Monday, May 13, 2013

Is a QE exit really scary?

With the publication over the weekend of a story by John Hilsenrath discussing the Fed's plans for exiting Quantitative Easing, it is clear that the time is rapidly approaching when the Fed will begin scaling back its monthly purchases of Treasuries and MBS. Once new purchases cease, the next step will be for the Fed to reduce its holdings of Treasuries and MBS, and at some point in this process, short-term interest rates will almost certainly begin to rise. The only thing newsworthy about this is that the unwinding of QE might start a bit earlier than the market has been expecting. In fact, the Fed could well start scaling back its purchases within a few months. So how scary is this?

It's very scary if you believe that the Fed's aggressive expansion of its balance sheet has been the main force sustaining and powering the recovery. Without continuing injections of tens of billions of bank reserves each month, how can the recovery continue, and won't higher interest rates threaten the recovery?

It's not scary at all if you believe, like I do, that the primary goal of QE was not to "print money" or stimulate the economy, but rather to satisfy the world's apparently insatiable appetite for safe-haven, risk-free assets. It's not unreasonable to think that now, after four years of recovery, with over 6 million jobs created, with industrial production having staged an almost-complete recovery, with housing starts and auto sales growing at double-digit rates, and with global equity market capitalization only 8% shy of its 2007 all-time high, the demand for risk-free assets is beginning to taper off. If the world is now beginning to feel more comfortable with the fact that economic and financial conditions have improved, and thus the risk of another collapse has receded, then it would be entirely appropriate for the Fed to begin tapering its balance sheet expansion, simply because there is no longer a need for it.

It's not scary if you realize that higher interest rates typically accompany a recovering economy. Higher interest rates only become a threat to growth after at least a few years of aggressive Fed tightening—when real interest rates approach 3-4% and the yield curve becomes inverted. We are still many years away from conditions such as these. The Fed is likely to get really tight only if the economy and/or inflation start to really boom.

It's also not scary if you realize that the end of Quantitative Easing means the end of an unprecedented experiment in monetary policy that held the potential for dramatically increasing inflation and undermining the value of the dollar—and that was thus a major source of uncertainty. The unwinding of QE means the beginning of the end of a major source of risk-stifling uncertainty, not a new source of uncertainty. It's just plain old good news. Maybe that's why the market today reacted to the news with equanimity.

I've explained in detail here how the Fed's purchases of Treasuries and MBS were not the equivalent of printing money; how they were instead the equivalent of swapping newly-created, risk-free T-bills for more risky notes and bonds; and how banks have been quite content to hold on to virtually all the extra reserves the Fed has created in the process. As I show in the charts that follow, there is no evidence in the money supply numbers of any unusual growth, and there is no evidence of unusual dollar weakness. Gold's recent decline and the relatively flat performance of commodities are more evidence that QE has not been an exercise in massive money-printing. Moreover, short- and long-term inflation expectations remain quite normal.

The chart above shows that Fed tightening has been the source of all the recessions since the late 1950s. Tightening shows up as a rise in the real Fed funds rate, and in an inversion of the Treasury yield curve. Currently, the real Fed funds rate is still negative, and the yield curve is still quite positively sloped. Monetary conditions are easy, and extremely unlikely to lead to a recession.

Financial conditions are about as good as they get. No sign in the above chart of any financial stresses or deterioration.

Swap spreads have traditionally been excellent coincident and leading indicators of financial market and economic health. Absolutely no sign here of any unusual systemic risk. Liquidity conditions are excellent. It would highly unusual for there to be any near-term economic deterioration given the current health of financial markets.

M2, arguably the best measure of the money supply, is growing only slightly faster than it has grown for the past 18 years. Faster M2 growth is most likely a sign of increased money demand, since the lion's share of M2 growth has been in bank savings deposits, a classic refuge of safety in times of uncertainty. Faster money growth that is driven by rising money demand is not the kind of money growth that creates inflation. We would have to see a significant decline in money demand for inflation to rise, and so far there is no sign of that.

To date, the Fed has injected over $1.8 trillion of bank reserves into the banking system as a result of its purchases of Treasuries and MBS. Of this amount, only $115.8 billion are "required" to back up the deposits of the banking system. That means that banks have been willing to accumulate over $1.7 trillion of reserves on their balance sheets, earning only 0.25%. Why? Because banks are unwilling to lend more and many people and many businesses are still reluctant to borrow and many are still trying to deleverage. There clearly has been no excessive lending taking place, and thus no unusual growth in the money supply. Banks see reserves as substitutes for T-bills: as safe assets with which to bolster their balance sheets in times of uncertainty. This may well change in the future, of course, and the Fed will need to withdraw reserves in a timely fashion lest they be used by banks to engage in a wild, free-for-all lending spree.

Gold and commodity prices can be very sensitive to monetary excesses and shortages. Both declined in the years leading up to 2002, a time when the Fed was demonstrably tight. Both rose in the wake of the Fed's dramatic attempts to ease policy from 2003 through 2007. Both fell as the financial crisis of 2008 unfolded, as the world's demand for safe money rose precipitously but the Fed was slow to react. Both rose from 2009 on, as the world began to fear that Quantitative Easing would unleash tremendous inflation pressures. Both have been flat to down in the past year or so, as it has become increasingly evident that monetary policy has not produced the much-feared results.

It's not surprising that the dollar is quite weak from an historical perspective, given the Fed's overtly accommodative policy and the disappointingly slow U.S. recovery. But the dollar is not collapsing, and it has actually strengthened a bit over the past year or so. No sign here of any unusual excess of dollars in the world.

The first of the above two charts shows 5-yr nominal and real yields and their difference, which is the market's expectation for the consumer price index over the next 5 years. The second chart shows the same relationship for 10-yr yields. Both show that inflation expectations remain "firmly anchored" as the Fed is wont to say.

All things considered, there is nothing very scary going on. The only thing to be worried about is that the Fed fails to reverse QE in a timely fashion, since that could unleash a tidal wave of inflation. In the meantime, it's a good thing that the Fed seems to want to accelerate the reversal of QE.


Michael Meyers said...

Excellent post, as always

William said...

Makes sense, except for what's missing: how global investors owning the Trillions of Dollars of "safe-haven, risk-free assets" will fair between now and when "real interest rates approach 3-4% and the yield curve becomes inverted" many years from now.

It seems Bag Holders were created; they apparently just don't know it yet.

steve said...

bondholders are going to get killed-finally.

Jon S. said...

Scott (or any commenter): do you think REITs are in trouble as QE winds down?

Unknown said...

Scott - can you look into and comment to what will happen to US debt service when rates rise?

I've heard almost all the debt is 4yrs. and under at 25bps & at that rate it is still 220 billion interest per year.

What happens when Fed funds rises and bonds roll off?

Scott Grannis said...

Forecasting debt service costs is tough, because it requires assumptions about several independent variables: spending, tax revenues, the level of interest rates, and the timing of interest rate rises. But in general, I think it's likely that interest rates rise as the economy strengthens, and a stronger economy is likely to bring with it higher tax revenues and only marginal increases in spending. Thus the deficit will probably fall as rates rise, and that mitigates the rise in debt service costs. Debt service costs will undoubtedly rise significantly, but it's not necessarily going to be catastrophic. If the economy is stronger and the deficit is under control higher debt service costs could end up being a relatively minor problem.

Benjamin Cole said...

There seems to be a presumption that the Fed has to wind down its QE holdings in a rash way. or at all.

Where this comes from, I do not know.

The Fed may even just maintain its current buying pace for many more years. Inflation is dead, and the fed should not want to make the mistake of the Japan's BoJ, which went to Qe in 2005 but then quit too early.

Better a robust and sustained recovery with moderate inflation, than a weak faltering recovery, with no inflation.

Will the Fed see it that way?

Probably not. They are central bankers in safe sinecures. And they have a peevish fixation on inflation.

Benjamin Cole said...

The Fed is "overtly accommodative'?

Then why are both import and export prices falling?

Import prices slipped 0.5% last month, the biggest decline since December, the Labor Department said on Tuesday...The Labor Department report also showed export prices fell 0.7% last month, the largest decline since June.

The answer is, the Fed is not "easy." In fact, the Fed is probably not stimulative enough. That is why inflation is lower today than at any time since the immediate postwar period. Record low inflation is not a sign of any "easy" central bank.

New times call for new perspectives....

Tom Gates said...

Any way you could email push your blog posts? With iGoogle set to go away this November, other blog's email me.

wesley mouch said...

A QE exits is not scary. It is impossible. The Fed is buying 70% of new treasury issues. This will continue until (and it may be a long time) there is loss of faith in the dollar. The fact is that if the Fed does not buy the debt then interst rates will shoot up and an already broke country will become even more broke. When that happens watch out.

Hans said...

Mr Grannis, thank you for the most excellent information on the bank's reserve numbers and reserve requirements !

Hans said...

Oh dear, I forgot to axe how the Fed (Feed) would remove the excess reserves from the banks ?

Could someone, anyone, explain how this would be done..?

Thank you kindly in advance..