How do asset purchases effect the money supply?

When the Fed buys bonds on the open market it creates bank reserves to pay for them. Economists call the sum of reserves held at the central bank and paper currency in circulation the “monetary base” or sometimes “high-powered money”. The expansion of the monetary base can only be called dramatic as can be seen in Figure 1, with periods of quantitative easing highlighted.

one

Banks can loan out a multiple of their reserves held at the Fed so in normal times we would expect the expansion of the monetary base to lead to a ballooning of the money supply. On the contrary, as we see in Figure 2, the money supply has been growing at its customary measured pace and does not spike with the QE programs as the monetary base does. This is good and bad news. Good because the runaway inflation many have feared as a necessary consequence of QE is nowhere to be seen: inflation rates and expectations seem locked at very low levels. The bad news is that the Fed cannot stoke the economic furnace through increasing the money supply.

two

What about the printing presses of money?

The dominant metaphor used by the overwhelming majority of market commentators has been that the Fed is printing money to buy bonds. This sounds frightening to all of us who feel a duty to manage our client’s wealth as more money in the system is supposed to generate inflation. It is sort of true that the Fed is issuing money to pay for the bonds it takes on its balance sheet, as noted above reserves are increasing dramatically. But in a much more important sense this metaphor is misleading. The situation is dramatically different than if the Fed was mailing checks to each of us because the potential expansion of the money supply is largely contained in bank reserves at the Fed.

Is this monetizing the debt?

Not really. Monetizing the debt involves the central bank buying the entire bond issue from the government and paying with newly created currency. The Fed does not bid in the treasury auctions – rather they are buying from the open market. In addition, the Fed does not own even a majority of the treasury bonds outstanding. Yes, if the Fed was not buying bonds the yield on newly auctioned bonds would likely be higher, however there is no doubt that the market would clear someplace near current levels.

If banks aren’t lending as a result of QE, how does this help the economy?

If you reduce the quantity of a thing, the price of that thing will rise. The Fed has been steadily reducing the supply of MBS and Treasury bonds available to the market, causing their prices to rise above where they would otherwise be and for yields to fall. For example, purchasing MBSs seems to reduce mortgage rates (see this paper by Fed economists Diana Hancock and Wayne Passmore). There are also indirect effects as when the fall in treasury and MBS yields causes yields of other assets to fall, as well. Clearly lower interest rates will help both consumers and businesses increase economic activity.

What are the costs?

There are no direct costs to the taxpayer as the Fed simply creates the reserves to buy the assets. The downside to these purchases is simply the mirror of the upside: by removing assets from the marketplace, all assets go up in price (by how much depends on how close the asset is to the assets the Fed is buying). Corporate bonds, for example, have probably had their prices driven up (yields driven down) by QE. Fed governor Jeremy Stein has expressed concern that there are signs of bubble-like behavior beginning to show in the corporate credit market. Simply put, both the cost and the benefit of the program is to distort financial markets.

What about inflation?

In normal times a vast expansion of bank reserves would make us worry about inflation. Although it has been five years since the onset of the financial crisis, these still do not seem to be normal times. Banks are flush with reserves but are still not lending as they both need to maintain a strong balance sheet and end users are not demanding credit. Both market and survey based measures of inflation remain “well-anchored.” That is, if we look at inflation expectations implied by the price of inflation protected treasuries or by asking economists, core inflation is supposed to be near the target 2% mark for the next few years. For long term inflation expectations readers can look at the Survey of Professional Forecasters.

When will the Fed stop buying bonds?

Nobody knows! Even the fed does not know. They are likely to begin to scale back purchases in the next six months, though surprises in the economy could quicken or delay that.

What will the mechanics be of ending Large Scale Asset Purchases?

Again, the decision has not been made. Some information was communicated in the minutes from the Fed’s April 2011 meeting and in Chairman Bernanke’s March 2013 press conference. Piecing these and other hints together we expect:

  • Stage 1: The Fed will gradually cut the amount of bonds it buys. The first reduction may be symbolic (the Tiny Taper), taking the monthly purchases from $85B to $75B, for example. Around the same time it reduces the amount of bonds purchased, the Fed may try to give more dovish forward guidance on rates to reduce the impact on the fixed income market.
  • Stage 2: Eventually (perhaps after six to nine months), the Fed will no longer be adding to its stock of bonds. At this point, however, it will still be re-investing coupon and principal payments.
  • Stage 3: The Fed ceases to reinvest coupon and principal payments. This will happen only after substantial improvement in the labor market or higher inflation expectations.

The Fed will still have a lot of bonds. When will they sell their holdings?

The Fed may just let the bonds mature and never sell their holdings. Selling would be a sign that the Fed is quite confident about the economy.

When will the fed raise rates?

Maybe not until 2016. The Fed has a dual mandate, it must pursue price stability and full employment. In the context of inflation rates and expectations for future inflation well below the Fed’s 2% target, the Fed should be patient until the labor market shows substantial improvement. Whether you ask the FOMC members or survey professional forecasters, it will likely take us until the second half of 2015 or early 2016 before the unemployment rate gets below 6%.

-John Eckstein

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