Can the Fed phase out quantitative easing (QE) without causing financial and economic instability in both the United States and its trading partners?

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Mohandass Kalaichelvan's picture

Since 2007, the central banks of the US, UK, Japan and the Eurozone, have engaged in a gargantuan effort to provide liquidity and stability to the financial markets. Although the initial response focused on preventing a complete collapse, subsequent efforts have been centered on nurturing growth and capital flow through the use of conventional and unconventional monetary policies such as quantitative easing (QE). In the US, QE has gained prominence as the brainchild of departing Fed Chairman Ben Bernanke. Over the last 5 years, QE has involved large-scale purchases of financial assets, including long-term government bonds and mortgage-backed securities to the tune of US$85bn a month. Despite its critics, this era of ultra-low interest rates has aided the recovery of the US which posted a GDP annual growth rate of 3.7% in the second half of 2013, a rate unseen since 2003[1]. The Fed has taken the positive macroeconomic indicators of positive GDP growth and falling unemployment in the US as signs that the time has come for the wind-down of QE with Bernanke reducing the buyback to US$65bn in his last FOMC meeting as the Fed Chairman. This essay seeks to explore the impact of the Fed taper on the financial and economic stability of the US and its trading partners, particularly the emerging countries.

The performance of the financial sector has a direct impact on the real economy. The era of ultra-low interest rates has seen the increase in prices of assets such as equities, real estate and fixed-income instruments which have contributed to the rise in household wealth, consumer spending and a positive business sentiment. Whether lower interest rates have directly contributed to those increases in asset prices is a whole different question. Although the increase in bond prices is unambiguously linked to the low-interest rate environment[2], the corresponding effect on equity prices is far less certain. When the Fed first mooted the possibility of tapering in June 2013, the S&P 500 fell by about 1.4%[3]. During the September 2013 FOMC meeting, the Fed announced that tapering would be delayed and the S&P 500, NASDAQ and the Dow increased by 1%. Although it would be tempting to draw a negative relationship between tapering and stock market performance, there is no strong empirical evidence that suggests that such isolated daily movements should persist over the longer term since a variation of 1% is within the normal daily variation of developed stock markets[4]. Although theory suggests that ultra-low rates could increase equity prices in the long-run[5], the P/E ratios for the S&P 500 index have not moved outside the range of the typical long-run averages during this period[6]. Hence, the paper asserts that while the Fed taper will lower bond prices and affect bond investors drastically, US equity prices should not be fundamentally affected in the long-run.

The future of rising interest rates will have macroeconomic ramifications for the US. Although the Fed, with its Delphic forward guidance, seems to be on an auto-pilot mode in terms of winding down its QE program, the markets are still expected to react unfavorably in the short-run. Market volatility will increase once liquidity dries up and this increased volatility will have ripple effects in the form of fire-sales of declining bonds and other assets that are liquidly traded. The perpetuation of uncertainty in the markets could trickle down to the real economy in terms of individuals and firms cutting down consumption and expenditure on goods and capital expenditures respectively.

The taper will not be painless for the US government and other advanced economies. The low-rate environment of the past 5 years has allowed governments to increase their level of debt, with bonds outstanding rising by US$11tn since 2007[7]. The Congressional Budget Office estimates that rising interest rates could cause the US government’s net interest costs to double relative to the size of the economy over the next decade, from 1.25% of GDP in 2013 to more than 3% by 2023[8]. Hence, rising interest expenses on outstanding debt will place an additional burden on the US and other advanced economies.

This era of ultra-low rates has also benefitted non-financial corporations and “Main Street” firms. The lower cost of borrowing allowed firms in the US to increase corporate profits by 5% last year[9].  However, this source of profit will be erased when interest rates rise. Most importantly, the rise will disproportionately damage companies in capital-intensive industries such as utilities, manufacturing and mining since these possess low levels of capital efficiency[10]. Hence, one of the macroeconomic ramifications of the taper could be the loss of jobs in such capital-intensive industries which account for a sizeable percentage of the US workforce.

Although the Fed ultimately determines the financial conditions in the US, it possesses the power to influence the financial and economic stability of its trading partners, particularly emerging countries.  The era of QE has been a boon for emerging nations: the search for yield has seen financial capital flow[11] to these regions. Lim et al. assert that the financial inflows to developing economies due to QE operate along three potential channels of transmission: (1) portfolio balance channel, (2) liquidity channel and the (3) confidence channel[12]. Between 2000 and 2013, annual gross capital inflows to developing countries grew by an order of magnitude, to US$1.8tn (annualized)[13]. Emerging world equity markets experienced substantial gains and a substantial appreciation of their real exchange rates.

Despite the positive impact of capital inflows, the initial fears of emerging countries over unmanageable financial inflows have since been compounded by disorderly capital flow reversals brought about by the Fed taper[14]. In January 2014, the Fed decided to scale back its asset purchases by another US$10bn a month without acknowledging the impending volatility in emerging markets. Critics have come down hard on the manner of the Fed’s winding down of the QE program. India’s central bank governor, Raghuram Rajan, hit out at the US for running selfish economic policies at the expense of emerging markets that had helped the world pull out of the 2008 financial crisis[15].

Since the Fed taper, emerging countries such as India, Turkey and South Africa have seen investors pull close to US$12bn from their stock markets in response to rising interest rates in the US and advanced economies[16]. Despite intervention from these countries’ central banks through the raising of interest rates, there is a global negative sentiment surrounding emerging markets. The main danger of raising interest rates is the risk of inflation in these emerging nations. Eichengreen and Gupta also argue that largest impact of tapering would be felt by emerging countries that had (1) allowed exchange rates to run up most dramatically in the earlier period of expectations of continued easing on the part of the Fed and (2) countries that had allowed the current account deficit to widen the most.

Although it is hard to directly quantify the link between the Fed’s tapering and the financial imbalances in emerging nations, Lim et al. run compelling scenario analyses in which they simulate the effects of a QE withdrawal on inflows to emerging countries, relative to a status quo scenario. The authors conduct 3 tapering simulations[17] and find that when the Fed issued forward guidance that it would begin the taper, the inflows to developing countries decline by a cumulative amount of between 10 and 12 percent[18]. Additionally, Lim et al. also caution that their scenario analyses could be severely under-estimating the financial outflows[19].

Although there are several financial and economic implications for the US and the emerging countries in particular due to the taper, I am not advocating that QE continues indefinitely. Despite its purported benefits, QE has created an artificial economic environment predicated on ultra-low rates and the Fed must ensure that the markets are given time to regain their efficient allocative capabilities when interest rates rise again. Beyond trying to maintain stability and growth in the US, the Fed must take concrete action to ensure global financial and economic stability. Amidst the taper, Malpass asserts that the Fed must return to a less distortive monetary policy that advocates a credit policy which reduces financial system risk. To reduce the impending financial and economic instability in emerging countries, this paper advocates for the US to oversee an international committee that focuses on implementing capital account restrictions to manage large volatile capital outflows. Sabarowski et al. find that the tightening of outflow restrictions can indeed be effective in terms of stabilizing domestic exchange and interest rates if supported by strong economic fundamentals and good institutions. In conclusion, this paper believes that while it may be nearly impossible for the Fed to phase out QE without causing financial and economic ripple effects in the US and the rest of the world, it can undertake measures to alleviate the impending volatility. After unleashing the effects of QE upon the world, such action would be the least the US can do to ensure a healthy global financial ecosystem in the near future.

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[2] In the US, the aggregate bond index was about 37% higher on average in 2012 than in 2007. In the UK, the bond index increased by about 16%; in the Eurozone, it was up by 29%. On a mark-to-market basis, the value of sovereign bonds in the US, the UK, and the Eurozone increased by US$10.8 trillion. (Source: McKinsey Global Institute)

[4] Source: McKinsey Global Institute

[5] Ultra-low rates could boost equity prices by (1) lowering the discount rate that investors use, (2) portfolio rebalancing and (3) directly increasing corporate profits through lower debt service payments and through stronger economic growth. (Source: McKinsey Global Institute)

[6] Source: McKinsey Global Institute

[7] Source: McKinsey Global Institute

[8] Congressional Budget Office, The 2013 long-term budget outlook, Sep 17 2013

[9] Source: McKinsey Global Institute

[10] Source: McKinsey Global Institute

[11] Capital flow occurs in two ways: (1) foreign direct investment, where foreign companies directly buy or build factories and plants and (2) debt and equity flows, where foreign investors make investments in a foreign nation’s capital markets.

[12] The effect of QE through the portfolio balance channel occurs due to the heightened demand for temporal and spatial assets. The effect of QE through the liquidity channel occurs because the decline in borrowing costs increases overall bank lending. The effect of QE through the confidence channel occurs because large-scale asset purchases serve as a credible commitment to keep interest rates low.

[13] Lim et al. (2014)

[14] Lim et al. (2014)

[15] Financial Times: “India’s Raghuram Rajan hits out at uncoordinated global policy”

[16] Financial Times: “Emerging market currency sell-off intensifies”

[17] The main difference between the 3 scenarios is the speed of adjustment of the effects of the taper.

[18] Approximately 0.6% of GDP (Lim et al, 2014)

[19] Lim et al. argue that the data-dependence of monetary policy and market uncertainty regarding the path of macroeconomic variables will most likely cause the expectations channel to play an increased role during the taper.

References: 

1) Rushe, Dominic. "US Economy Shrugs off Shutdown with 3.2% Growth in Fourth Quarter." Theguardian.com. Guardian News and Media, 30 Jan. 2014. Web. 12 Feb. 2014.
2) "QE and Ultra-low Interest Rates: Distributional Effects and Risks." McKinsey Global Institute. McKinsey, 1 Nov. 2013. Web. 12 Feb. 2014.
3) "S&P 500 Falls Most in 2 Weeks After Fed Policy Statement." Bloomberg.com. Bloomberg, n.d. Web. 12 Feb. 2014.
4) USA. Congress. Congressional Budget Office. N.p., 19 Sept. 2013. Web. 12 Feb. 2014.
5) Lim, Jamus, Sanket Mohapatra, and Marc Stocker. "Tinker, Taper, QE, Bye? The Effect of Quantitative Easing on Financial Flows to Developing Countries." World Bank (2014): n. pag. Print.
6) Harding, Robin. "India’s Raghuram Rajan Hits out at Unco-ordinated Global Policy." Financial Times. Financial Times, 30 Jan. 2014. Web. 12 Feb. 2014.
7) Derby, Ron. "Emerging Market Currency Sell-off Intensifies." Financial Times. Financial Times, 31 Jan. 2014. Web. 12 Feb. 2014.
8) Malpass, David. "The Fed Needs to Change Course." Cato Institute. Cato Institute, 1 Sept. 2013. Web.
9) Kumar, Navya. "The impact of Fed tapering on emerging economies: Struggling with the ebb”. Deloitte University Press, 24 Oct. 2013. Web. 12 Feb. 2014.
10) Eichengreen, Barry, and Poonam Gupta. "Tapering Talk: The Impact of Expectations of Reduced Federal Reserve Security Purchases on Emerging Markets." World Bank (2014): n. pag. Print.
11) Sabarowski, Christian, Sarah Sanya, Hans Weisfeld, and Juan Yepez. "Effectiveness of Capital Outflow Restrictions." IMF Working Paper (2014): n. pag. Web.