Perhaps the biggest market-moving event that seems like an inevitability to market participants in the coming years is the Federal Reserve’s exit from quantitative easing (QE), the bond-buying policy it has employed since the financial crisis, in the process growing its balance sheet to over $US3 trillion in an attempt to stimulate the U.S. economy.
Right now, the Fed is buying $US85 billion of bonds every month, indefinitely: $US45 billion of U.S. Treasuries and $US40 billion of mortgage-backed securities.
Yet over the past three months, a vicious sell-off has gripped the Treasury market, sending bond yields soaring as fears that the Fed will begin to taper back the amount of purchases it makes each month have permeated the marketplace.
“The surge in the 10-year yield came on the mere mention that the Fed might reduce its purchases of bonds,” writes Nomura chief economist Richard Koo in a note. “If the central bank were to actually begin selling the securities it has accumulated, rates would probably react much more violently. Making matters worse is the fact that bank reserves injected into the system under QE already amount to 17.8 times the statutory reserves needed to sustain the US money supply. In other words, the Fed has a long way to go.”
The trillions of dollars worth of bonds accumulated on the Fed’s balance sheet over the past several years thus put the central bank in a tricky spot.
Koo argues that the Federal Reserve will probably need the Treasury’s help to pull off the normalization of its balance sheet:
Treasury’s cooperation should be enlisted in ending QE
The next question is how to mop up the excess reserves that now amount to 17.8 times statutory reserves in the US. Given the size of the problem, I think any answer will have to involve the Treasury Department.
A substantial portion of the funds supplied by the Fed were provided via the purchase of long-term Treasury securities. This means the securities the central bank has to sell as it winds down QE will consist largely of long-term bonds.
But if the Fed begins selling long-term Treasurys at a time when the private sector has completed its balance sheet repairs and is starting to borrow money again, the result will almost certainly be a steep rise in interest rates that could stop the long-awaited economic recovery in its tracks.
Fed should first shift portfolio from long-term to short-term bonds
When the BOJ ended its first experiment with QE in 2006, banks held deposits with the central bank equal to seven times statutory reserves. But since all of these funds had been supplied via the money market, the impact on long-term interest rates when the funds were absorbed (again via the money market) was limited. The 10-year JGB yield rose about 40bp when the removal of QE was announced but returned to its previous level within a few months.
If the Fed similarly hopes to minimize the impact on long-term rates of ending QE, I think it will have to end the program in two stages, with the cooperation of the Treasury Department.
First, the Fed needs the Treasury to reduce issuance of long-term debt while QE is being unwound and instead issue mostly short-term debt. The Fed can then sell its long-term bonds in the market while purchasing an equivalent amount of short-term debt, in a reversal of Operation Twist. The impact on long-term rates should be limited if the Treasury Department agrees to minimize issuance of long-term debt during this operation.
Shorten duration, then mop up excess reserves
Most of the bonds held by the Fed would then be short-term securities with a shorter duration (average remaining maturity), and the Fed could mop up the excess reserves in the money market just as the BOJ did.
Following this two-step procedure would substantially reduce the impact on the yield curve of winding down QE and limit market turmoil, assuming market participants understood what was being done.
There are other tools that could — and probably will — be used as well, including increases in statutory reserve ratios, capital adequacy ratios, and liquidity ratios. But close cooperation with the Treasury Department would be especially effective in minimising the impact on the yield curve, and particularly on the long end of the curve.
Other economists have considered how the Treasury — through adjustments to fiscal policy — could help the Fed eventually stage an exit from QE and normalize its balance sheet.
“Tight fiscal policy could offset easy monetary policy until the Fed’s portfolio begins to shed enough assets to tighten policy (an event that may take until 2018),” wrote UBS economists in a November report. “As growth accelerates in 2013 and 2014, it would appear to make sense that tighter fiscal policy be put into place, not just for the positive impact on the deficit, but also because such an action may be the only way for the Fed to extract itself from its quantitative easing programs — a feat that would make the Federal Reserve the only central bank to successfully exit a QE program.”