If QE was Mostly Placebo, What about the Unwind?

During the Great Depression, countries discovered their balance sheets. 
Fiscal spending helped augment aggregate demand.  After the WWII, high
income countries have typically run persistent deficits, resulting in the
accumulation of debt.  

During the Great Financial Crisis, central bank balance sheets were discovered.   Central banks
bought a variety of assets, but especially their own government bonds.   The idea was that the proximity of the
zero bound (zero policy rate) could be overcome
through the purchase of bonds and the expansion of the central bank’s balance

Some economists have argued that the bond buying by the Federal Reserve
lowered the 10-year yield by as much as 85 bp
.  We are
skeptical.  The Fed did not simply buy long-term securities.  It is
better to understand the asset purchases as an asset swap.  The Fed
swapped reserves for the bonds.  It took duration out of the market, for
sure, but this is not the same thing as getting beyond the zero bound. 
Moreover, reducing the term premium of bonds is not the same as cutting the Fed
funds rate. 

This is important because the Fed
has begun allowing its balance sheet to shrink, and some argue that this is
tantamount to tightening of policy.
  Indeed, Benn Steil and Benjamin
Della Rocca at the Council on Foreign Relations warned that the Fed’s balance sheet
reduction that has been announced is
tantamount to a 100 bp hike in the Fed funds rate by the end of next

Steil and Rocca’s concern is that the markets and the Fed do not seem to
be aware of this.
  They note that neither the Fed’s forecasts (dot
plot) nor the Fed funds futures strip through 2019 have reflected the impact of
the balance sheet reduction.  They conclude:  “These facts
suggest that they [Fed and investors] are largely ignoring-and therefore the greatly underestimating-the tightening impact
of the balance-sheet reduction.”   

Are the markets and Fed officials as naive as Steil and Rocca suggest?  
We do not think that the $450 bln reduction of the Fed’s balance sheet (Oct
2017-Dec 2018) is the equivalent of hiking the Fed funds target rate by 100
bp.  Of course, it must be acknowledged
up front that the unwinding the central
banks’ balance sheet is unprecedented. 

When the Fed announced its first rate hike in the current cycle in late
2015, many observers thought the central bank would have to conduct huge
reverse repo operations to solidify its new target.
didn’t.  It almost seems as if once the Fed lifts its target, market
participants accepted it as given. 

In a similar fashion, many
observers see the QE as easing policy (rather than removing duration) because
that is what Fed officials wanted them to believe.
  The messaging from
the Fed is different now.  The Fed says that the reduction of the balance
sheet is a technical operation distinct from its monetary policy
goals.    The Fed has been clear on this point.  The Fed
funds target range, the upper end of which is the rate of interest it pays on
reserves (not just excessive reserves, as is often mistakenly asserted in the
media) is the main policy tool.   

The power of the Fed’s asset purchases lies
in the signaling effect.
  In fact, the biggest impact of the asset
purchases seemed to be on the announcement.  Yields seemed to rise during
the actual purchases. Another example, of how official intentions matter is in
Japan.  The Bank of Japan had been engaged
in what it calls “rinban
operations for years. These are outright purchases of government bonds. 
The BOJ did not call this quantitative easing,
and they were not regarded as such by the
market.  When BOJ Governor Kuroda announced Quantitative and Qualitative
Easing, the outright bond purchases were then
as part of the extraordinary monetary policy.  

Also, we note that the impact of the Fed’s asset purchases is not thought to be constant over time.  Many
observers argue that the first round of asset purchases had a greater impact than rounds two and three. 
In a similar vein, some observers argue that the ECB’s asset purchases, which
began several years after the Fed’s program, have been less effective because it had
waited so long, and interest rates were already quite low.  

Keynes’ taught that investing is like a beauty contest.  The
challenge is not to pick who you think is the most beautiful but who others think is the most beautiful.  The argument we sketch here places a premium on central bank intentions, guidance, and signaling.  The Fed says the
shrinking of its balance sheet is independent from the conduct of monetary
policy.  As Steil and Rocca note, the Fed’s forecasts and the market
pricing seems consistent with that understanding.  Our argument is also
consistent with the apparent uneven
impact of the asset purchases in the first place.  

We are happy to revisit the issue in
the middle of next year.
  The Fed’s gradual approach to its balance
sheet reduction gives investors plenty of time.  Steil and Rocca use an average of purchases for their
calculations.  In contrast, we think it is important that this quarter the balance sheet is set to
shrink by $30 bln, which is hardly even a rounding error.  In the Q1 18,
the balance sheet is to shrink by $60 bln and in Q2 18 by $90 bln.  

The Fed funds futures contracts settle at the average effective rate for
the month.
  The Fed says that three rate hikes next year are likely to
be appropriate. The current effective average is 1.16%. The 25 bp rate hike that is nearly fully discounted for next month will
lift the effective average to 1.295% in December (due to the meeting on
December 13, and assuming a somewhat lower rate at the very end of the year as
has been the case at end of quarters this side of the financial crisis).

 The effective rate in January (FOMC meeting on last day of the month) implied by the January Fed funds futures contract is 1.39%.

The December 2018
Fed funds futures contract currently implies an effective average of 1.735%.
  That seems to be pricing in one hike next year.  We agree with
Steil and Rocca that the market is underestimating
the extent of next year’s Fed tightening, but we see it through its monetary
policy actions, not through its balance sheet.  


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