Quantitative easing (QE), also known as ‘unconventional monetary policy’, started off as a far-reaching experiment prompted by exceptional circumstances and used only as a last resort. But the unconventional has now become conventional, and large-scale asset-purchasing programmes have landed the Federal Reserve, the European Central Bank (ECB), the Bank of England and the Bank of Japan with enormous balance sheets.
In the face of an impeding global bout of ‘QE in reverse’, economists are stressing the fact that this is by and large new territory
Former Chair of the Federal Reserve Janet Yellen said that she hoped the reversal of QE would be as “dull as watching paint dry”. However, given the scale of central bank assets set to be shed, this is unlikely to be the case. When the banking sector began to cave in September 2008, the Fed’s balance sheet stood at just $905bn – six percent of GDP. It is now being wound down from a peak of $4.5trn, which represents around a quarter of US GDP (see Fig 1). Together, the ECB, Bank of England, Bank of Japan and the Fed have amassed balance sheets of over $14trn.
In the face of an impeding global bout of ‘QE in reverse’, economists are stressing the fact that this is by and large new territory. In the words of Christopher Martin of the Institute for Policy Research, there are very real “dark areas” in our knowledge of the process in reverse.
As we look ahead to a post-crisis era, it is unclear what role balance sheet alterations will play in the mix of central bank policy tools. Central bankers have to establish how quickly balance sheets should be unwound, as well as whether they plan to go back to the same monetary policy framework from before the crisis. This is wrapped up in the question of whether QE will be remembered as a one-off affair, or whether it will be employed in the near future as ammunition against recession. Policymakers are generally in agreement that a ‘new normal’ has to be found, but are far more divided on what it should look like.
Flicking the switch
Back in 2014, in what became known as the ‘temper tantrum’, the first hint of balance sheet normalisation famously rattled the markets when the Fed stated that it intended to reduce the size of its asset purchases. The announcement saw bond markets plummet and tens of billions of dollars wiped off stock markets worldwide. The instability also hit mortgage rates and filtered through to commodity markets, knocking down the price of gold by several percentage points. This underscores one of the key dark areas regarding QE: the role of forward guidance. When it comes to the policy in reverse, the interplay between markets and central bankers’ statements about the future is still not fully understood. “Some statements have a weak impact and some have a strong impact and we don’t really know why,” said Martin. But since the temper tantrum, central banks have been wary of sudden policy changes, taking a more incremental approach.
The decision was made to flick the switch on QE at the Fed’s meeting in September of last year, and it has since been reducing the size of its balance sheet at a gradually accelerating pace
Having been the first to take the plunge into unconventional policy in the wake of the banking crisis, the Federal Reserve has become the first to begin the process of turning it into reverse. The decision was made to flick the switch on QE at the Fed’s meeting in September of last year, and it has since been reducing the size of its balance sheet at a gradually accelerating pace.
The Fed’s chosen strategy is to unwind balance sheets not by selling bonds, but by progressively stopping reinvestments when its assets mature. This is called a cap approach, and requires the Fed to commit to an upper limit on the amount of investments that are allowed to mature without reinvestment each month. The official plan is to gradually increase the pace, with the initial cap of $10bn set to increase by $10bn each quarter until it reaches $50bn, which is scheduled to take place in October 2018. Since the appointment of Jerome Powell as the new chair of the institution, this initial plan is expected to continue without any considerable changes.
Starting to unwind
No other central bank has begun actively downsizing its balance sheets, though a string of central banks are poised to follow in the Fed’s footsteps. The Bank of England brought its quantitative easing programme to a standstill last year, capping asset purchases at £435bn ($601bn). It has since indicated that the unwinding will begin when interest rates have returned to around two percent. This leaves just the Bank of Japan and the ECB still actively buying up new assets, although the ECB is already slowing its pace of expansion. The ECB has committed to a gradual tapering of the size of stimulus, and has halved its asset purchases from €60bn ($74bn) per month to €30bn ($37bn) (see Fig 2). Even the Bank of Japan, which has committed to QE like no other central bank, has been gradually reducing the size of its asset purchases.
As central banks move closer to reversing QE, they will be watching the US for strategy cues. But while all eyes are on the Fed, its approach cannot be described as much more than ‘wait and see’. A statement from the Fed on its principles for policy normalisation noted that it would be prepared to reduce the speed of balance sheet reduction, or even go back to balance sheet expansion if the economic outlook were to warrant it. The message is that the plan can be sped up, slowed down or even reversed if necessary. “It looks like a very unscientific method”, said Grégory Claeys of Brussels-based economic think-tank Bruegel. “But given the uncertainty that surrounds it, it is important to do some trial and error. It was already the case when QE was created that there was a lot of trial and error. And for this reason, I expect that the speed will be very slow at first because they will have to test the effects on the economy. First you must test the policy, and then you increase the speed or you reduce the speed.”
Taking it easy
The Fed’s unwinding policy started slow, but if all goes according to schedule, it will pick up substantially in the months ahead. As its pace increases and a synchronised global wind-down of balance sheets approaches, many are anxious that cutting off the flow of new money to the bond market will trigger considerable market instability as investors react to the absence of central banks as a buyer of assets.
The Fed’s chosen strategy is to unwind balance sheets not by selling bonds, but by progressively stopping reinvestments when
its assets mature
In addition, there is the chance of a sharp fall in bond prices. It is widely acknowledged that bond values have been pushed up by QE as a stimulus, implying that the reverse would bring them back down again. The associated monetary tightening, if it occurs too quickly, could dampen the green shoots of economic recovery. This said, estimates vary wildly for the extent to which the policy pushed up bond values, although empirical studies imply that the impact was more muted than expected. For instance, a group of Fed economists estimated that the impact of all the stimulus programmes on benchmark 10-year US Treasury yields was just one percent.
There is also no guarantee that the effect will be symmetrical on the way down. “My view is that [the effect] will be quite asymmetric,” said Claeys. “When you do QE, you do it in a period of significant uncertainty, and it has a positive effect on growth… You could say that if you unwind QE, the opposite will be true. However, the situation is very different because risk aversion from investors is very different.”
Another concern is that the fiscal implications of higher bond yields could throw up fiscal policy issues. According to Martin: “Take the UK case, for example – the Bank of England has bought huge amounts of government bonds. If the Bank of England starts selling off bonds, then the Treasury would be very nervous about that.” This also gives reason for caution, but again it is unclear whether the effect on yields will be deep enough to trigger any economic trouble.
According to Ricardo Reis, Professor of Economics at the London School of Economics, the biggest danger to come with a rapid decrease in balance sheet size “is to overshoot on the size of the balance sheet, and return to a world where liquidity was scarce, a significant gap emerged between interbank rates and the interest on reserves… The central bank would have an inconsistent set of tools on inflation control”. But despite these concerns, the first stages of balance sheet normalisation from the Fed have gone down with relatively little drama. As of March 2017, total assets were the lowest they’ve been since September 2014 (see Fig 3).
The old normal
Aside from the speed at which balance sheets should be unwound, Reis argues that “the more important discussion is on what the new normal should be in terms of the size of the central bank’s balance sheet”. Discussions surrounding QE have generally assumed that the end of the crisis would see a return to the ‘old normal’. This approach would see a return to a pre-crisis monetary policy framework in which balance sheets were far leaner. However, there is a question over whether attempting such a return is the right choice.
The official plan for normalisation, as communicated by the Fed in 2011, is to return “both short-term interest rates and the Federal Reserve’s securities holdings to a more normal level”. However, in June 2017, the Fed announced that its anticipated plan would involve “reducing the quantity of reserve balances over time to a level appreciably below that seen in recent years, but larger than before the financial crisis”. As such, details regarding the new normal for the Fed’s balance sheet remain up in the air, and the future interest rate framework is yet to be set in stone.
“There used to be a consensus of going back to the pre-2007 world with close to zero excess reserves and a very small balance sheet,” said Reis. However, he believes that this consensus could be shifting towards the idea that there should be a ‘new conventional’ central bank, in which balance sheets can be held permanently higher in order to guard financial stability.
He told Mrassociates: “The view… that the new normal should instead be a balance sheet large enough to keep the demand for reserves satiated and the interest on reserves (or on deposits at the central bank) the main policy tool has, in my view, gained much traction and is becoming the new consensus. I think it would be a bad idea to return to the pre-crisis level, but it is a good idea to shrink from the current levels. My ideal would have, for the Fed, a level of excess reserves around $500bn to $700bn, enough to satiate the demand for liquidity.”
But there are questions over whether central banks will be willing to deviate substantially from the initial plan of returning to the pre-crisis framework. Some commentators warn of the dangers of excess cash in the system, arguing it could give rise to dangerously high inflation once bank lending starts to pick up. In this case, it would constitute an unnecessary stimulus, meaning a return to a pre-crisis policy framework should be seen as a priority. According to Claeys: “Central banks are generally very conservative, so it looks like they will head back towards leaner balance sheets.”
The fact that QE is tried and tested is likely to mean that there is less reluctance to fall back on it in times of economic trouble
One issue weighing on central bankers’ minds is that of room for manoeuvre in the future. A bloated balance sheet could make QE less viable if a recession were to hit at a later date. This is particularly relevant in Europe, where the ECB has committed to an upper limit of 30 percent for bond issuances in order to distance itself from accusations of monetary financing.
QE, or not QE
This leads to the broader question relating to the new normal, which is whether QE is here to stay as a policy tool. While QE was originally planned as a one-off measure, central bankers may be tempted to keep it as part of their monetary policy arsenal.
Whether this situation comes to light depends on the long-term neutral interest rate, the rate at which the economy can run at full capacity. This in turn depends on whether inflation picks up enough to enable central banks to shift their rates away from the lower bound. If the neutral rate remains low, then the primary policy tool of interest rates would provide little protection against future recessions.
According to Claeys, historical standards would imply that interest rates need to be cut by somewhere between 350 and 500 base points to give enough stimulus for the economy during a normal recession. This means that the neutral rate would have to reach a minimum of 3.5 percent in order to safeguard enough room for manoeuvre in the case of a recession.
At present, the historically low rates of interest across advanced economies are prompting arguments that the neutral rate may remain low for some time. “Defining the new normal today is difficult. At the moment, we still bear the scars from the Great Recession and also from the policy mistakes made here in Europe, so it is difficult to know if we are in a new normal where growth and interest rates are lower, and we need to use more… QE, or if we are just in a long aftermath of the Great Recession and the sovereign debt crisis,” said Claeys.
The fact that QE is tried and tested is likely to mean that there is less reluctance to fall back on it in times of economic trouble. According to Reis: “I think that QE should be a tool that central banks use with some frequency in the future. It has proven to be effective at affecting financial markets and at providing signals about the future path of interest rates while having modest, if any, additional effects on actual inflation.” In any case, the big test of the coming months will be to redefine what is conventional for the
central banks of the future.