The Fed’s balance sheet is (mostly) a red herring

QE had significant economic and market impact but QT will not be so important

 

This year, global central bank balance sheets will contract significantly relative to nominal GDP for the first time since the 2008 crash (see box). With the ECB ending its asset purchases, and the Federal Reserve shrinking its balance sheet, quantitative tightening (QT) is replacing quantitative easing (QE), and investors are extremely concerned about the consequences for markets.

While an unexpected tightening in monetary policy can hardly be good for risk assets, the size of the central bank balance sheet should not be accorded such an important role relative to interest rate policy, which remains the leading actor in the drama.

The arrival of QT will offset only part of the effects of QE, because central bank balance sheets will only retrace a fraction of the increase that occurred under QE. In the US, for example, the Fed’s balance sheet rose from $900bn in 2008 to $4300bn in 2018. It is likely to drop only as far as $2900bn by the end of 2020.

The effects of the Fed’s QE came in three separate phases, each of which was very distinct:

  • QE1 lasted from the Lehman crash in October 2008 to March 2010. The demand for liquidity surged, and the Fed was forced to be the “last resort” provider of that liquidity, since there was no alternative at any price. This prevented a huge collapse in all asset prices, so its effect on markets, in counterfactual terms, was enormous.
  • QE2 ran from November 2010 to June 2011. Bond purchases were funded by increasing bank reserves at the Fed, with the intention of reducing interest rates on longer term debt, and on private credit in the mortgage market. This phase operated through “portfolio balance effects”, which reduced yields in order to induce investors to hold cash instead of riskier bonds and credits.
  • QE3 ran from September 2012 to October 2014, when the main purpose was increasingly to reinforce the Fed’s forward guidance about policy rates in the medium term.

 

Importantly, neither the liquidity effects under QE1, nor the signalling effects under QE3, will be reversed under QT. The only relevant reversal will be a part of the portfolio balance effects that occurred under QE2.

Important academic research has been very sceptical whether even these portfolio effects were very important for bond yields, separate from the effects of economic activity and changes in policy rates. However, some Fed research has suggested that the total portfolio balance effect of QE was to reduce bond yields by about 100 basis points at the peak impact.

Part, but only part, of this maximum impact will now be reversed under QT. This should occur mainly via a rise in long term bond yields, especially the term premium (the extra yield investors demand to hold long term bonds, compared to the expected return from short rates over the same period). For those who have attributed the recent market turbulence to the start of QT, it is awkward to explain why neither bond yields, nor term premia, increased during 2018.

There is another, more logical, reason for thinking that the impact of QT on asset prices should not be expected to be simply the reverse of QE.

During QE, the Fed’s policy rate was fixed at zero, so the main way the Fed could ease monetary policy, or signal a future desire to ease, was to vary the size of the balance sheet. Apart from forward guidance, changes in the balance sheet became the only instrument of policy changes. However, working in reverse, the same is not the case.

During QT, unlike under QE, policy rates are free to move. The central bank therefore has two instruments at its disposal — the balance sheet and policy rates — that are determined together. This means that the impact of QT has to be judged in conjunction with the level and path for short rates, not independently of that path. The FOMC has decided to fix the run off in the balance sheet on a preset path, so that it will not be used to vary the stance of policy over the short and medium term. All of the Fed’s intentions and signals about policy setting should be understood by observing the short rate, not the balance sheet.

This choice about instruments was made for two reasons.

  • The FOMC believed that the impact of short rates on the economy is far more reliable, and better understood, than the impact of QE or QT.
  • They wanted to raise rates gradually towards equilibrium, so that they have sufficient room to reduce rates in the next economic downturn. This policy flexibility from varying rates was considered more important than returning the balance sheet more rapidly to pre-crisis levels.

 

The balance sheet objective will reflect the equilibrium long run demand for banknotes and bank deposits, a total that must be accommodated by the Fed when policy is “neutral”. The planned return to that total will be pre-announced and rather gradual, to avoid any danger of upsetting markets or the economy.

A necessary implication is that the Fed’s actions on short rates have already been, and will continue to be, less hawkish than they otherwise would have been, because they take into account the pre-determined effects of QT at all times. Therefore, the only reason for the market to be concerned about unintended excessive tightening is if the FOMC has underestimated the true impact of QT.

But even in that worst case, Chairman Powell has now said that the FOMC “would not hesitate” to slow down balance sheet normalisation if they ever decided that the size or composition of the Fed’s balance sheet is “part of the problem”.

The conclusion is that, while the market certainly needs to worry about a hostile Fed, the behaviour of the balance sheet per se is probably a red herring.

 

Central bank balance sheets under QE and QT

These graphs show levels and 12 month changes in central bank balance sheets, estimated by Chris Adjaho at Fulcrum:

 

Total Central Bank Assets

 

Total Central Bank Assets

 

 


 

Disclaimer
Source: This note is based on material which appeared in an article by Gavyn Davies published in the Financial Times on 20 January 2019.
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