September 13th, 2013 | By Nick SargenHighlights
The theme of this year's Jackson Hole conference sponsored by the Kansas City Fed was "The Global Dimensions of Unconventional Monetary Policy." It turned out to be very timely as market participants are now focused on a looming cutback (or tapering) in the Fed's asset purchases. Several of the academic presentations challenged the Fed's contention that asset purchases have been effective in promoting stronger economic activity, and other presenters argued the Fed should take into account the external impact of its policies, especially the spillover effects on emerging economies. However, no consensus emerged on these issues, and there was no broad-based review of the quantitative easing program.
From my perspective, a comprehensive assessment of quantitative easing should distinguish two phases of the program: (i) the initial implementation from December 2008 to March 2010; and (ii) the subsequent expansion from November 2010 to present that included QE2, Operation Twist and QE3. As discussed below, the initial phase succeeded in stabilizing the financial system and laying the groundwork for economic recovery. However, subsequent programs that were directed at reducing long-term bond yields had less impact in promoting stronger economic growth.
The initial phase of the Fed's QE program began in late 2008, when the financial system was under severe strain following the collapse of Lehman Brothers and near collapse of several other leading financial institutions. This resulted in money markets and credit markets seizing up and credit spreads blowing out. The TED spread, for example, which measures the difference between LIBOR and the yield on Treasury bills and is a gauge of confidence in the banking system, increased to 4.5 percentage points in September of 2008. At the same time, credit spreads versus Treasuries for both investment grade and below-investment grade corporate bonds widened to record levels, and trading in non-agency mortgage-backed securities came to a halt.
Against this backdrop, the Federal Reserve lowered the federal funds rate to zero and subsequently announced in late November that it would purchase up to $600 billion in agency mortgage-backed securities (MBS) and agency debt. The program was formally launched a month later, and in mid March of 2009 the FOMC announced it would be expanded by an additional $750 billion in purchases of agency MBS and agency debt and $300 billion in purchases of Treasury securities over the next 12 months. The program succeeded in calming financial markets and improving liquidity in the financial system, as credit spreads proceeded to decline steadily throughout its duration.
Another development that bolstered investor confidence occurred in March of 2009, when Treasury Secretary Geitner announced a Public-Private Program (P-PIP) to buy troubled assets from banks' balance sheets. This program used the remaining $300 billion in TARP funds to directly infuse capital into banks. It lessened concerns about bank insolvency and spawned a rally in bank stocks and the broad market. Taken together, the Fed's initial QE program and the Treasury's P-PIP program lessened fears about the safety and soundness of the financial system and thereby set the stage for economic recovery, which began in mid-2009.
By comparison, the objective of the second phase of the QE program was to boost overall economic growth and maintain inflation at levels consistent with the Fed's dual mandate. QE2 was launched in November 2010, when the economy had softened and the unemployment rate was hovering close to 10%. The goal was to bolster the economy and lower the unemployment rate by reducing long-term bond yields. To that end, the Fed announced it would purchase $600 billion of intermediate and longer dated Treasuries through June 2012.
The announcement surprised market participants, as the yield on the 10-year Treasury already was down to 2.5%, while yields for investment-grade corporate bonds were near 4%, the lowest since the financial crisis. Many observers questioned how effective the program would be considering how low yields were at the time, and yields rose by about 100 basis points immediately following the announcement. However, this did not deter the Fed from embarking on "Operation Twist" in September 2011, in which it sought to lower yields on intermediate and longer- dated instruments without expanding its balance sheet. One year later it embarked on QE3 in which it would purchase $85 billion of bonds monthly ($40 billion of agency backed paper and $45 billion of Treasury bonds) until the labor market improves "substantially".
With money market rates near zero, the main transmission mechanism for these programs to influence the economy is via financial markets. One of the programs' clear successes is that the value of equities and other risk assets have recovered fully from the financial crisis, and household net worth currently is above its pre-crisis record level. Fed officials can also point to a revival of auto sales and a turn in housing as being underpinned by record low interest rates.
These programs, however, have had less effect in boosting economic growth above a tepid 2% annual rate over the past four years, and spending by households and businesses has not accelerated materially. A recent study by economists at the San Francisco Federal Reserve concluded QE2 added only about 0.13 percentage points to real GDP growth and that without forward guidance it would have added even less. (See FRBSF Economic Letter, "How Stimulatory Are Large-Scale Asset Purchases?" August 12, 2013.) Similarly, Stanford University Professor Robert Hall concluded his Jackson Hole presentation by stating, "Both quantitative easing and forward guidance, as implemented by the Fed, are obviously weak instruments."
The next test of the QE program lies ahead as the Fed begins to scale back or taper its purchases of securities. I expect the Fed will announce it is reducing monthly purchases by $10- $15 billion at the September FOMC meeting, and it will indicate future reductions are dependent on how the economy and unemployment fare.
Ultimately, for the program to be viewed as a success, the Fed must be able to engineer a successful exit strategy. Some commentators are concerned that the huge buildup in bank reserves will become a source of inflation pressures over the long-term. From my perspective, however, the more pressing risk is that the Fed's exit strategy could unsettle financial markets: So-called "carry trades" are likely to become less attractive, and financial markets could respond in unpredictable ways as investors exit these positions.
The debate about Fed "tapering" already has resulted in Treasury yields surging by a full percentage point, and yields for investment grade and corporate bonds have risen by greater amounts. This pattern is very different from the typical one in which credit spreads narrow as Treasury yields rise. One reason is there is less liquidity in the bond market now that there are fewer securities firms playing the role of market makers. Also, many retail investors poured money into bond funds after the financial crisis, believing they were safe investment havens. However, the sell-off in bond markets over the past five months has led to redemptions out of bond funds and ETFs.
The situation is more problematic for emerging economies. When the QE program expanded, investors shifted money into emerging market funds, which caused their currencies to soar. Officials from certain countries complained that the Fed's actions could create "currency wars", as they felt obliged to intervene in the foreign exchange markets or to lower domestic interest rates to limit the appreciation of their currencies. Today, these same countries face the opposite situation in which capital has flowed out of their countries, their currencies have weakened significantly, and their financial markets have sold off. Accordingly, developing country representatives who attended the Jackson Hole conference urged Fed officials to take into account the consequences of their actions on the emerging economies.
Fed officials have tried to calm the markets by indicating they intend to proceed gradually in phasing out the QE program, and they are not inclined to raise short-term interest rates until the unemployment rate, currently at 7.4%, is below 6.5%. Nonetheless, market participants are not heeding the message that "tapering is not tightening": The bond market is pricing in Fed tightening to commence in the second half of 2014, or roughly a full year earlier than current FOMC members are anticipating. To some extent, this may reflect uncertainty about the next Fed Chairman and the composition of the Board of Governors, where a minimum of three members are slated to step down.
My own take is the bond market's expectation that yields will rise over the next 12 months by an additional 25-50 basis points across the maturity spectrum (more in the intermediate area than at the long end) is reasonable. If so, the U.S. economy is likely to accelerate gradually and appears set to achieve 3% growth by next year. However, if yields were to increase substantially more – say by an additional 100 basis points or more the prospect for the economy gaining traction would be reduced significantly. How financial markets respond to Fed tapering, therefore, will have an important bearing on whether the economy achieves sustainable growth in the coming year.