The Path Forward for US Quantitative Easing

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John McDonough's picture

After five years of an unprecedented expansion of the balance sheet to over 4 trillion dollars, the Federal Reserve announced the tapering of asset purchases in December, 2013. Although the phase-out of the program was inevitable, the imminent conclusion has raised serious concerns about the financial and economic stability of the United States and its trading partners. While financial stability involves the smooth functioning of financial markets (particularly characterized by low volatility), economic stability consists of relatively constant output growth coupled with low & stable inflation. Together, these are both critical components of a successful recovery. The very nature of phasing out the quantitative easing program—namely tapering and unwinding—can pose threats to the stability of the financial system and the macro economy. However, those threats can be effectively mitigated if handled with the proper guidance.

 

The first step in predicting the future success of any policy is to study the past, but in the case of Quantitative Easing, there is very little to serve as a guide. Q.E. is a virtually new instrument, having been developed just over a decade ago by the Bank of Japan. As a result, Japan’s termination of its original Quantitative Easing program is the only full case study available, and its conclusions are not entirely clear. The phase-out in 2006 resulted in a sharp 20% drop in the Nikkei Index and a nearly 100 basis point increase in the 10-year government bond rate, seemingly illustrating the threat to stability of the financial markets that is at the center of concern. However, the speed of the policy shift heavily complicates the picture. As the chart below indicates, the Bank unwound a substantial portion of the balance sheet (approximately 45 trillion Yen) in an extremely short time span of 3-4 months. The rapidity of this shift, along with the fact that the Nikkei Index quickly reverses, and even exceeds its previous peak, are telling signs that the shocks of unwinding were only temporary results of the fast exit.

 

Case Study: Bank of Japan QE Exit, 2006

 

In regards to US tapering (the first aspect of the phase-out), the recent actions of the Federal Open Markets Committee suggest that the Fed has learned the lesson of patience from Japan’s poor example. The FOMC announcement in December assured a gradual taper, continuing asset purchases in the short term but reducing the amount of new purchases at an incremental pace of $10 billion per month. From a financial stability standpoint, the preliminary signs of tapering are positive. The VIX, a widely cited index of implied volatility in the S&P 500, shows completely normal volatility spikes for FOMC meetings (an elevated VIX is a natural occurrence during those dates due to increased trading activity surrounding the announcements). What is especially interesting is that the initial announcement of tapering in December resulted in a VIX level (seen in the chart below) that was lower than both the preceding and succeeding FOMC-associated increases, both of which are well below the VIX levels in the heat of the crisis. This return to pre-crisis volatility, especially during the initial tapering of QE, is a very encouraging sign for the continued stability of the financial system.

 

VIX Implied Volatility Index

 

 

The issue of unwinding the balance sheet is a much tougher question, one that carries additional implications for economic stability. But in order to understand that impact, it is important to consider how the Quantitative Easing program has affected the economy in the first place. As a tool of monetary policy, it has arguably been highly effective at mitigating the fallout from the recent financial crisis, but it is not without risks and critics. By its very nature, it is used when the primary tool of central banks, the adjustment of interest rates, has been exhausted, and the economy sits in the dangerous territory of what is known as the Zero Lower Bound. Nominal interest rates cannot fall below zero, and so the only way to introduce more liquidity to stimulate the economy is to purchase assets.

 

The actual purchase of assets results in an expansion of the Fed’s balance sheet (seen in the graph below) and an associated expansion in the money supply, since the new money that the Fed used to purchase those assets are now floating in the economy. During a recession, that can have a positive impact on spending. Left unchecked, a large expansion in the money supply leads to inflation, which poses a direct threat to economic stability of the United States.  Since the beginning of the program, it has been clear that Quantitative Easing was a temporary measure during extraordinary times, and so the “unwinding” (reversing the monetary expansion by selling the assets purchased during QE) was inevitable. The unanswered question has always been when, and how.

 

Federal Reserve Balance Sheet, 2007-2013:

 

In that regard, the Fed has to navigate a very tricky path. If they unwind the balance sheet aggressively, they eliminate (or greatly reduce) the threat of increased inflation to economic stability. But as the Bank of Japan example illustrated earlier, a rapid decrease in the balance sheet can send shocks through the markets, destabilizing the financial system. The appropriate strategy for unwinding QE therefore must use a “goldilocks” approach. Not too fast in order to avoid spooking the markets, but not to slow thereby minimizing the potential for elevated inflation.  Under ideal circumstances, such an approach would preserve both economic and financial stability for the US and global economy.  

 

The effects of solely phasing out Quantitative Easing on US Trade partners are largely unclear. Depending on how the markets react to the pace of tapering and unwinding, the dollar could appreciate or depreciate relative to other currencies, directly affecting the trade deficit in differing ways.  However, the elephant in the room is the future path of interest rates, which is far more relevant to the finance of trade between the US and its partners. The conclusion of the Quantitative Easing program signals that the Federal Reserve has raised their economic projections, which implies that the rise of interest rates from the zero lower bound is not far off. Those higher interest rates will raise the costs of trade, making it more expensive for the US and its trade partners. But as long as the Federal Reserve fulfills its commitment to maintain zero rates in the current environment, favorable economic conditions for investment will continue to be stable.

 

If handled responsibly, the Federal Reserve can absolutely achieve a phasing out of its Quantitative Easing program that preserves both economic and financial stability. The only question that remains is whether the Federal Reserve will be able to take the necessary steps to ensure that optimal outcome. The answer is uncertain, but there are several positive indications. First, financial market reaction to tapering has been positive thus far, exhibiting both low volatility and a consistent level in the S&P 500. Second, the use of Forward Guidance to maintain well-anchored expectations has developed significantly under the chairmanship of Ben Bernanke as a reliable policy tool on its own. And finally, recently appointed chairwoman Janet Yellen has developed a reputation over the course of her career as a sound advisor with a skill for very accurate economic projections. Under her guidance, 2014 will certainly be an interesting year for the US Federal Reserve.

 

References: 

"Monetary Policy at the Zero Lower Bound". Speech by Charles Evans, President of Chicago Fed at the 2013Asian Financial Forum;
http://www.chicagofed.org/webpages/publications/speeches/2013/01_14_13_a...

"Federal Open Markets Committee: Meeting Calendars, Statements, and Minutes";
http://www.federalreserve.gov/monetarypolicy/fomccalendars.htm

"Japan's Experience with Tapering";
http://www.businessinsider.com/chart-of-the-day-japans-experience-with-t...

"Federal Reserve: Quarterly Report on Balance Sheet Developments"
http://www.federalreserve.gov/monetarypolicy/quarterly-balance-sheet-dev...

"Volatility Index Quote";
http://finance.yahoo.com/q?s=%5EVIX