Daily Commentary
Comments by top Federal Reserve officials support the idea that the Fed is going to move away from quantitative easing as a policy tool and lean more heavily on forward guidance. There are a number of reasons for this, not the least of which is political. Comments by Atlanta Fed President Dennis Lockhart in particular suggest that the move away from QE has already been decided. Below are some thoughts on the why, when and how and what this will mean for markets.
It becomes a bit dull to have to write about the Federal Reserve and quantitative easing so much. But the reality of today’s economy, not just in the US but globally, is that the policy moves of the top central banks have taken on critical importance both for markets and the real economy. I have argued that the importance of central banks is in part due to an over-reliance on monetary policy to drive macro policy due to an aversion to using fiscal policy or due to political and market constraints on fiscal policy following large deficit spending. Moreover, I believe this over-reliance on monetary policy is inherently dangerous because, with interest rates pinned near the zero lower bound, monetary policy increasingly relies on the expectations and private portfolio preference channels and the trickle down of flows from buoyant asset markets to have an impact on the real economy. My concerns here are even based on a framing of the economics which comes from policy makers’ own commentary, including Fed Chair Bernanke. So we know they know what the risks are. They simply believe there is no better way at this juncture.
There are widely differing opinions about the effectiveness of the various policy tools. For example, recent Nobel Laureate Eugene Fama has said QE is “no big deal”, even suggesting that the Fed is out of bullets. On the other end of the spectrum are the hyperinflationists who continue to warn that QE is money printing which will end in disaster. A more credible critique of QE, however, is that it is effective but that its effectiveness is limited and that the risks of using QE have increased both from a political and asset market perspective. The recent Wall Street Journal article by Andrew Huszar, who managed the Fed’s QE1 program from 2009 to 2010, is an example of this kind of critique. So I want to delve a little deeper in on this and discuss why I believe Fed officials actually share his concerns – and are thus moving away from QE as a policy tool.
Let’s look at what the Fed has actually said about what QE is and what the Fed is trying to achieve. We can create a framework for thinking about the Fed’s reaction function based on this.
QE1 as liquidity for a classic financial panic
The nature of QE has changed over time. The first hint of what the Fed was doing with QE came from a speech by Ben Bernanke at the LSE in January 2009 at the height of the financial crisis. As QE1 manager Huszar noted in the Wall Street Journal, QE1 was about ‘credit easing’ because the Fed was more concerned about the asset side of the balance sheet. So it is important to note that with QE1 the Fed was engaged in both qualitative and quantitative easing. Indeed, that’s what Bernanke told us at the London School of Economics.
Before QE1, the Fed had never bought a single mortgage bond as the asset side of its balance sheet was comprised purely of U.S. government liabilities. Brian Sack, an EVP of the Fed at the time, gave an important speech at the end of 2009 reviewing what the Fed had done. He said that QE1 was a $1.75 trillion program and that during QE1 the Fed would purchase $175 billion of Fannie and Freddie debt as well as $1.25 trillion of mortgage-backed securities and $300 billion of Treasuries. The Fed’s balance sheet would also nearly triple from $800 billion to $2.25 trillion.
During the LSE speech, Bernanke said that the Fed had wanted to provide liquidity to markets because the market for mortgage-backed securities had broken down as banks came to mistrust each other as counterparties. Bernanke was careful to note that the Fed was not giving out free money; it was taking a ‘haircut’ and receiving ‘enhancements’ from the banks in order to protect the Fed’s balance sheet. At the time, I noted that I did not find this part of Bernanke’s talk convincing and came to believe that, “the Fed lent freely, but at a low rate, on dodgy collateral”. But this is history now. The reality is that QE1 was a legitimate lender of last resort activity in dislocated markets in the midst of a classic financial panic. Ben Bernanke gave a speech just this month referring to the financial crisis as a “classic financial crisis”, comparing the recent crisis to the Panic of 1907 which galvanized the U.S. Congress to create the Fed to prevent disaster from such panics. So that tells you how the Fed thinks about QE1 subsequently.
Now Huszar describes the day-to-day difficulties in purchasing so many assets. He contends that the Fed was buying so many assets that it created a chaotic atmosphere in which they constantly feared driving up prices artificially and “crashing global confidence in key financial markets.” Huszar wrote, “[w]e were working feverishly to preserve the impression that the Fed knew what it was doing.” But he left the impression in his Op-Ed that the Fed, in fact, did not know what it was doing. Even so, I would say that QE1 was a success in that, without QE1, we would have suffered an economic depression of much greater severity, more akin to the Great Depression of the 1930s.
QE2 and QE3 transmission channels
QE2 and QE3 are different beasts altogether. The Fed had reached the zero lower bound and could not cut rates any further. But it wanted to add monetary stimulus to support the full employment side of its dual mandate since inflation was still low. So the QE2 and QE3 programs are designed to stimulate the economy. They are not lender of last resort operations like QE1.
Because I have written on this before, I will simply quote from my June 2011 post on the differences between QE1, QE2 and QE3.
“The second round of quantitative easing was distinct from the first – and more akin to what the Japanese had done. The aim was to support economic activity in the US domestic economy. Starting in August 2010, the Federal Reserve started reinvesting principal payments from agency debt and agency mortgage-backed securities that it had acquired in QE1 in longer-term Treasury securities. By November 2010, after the 2010 mid-term elections, the FOMC decided to expand its balance sheet by $600 billion through the purchase of Treasury securities.
“But, as we have detailed many times here at Credit Writedowns, quantitative easing doesn’t actually have an impact on the real economy. It is an asset swap. The Federal Reserve buys Treasury bonds and sells dollars it has created expressly for that transaction. After the asset swap, the balance sheet of the primary dealer which sold the Treasuries to the Fed has not increased; it now has cash instead of Treasuries. So there are more reserve deposits and fewer Treasuries in the private sector. The Federal Reserve has Treasuries instead of the money it created in expanding its balance sheet. While the reserves can ostensibly be lent out, the reality is that this money will sit in a bank vault idle unless the demand for loans warrants otherwise. It is a misunderstanding of how the banking system works to assume the mere creation of reserves has any significance regarding lending. I would argue the swap drains the economy of higher interest-bearing assets that add to income, replacing them with essentially non-interest bearing assets.”
Janet Yellen has said specifically that unlike interest rate cuts, which lower interest rates and spur credit demand directly, QE does not improve economic conditions through direct effects on the real economy. Rather QE works through the portfolio balance and expectations channels. In a February 2011 speech about unconventional monetary policy and central bank communications, she said the following:
“It is important to recognize at the outset that conventional and unconventional monetary policy actions bear many similarities. Forward guidance concerning the path of the federal funds rate, for example, is explicitly intended to influence market expectations concerning the future trajectory of shorter-term interest rates and thereby affect longer-term interest rates. That said, standard monetary policy actions also typically alter not just current short-term rates, but the anticipated path of short-term rates as well, influencing longer-term rates through the identical channel. In fact, central bankers have long recognized that this “expectations channel” operates most effectively when the public understands how policymakers expect economic conditions and monetary policy to evolve over time, and how the central bank would respond to any changes in the outlook.
The transmission channels through which longer-term securities purchases and conventional monetary policy affect economic conditions are also quite similar, though not identical. In particular, central bank purchases of longer-term securities work through a portfolio balance channel to depress term premiums and longer-term interest rates. The theoretical rationale for the view that longer-term yields should be directly linked to the outstanding quantity of longer-term assets in the hands of the public dates back at least to the 1950s.
Each of these policy tools tends to generate spillovers to other financial markets, such as boosting stock prices and putting moderate downward pressure on the foreign exchange value of the dollar. My reading of the evidence, which I will briefly review, is that both unconventional policy tools–the use of forward guidance and the purchases of longer-term securities–have proven effective in easing financial conditions and hence have helped mitigate the constraint associated with the zero lower bound on the federal funds rate.”
Notice three things then. First, Yellen only highlights two unconventional policy tools: large scale asset purchases and forward guidance. That’s it. Second, she believes that unconventional policy works through similar channels as conventional monetary policy meaning that the Fed is not out of bullets at the zero lower bound. And third, she also believes that these policy tools “generate spillovers to other financial markets”.
Yellen’s description then perfectly outlines the Fed’s intellectual framework for understanding the Bernanke/Yellen Fed’s reaction function in a zero rate environment:
- Maintain commitment to the Fed’s dual mandate of supporting price stability and full employment.
- If inflation is low and stable and inflation expectations remain anchored and the economy is not yet at full employment, use unconventional monetary policy at the zero lower bound to add monetary stimulus.
- Focus in on forward guidance and/or large scale asset purchases to do what interest rate cuts would do in a non-zero rate environment
- Be wary of spillovers to other financial markets that could destabilize the economy.
That’s what the Fed is doing and will continue to do until it can normalize policy.
Below I will describe why QE has been so controversial and why the Fed is now jettisoning it altogether in favour of forward guidance and what this means for markets and the economy.
The Political Fed
Before the financial crisis began, the general public in America didn’t care about the Fed. In fact, most people had probably never even heard of the Fed. But QE changed all that.
In January 2010, I wrote a post called the political central bank in which I said that the Fed’s QE program had turned it into a quasi-fiscal agent which was engaged in a backdoor bailout of the US banking system. My argument here was that the Fed’s balance sheet expansion at once supplied the Federal government with a ready buyer of bonds to cover deficit spending and supplied the banks with a ready buyer of bonds to solve liquidity problems which may or may not have been solvency problems. These two factors made QE toxic politically and brought the Fed into the political arena like never before. I don’t think it will ever be the same again.
Despite this politicization of the Fed, the intellectual framework that Yellen laid out for monetary policy at the zero lower bound is still operational; the Fed has a dual mandate to meet and it intends on doing so regardless of the political pressure. So even after QE1 raised the political backlash I wrote about in 2010, the Fed felt forced into QE2 in 2010. Here, however, the Fed only bought Treasury securities and it bought many fewer bonds – $600 billion worth. I believe the limited nature of QE2 was due to the Fed’s reacting to political blowback. Yes, it was fulfilling its dual mandate but it was doing so in a circumscribed manner.
But QE2 was a bust. It was the first of many communications failures for the Fed with unconventional monetary policy. It did not lower rates because it raised inflation expectations, working at cross-purposes with its intended function of bringing down risk premia. Thus, QE2 could only work via the spillover effect from increased asset prices as private portfolio preferences shifted to risk-on. Economic growth actually declined during QE2 and inflation expectations only dropped when the economy cooled.
The Fed’s experiment with QE2 is what I believe soured the Fed on QE as a policy tool. The next round of monetary easing in 2011 shifted focus to forward guidance. And while it’s hard to say how effective any of these policy tools are in isolation, the Fed did shift back to QE for the next round of easing in 2012.
With QE3, the Fed felt it had to move from just buying Treasuries as it had done in 2010 with QE2 to buying Treasuries and mortgage-backed securities as it had done in QE1. The Fed knows that underwater mortgages are toxic to aggregate demand and to bank balance sheets and therefore a key area for reflation. In 2011, housing had not perked up and the economy remained depressed. So, the kinds of assets the Fed bought with QE3 were more similar to QE1 than QE2. But in terms of the policy aim, QE3 was more similar to QE2 than QE1.
Forward Guidance
At some point during the QE3 experiment, the cries that the risk that Yellen had outlined regarding spillover effects started to become ever louder. Yellen had already said that, “it is conceivable that accommodative monetary policy could provide tinder for a buildup of leverage” back in 2010. Her speech on unconventional monetary policy in 2011 was merely a confirmation of this view that bubbles were a risk. But it was not until Jeremy Stein came out in February 2013 with a speech about the perils of “reaching for yield” that the anti-QE view took full form.
February 2013 is when forward guidance became the defining policy tool.
I have written in the past how forward guidance relies on the expectations theory of interest rates. Long-term interest rates are a series of future short-term rates. As Ben Bernanke has said:
“it is useful to decompose longer-term yields into three components: one reflecting expected inflation over the term of the security; another capturing the expected path of short-term real, or inflation-adjusted, interest rates; and a residual component known as the term premium.”
Forward guidance then relies on the Fed’s ability to guide the market’s expectation of future short-term rates toward the Fed’s desired expectation. Yes, the Fed has made a hash out of the transition from QE3 to forward guidance but the intellectual framework is clear. San Francisco Fed President John Williams provided an explanation of forward policy guidance at the Federal Reserve which I think represents current thinking about forward guidance. He said it “affects longer-term interest rates, as investors adjust their views on future short-term rates” and outlined how the Fed was prepared to develop communications transparency, tools and guidelines to enhance the effectiveness of forward guidance as a policy tool.
I too have speculated in the last two months about how the Fed would try to enhance the effectiveness of forward guidance, first in September and then again last month. The Fed’s goal is to transition out of QE as a policy tool and use forward guidance to pave the way for normalizing policy. The most difficult part of this is making the transition from QE to forward guidance in a seamless way. How does the Fed transition to a tool that is all about normalizing policy without giving the markets the sense that it is tightening? This is the Fed’s conundrum.
My Conclusions
I have said this before, but comments by Dennis Lockhart yesterday make clear to me how the Fed intends to do this. Here’s how Bloomberg characterizes his comments:
‘Strong Stimulus’
The central bank wants economic growth to speed up to 3 percent or more, a pace faster than its long-term trend, Lockhart said. He called in the speech for “continued strong stimulus,” predicting the economy next year will grow from 2.5 percent to 3 percent.
“To achieve a faster pace of growth, it’s my opinion that we’ll need to see” greater consumer spending and a decline in “fiscal drag,” he said at a conference hosted by Auburn University at Montgomery.
Reducing bond purchases “ought to be on the table at upcoming meetings” by the FOMC, including Dec. 17-18, Lockhart said to reporters after his speech.
While inflation will be an important consideration, a decision to taper won’t be based on “a single development,” he said, adding that the labor market has made “significant progress” since the central bank began its third round of asset purchases more than a year ago.
‘Forward Guidance’
The Fed should make clear to investors that it will sustain stimulus even as it reduces bond buying, Lockhart said. That may mean changing its communication of “forward guidance” on interest rates at the same meeting, he said.
“I would be supportive of consideration of that,” he said. “We might enhance the forward guidance to convince the public and the market that the environment is not going to change much” after a reduction in bond buying.
What Lockhart is saying is this: In order to make the markets believe that the Fed is not tightening as we transition away from QE toward forward guidance, the Fed will have to shift its forward guidance to reflect a lower for longer path for the Fed Funds rate. This is exactly why I wrote last week that the Fed papers by Wilcox and English confirm its move to forward guidance and permanent zero. The Fed is trying to remain accommodative even while normalizing policy. And the only way it can do so credibly is by lengthening its timetable before it raises rates. And because forward guidance is predicated on unemployment targets, it must lower those targets in order to signal more policy accommodation.
Now, must-read Fed watcher University of Oregon economist Tim Duy takes issue with my view that the Fed is essentially saying that it will remain at zero through 2017, something Gavyn Davies at the FT also believes. His point on lowering the unemployment target is that the Fed’s present 6.5% target is a threshold, not a trigger – meaning they were never saying they would lower the rate at 6.5% to begin with. The Fed was always saying, that was just a threshold for raising rates, not a trigger.
I believe the context I provided above, especially given Lockhart’s statement, makes it clear that the Fed does want to harden the view that it will keep rates lower for longer. The Fed papers are part of the campaign to signal to markets that this is what will happen. And so, I believe that the Fed was jarred by the violent reaction to its discussing tapering QE. The Fed was unprepared for this and what’s to prevent a similar episode when it actually does taper.
Therefore, when the Fed does taper, it will also make a very clear dovish signal on rates designed to counteract the tightening signal. The Fed will taper but forward guidance will signal lower for longer.
Market implications
For me, this is a big green light for risk on frankly, concerns about reaching for yield notwithstanding. Unless the Fed makes a hash out of the exercise and raises inflation expectations too much, it should flatten the term structure of yields. Longer-duration Treasurys should outperform the short end. At the same time, private portfolio preferences should shift as the Fed signals that rates will be zero for longer. That’s risk on and it favours high yield, leveraged loans, emerging markets, convertible bonds, and equities as investors chase yield. The risk here is that as bank net interest margins continue to shrink under the zero rate assault credit quality will diminish as banks chase yield.
Last week, I wrote that:
“The ECB can compete with the Fed on forward guidance but it cannot compete with the Fed on QE. Therefore, the shift to forward guidance will make the ECB seem increasingly dovish on a relative basis and may help keep the Euro from appreciating.”
We are already seeing this. Draghi has cut rates and shifted to an ultra-easy forward guidance stance. Even the Austrian and German central bankers are talking about more policy accommodation. As a result, the Euro has collapsed.
One final note: the ECB, Bank of England and the Fed are all using forward guidance as a policy tool now. That’s big. Forward guidance is the new QE. And it is sending a big risk-on signal to markets. If you or your market friends aren’t reaching for yield yet, you will be soon.