Last Call: The End of Quantitative Easing
In 1955, Federal Reserve Chairman William McChesney Martin said, the Federal Reserve “is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.”1
But, since the financial crisis, the Fed has not been focused on diluting economic spirits. Instead, they have utilized a unique strategy commonly referred to as “Quantitative Easing” (QE), to spike the economic punch.
This paper explains the basics of monetary policy and quantitative easing, how monetary policy impacts the pace of economic growth, how the markets have responded to QE, and discusses the culmination of QE.
How Do You Make a Dollar?
In the United States, the ability to create money resides within the banking system. Yes, the government literally prints money and mints coins. But private-sector banks are responsible for creating the vast majority of the money flowing through the economy.
Money is created when banks make new loans. When a bank approves a $1,000,000 loan to a homebuilder the government doesn’t fire up the printing press to create fresh bills. And burly security guards don’t deliver a bag with $1,000,000 cash to the builder.
To “make” dollars, a banker punches keys on a keyboard and increases loans (assets) in the banking system by $1,000,000. The amount of deposits (liabilities) in the banking system increase by $1,000,000 as money flows into the homebuilder’s bank account.
The funds the builder borrows eventually become paychecks for lumber-yard employees, roofers, electricians, and plumbers—all the workers paid to build houses. The builder sells the homes, repays the bank $1,000,000 plus interest. The remaining money is the builder’s profit.
Money is created and it flows through the economy because of the loan agreement between the builder and the banker. The loan to the builder becomes the plumber’s paycheck. When the plumber buys groceries or makes a down payment for a new car the incomes of the grocer and the car dealer increase.
The economy surges ahead when profitable loans fund profitable enterprises. Houses are built and sold profitably, and grocery stores are filled. The economy stalls when the homebuilder is approved for half as much credit as last year. Car purchases are delayed; grocery store purchases include more low-cost, generic brands as consumers cut back on spending.
What is the Role of Bank Reserves in Monetary Policy?
The purpose of monetary policy is to quicken or slow the pace of economic growth by altering the interest rates of new loans. Making the cost of getting a loan more expensive reduces the quantity of new loans originated—the money creation machine is slowed.
The Fed alters the price of credit through the federal funds rate, commonly referred to as “fed funds.” The fed funds rate is the rate at which banks borrow and lend bank reserves on an overnight and uncollateralized basis.
Bank reserves are funds that a bank is required to have deposited with the Fed or in vault cash. The quantity of a bank’s required reserves is dependent on the quantity of a bank’s deposits.
Currently, banks with $89 million or more in deposits are required to have an amount equal to at least 10% of their deposits in their reserve account with the Fed or in their vault in cash.2 There are no non-financial players borrowing or lending in the bank reserve market.
When a builder receives a $1,000,000 loan the funds are deposited into the builder’s bank account. If $1,000,000 is deposited into an account at a bank with over $89 million in deposits, the bank’s required reserves grow by $100,000. If a bank needs additional reserves they can borrow them from another bank in the fed funds market.
As part of doing the cost-benefit analysis associated with making a new loan, a bank will estimate the interest income that will result from making a new loan. Income is assessed versus the bank’s cost of funding—how much it will cost to borrow the funds used to finance the loan, including the cost to borrow reserves.
In 2008, the Federal Reserve began paying interest on reserves for the first time ever. For holders of reserves, the income from making a new loan needs to be greater than simply holding reserves and receiving interest income.
Why Does the Fed “Raise” Rates?
You may hear people ask, “When is the Fed going to raise rates?” But the Fed cannot command banks to borrow or lend reserves for a specified interest rate.
The fed funds rate is not an etched-in-stone interest rate. It is a target rate set by the Fed. The target rate is hit by altering the supply of bank reserves through the conduct of open market operations between the Fed, banks or their broker-dealer subsidiaries.
To hit the lower target rate, the Fed buys bonds from banks and broker-dealers. When the Fed buys bonds they pay for them by crediting the seller’s reserve account. This increases the amount of bank reserves in existence. When the reserve market is flooded with a large supply of reserves the fed funds rate falls towards the target rate.
When the fed funds rate falls, it has an impact on long-term rates. Imagine a string connecting the overnight borrowing rate (the shortest possible loan term) with the 30-year Treasury bond (the longest loan term currently offered by the U.S. Treasury).
By flooding the reserve market, the Fed pulls down on the short-term edge of the string. But the intent of the yank is to cause a downward ripple all the way through to the 30-year rate, lowering the long-bond rate too. Lowering the overnight-interest rate at which banks borrow should also lower long-term borrowing rates. Economic growth accelerates. Investors return to the economic dance floor. The party heats up.
Inflation occurs when credit expands too rapidly in relation to the ability of the economy to produce enough goods and services. Higher, or inflated, prices are a reflection of a large supply of dollars chasing after a limited supply of goods.
Deflation, on the other hand, occurs when credit is tight in relation to the amount of goods produced by businesses. Lower prices are a result of fewer dollars chasing after an abundance of goods.
Builders and housing prices will be affected by inflation if the production of lumber does not keep pace with the demand for 2x4s to build new houses. When builders must buy lumber to build they will pay higher and higher prices for it. This causes the cost and price of new homes to rise. It’s important to note that this 2x4 inflation began because banks lent too much money to build houses.
Open the Window! What is the Federal Reserve’s Discount Window?
If, due to stress in the banking system, a healthy financial institution is unable to borrow overnight at the fed funds rate from another financial institution, it can borrow at the Fed “window.” The window is a “safety valve” that allows financial institutions to borrow money from the central bank—as opposed to another financial institution—at the “discount rate.”3
If a bank gets a loan through the window, it has to pledge collateral to the Fed and pay an interest rate greater than the fed funds rate. Yes, the “discount” rate is actually a premium rate compared to the fed funds rate. Loans from the Fed have higher interest rates because the Fed wants to incentive banks to borrow from other financial institutions, if they can, rather than from the Fed.
Nominal Yield v. Real Yield
Inflation is a major risk for investors and lenders because they have agreed to be paid interest in dollars in the future. They would like future dollar-based payments to retain their value.
The 30-year U.S. Treasury bond sold in February 2014 has a coupon of about 3.66%.The coupon is the bond’s stated rate of interest. If the U.S. Treasury sold an investor $1 million worth of this 30-year U.S. Treasury bond, each year the investor will receive $36,600 in interest. This bond’s 3.66% coupon rate is the nominal rate of return.
Currently, the 12-month Personal Consumption Expenditure (PCE) core inflation rate is 1.1%.4 When inflation is 1.1% per year, the purchasing power of the nominal 3.66% interest payment will be eroded by 1.1% annually. This means the bond’s real rate of return is 2.56%.
Inflation erodes the $36,600 interest payment by $11,000. The investor’s real purchasing power increases by $26,600. Inflation will also erode the value of the $1 million principal investment that the government will return to the investor at the end of the loan term.
If inflation rises to a point that is equal to a bond’s nominal return, the investor’s real rate of return will be zero. Therefore, ensuring that inflation remains “well-anchored,” in Fed-speak, is extremely important.
What is Quantitative Easing?
From the perspective of monetary policy, we are not living in normal times. In 2008, to combat the contraction of lending in the midst of the banking crisis the Fed lowered the fed funds target rate range to 0%-0.25%, the lowest possible range—where it remains today.
Faced with a “zero-bound” fed funds rate, the Fed has been compelled to take unconventional measures, one of which is quantitative easing or “QE.” The Fed refers to the QE program by its formal name, the Large Scale Asset Purchase (LSAP) program. And that’s an accurate description of what the Fed has been doing since 2008.
As a Federal Reserve Bank of New York Economic Policy Review noted in a 2011 report, “We believe that no investor—public or private—has ever accumulated such a large amount of securities in such a short period of time.”5
We believe that no investor — public or private — has ever accumulated such a large amount of securities in such a short period of time.
As stated above, normally the Fed executes monetary policy by buying or selling short-term Treasury securities. In QE, the Fed has broadened its scope to a larger group of government-backed assets.
In addition to short-term Treasuries, the Fed has purchased longer-term Treasury bonds, Agency mortgage-backed-securities, and Agency debt. Agency securities are the mortgage-backed securities insured by the government sponsored enterprises, Fannie Mae and Freddie Mac, and the bonds that they sell to fund their operations.
A finite amount of government-backed debt exists. When the Fed buys a large quantity of risk-free debt it is no longer available for market participants to buy. The Fed’s purchases, in a market with limited supply, force other investors to purchase other, non-risk-free market securities.
What is the Purpose of QE?
The objective of QE is to ease lending conditions and to keep long-term interest rates low. QE is intended to pressure long-term interest rates down by altering investment portfolios. This shift is known as the portfolio balance channel.
Former Federal Reserve Chairman Bernanke described the portfolio balance channel at the Federal Reserve Bank of Kansas City’s Economic Symposium in Jackson Hole, Wyoming in 2010 this way:
Once short-term interest rates have reached zero, the Federal Reserve’s purchases of longer-term securities affect financial conditions by changing the quantity and mix of financial assets held by the public. Specifically, the Fed’s strategy relies on the presumption that different financial assets are not perfect substitutes in investors’ portfolios, so that changes in the net supply of an asset available to investors affect its yield and those of broadly similar assets.6
What that means is the Fed is buying up a huge chunk of long-term, risk-free debt trading in the market. As the Fed buys up the finite supply of risk-free debt, investors (pension funds, hedge funds, insurance companies, and banks) are forced to buy riskier market assets like corporate bonds and stocks. Therefore, demand shifts to comparatively riskier securities. Not necessarily wildly or unreasonably risky securities, just simply riskier than risk-free.
As demand shifts to non-risk-free bonds, like corporate bonds, prices of those bonds rise and bond yields fall. Lower market yields allow companies to borrow to fund projects with cheaper debt, or refinance old bonds and loans into new bonds with lower interest costs.
In general, the objective of QE is the same as buying very short-term debt in order to lower the fed funds rate. Indirectly, those purchases should lower longer-term borrowing costs. The difference is, in QE, the Fed is buying longer-term bonds with the intention of directly impacting longer-term borrowing costs.
A Bond’s Price Moves Inverse To Its Yield
A fundamental principle of bond investing is that a bond’s price moves in the opposite direction of a bond’s yield. A coupon is a bond’s stated rate of interest. In 2013, Anheuser-Busch sold $1.25 billion of 10-year bonds with a 2.625% coupon. That means an investor who owns bonds with a $1 million face-value will receive $26,250 in interest annually.
A bond’s yield is a measurement of the total market-based return of owning a bond. If the price of a bond falls, the yield will rise. The market yield on the Anheuser-Busch bonds has risen in the past year. Investors now receive a yield of 3.3%—.675% greater than the bond’s coupon.7
The price of the Anheuser-Busch bond has fallen from 99 cents to 94 cents on the dollar.8 If market-interest rates drop, investors will scramble to buy higher yielding debt. The price of Anheuser-Busch’s bonds will rise, and the yield will fall.
Understanding the inverse relationship between bond prices and yields is crucial to understanding the portfolio balance channel and the dynamics of QE. In QE, the Fed scoops up lots of very safe, longer-term debt in the market. The Fed’s purchases force investors to buy other securities that are a slightly more risky. This forces bond prices up and bond yields down.
The QE Timeline: QE-1, QE-2, QE-3
Since 2008, the Fed has purchased securities in three separate series. And the Fed is currently purchasing securities at a clip of $55 billion per-month.
“QE-1” began in November of 2008 and ended in early 2010. During this first round of asset purchases the Fed bought $1.25 trillion of government-backed Agency mortgage-backed securities, $200 billion of Agency debt, and $300 billion in longer-term Treasury debt.9
From November 2008—at nearly the height of the banking crisis—through January 2010, the Average 30-Year Fixed Mortgage Rate fell from 6.2% to 4.9%.10 And the Merrill Lynch BBB Effective Yield Index—which is an aggregate of corporate, investment grade bonds—fell from 10.15% to 5.17%.11
- “QE-2” started in late 2010 and the Fed purchased an additional $600 billion in longer-term Treasury debt. This round of purchases ended in mid-2011.12
In the summer of 2011, the Fed started the maturity extension program (MEP)—referred to as “Operation Twist.” This program was intended to alter the makeup of the Fed’s Treasury bond holdings.
The Fed sold $400 billion in short-term Treasuries and purchased $400 billion in longer-term Treasury bonds. Buying the longer term debt was intended to put additional downward pressure on longer-term interest rates. But, because the amount of purchases equaled the amount of sales it did not add or subtract from the Fed’s asset holdings.
- “QE-3”, the final, ongoing round of bond purchases began in September 2012. At that point, the Fed announced $40 billion in monthly purchases of agency mortgage-backed securities.
- In December 2012, the per-month purchase target was increased to $85 billion, $40 billion in mortgage securities and $45 billion in longer-term Treasuries.
- Taper: In January 2014, the per-month purchases were cut back to $35 billion in mortgage securities and $40 billion in longer-term Treasuries. The $10 billion taper continued in February and April. In the month of April, the Fed will buy $55 billion in bonds.
The Fed’s communication policy—referred to as “forward guidance”—works in tandem with its asset purchases. Clearly communicating their intended future interest rate policy provides markets and businesses with some insight into what the Fed may do in the future. Announcing that the fed funds rate will be extremely low for a long period of time is crucial to setting investor expectations about the future path of short-term rates.
How Has the Market Reacted to QE?
The graphs below track four key market metrics over the entire QE timeframe: the 30-year mortgage rate, the 10 year U.S. Treasury rate, the borrowing rate for BBB-rated corporate borrowers, and the S&P 500 stock index.
Why is the Fed Winding Down QE?
The Fed’s monetary policy actions are governed by the Fed’s dual mandate—to support full employment and stable prices. Since the financial crisis, the Fed has used their full monetary arsenal—“zero” fed funds rate, QE, and forward guidance—to foster growth.
In May 2013, the Fed stated that it may begin to “taper” or trim its bond purchases by late 2013. In January and February 2014, the Fed reduced new bond purchases by $10 billion per month. In April, the Fed will continue to taper at a rate of $10 billion per month, making a total of $55 billion in new bond purchases.
Why is the Fed now spiking the punch bowl more slowly if QE has been effective in lowering rates and easing lending conditions?
1. It’s the Economy
The economy has generally been improving. Conditions have begun to warrant a monetary policy that is less than amazingly accommodative.
In 2013, for the first time since the financial crisis, the total amount of loans and leases held on U.S. commercial bank balance sheets exceeded 2008 levels.13 And in 2013, household borrowing rose at its highest rate since 2007.14
As of February 2014, the unemployment rate stands at 6.7%, a 3.3% improvement from the bleakest unemployment measure of the crisis era. The net worth of U.S. households rose to its highest level in history, $80.7 trillion, in 2013. This gain was due to rising stock market prices and the rebound in housing prices.15
Due to these clear improvements in economic conditions, the Fed believes that the time has come to reduce its historic level of monetary support.
If the Fed continues to wind down QE-bond purchases at its current pace, the taper will end during the second half of 2014. At that point, the Fed will not be making any new bond purchases. Their sights will shift to the question of when to raise the fed funds rate.
In a January 2014 speech, then Chairman Bernanke reiterated what the Fed’s policy has been since December 2012, “no increase in the federal funds rate should be anticipated so long as unemployment remained above 6.5%, inflation between one and two years ahead was projected to be no more than a half percentage point above the Committee’s 2% longer-run goal.”16
In March 2014, the Federal Open Market Committee stated that it “currently anticipates that, even after employment and inflation are near mandate-consistent levels [6.5% and 2%, respectively], economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.”17
Clearly, the economic indicators are signaling that these thresholds for considering future fed funds rate hikes are approaching. Based on the current economic projections made by Federal Reserve Board Members and Federal Reserve Bank Presidents, a fed funds rate increase is expected in 2015.18
2. QE is Not a Riskless Proposition
The conduct of monetary policy has the potential to create economic benefits and risks. QE presents its own set of unique risks. Through QE, the Fed is buying up the finite supply of riskless debt in the market. This forces market participants to buy riskier debt. Bond prices rise, yields fall.
Essentially, the Fed’s actions have inflated the prices of certain assets. By forcing bond yields down, the Fed’s intention was to improve the price of credit for business and consumer loans. But these economic rewards do not come without risks.
Recently, economists Michael Feroli, Anil Kashyap, Kermit Schoenholtz, and Hyun Song Shin, published “Market Tantrums and Monetary Policy.”19 The paper examines one way that long-term quantitative easing programs could create risks to financial stability.
The paper argues that the bond market has become hyper-sensitive to changes in monetary policy. As the authors note, “Our analysis does suggest that the unconventional monetary policies (including QE and forward guidance) create hazards by encouraging certain types of risk-taking that are likely to reverse at some point.”20
The authors argue that market participants could ‘reverse’ course by rapidly selling off bonds as the Fed orders away the QE punch bowl. This could create financial instability and cause yields—and borrowing costs—to spike as the Fed spikes the punch more slowly. Volatility in the debt markets caused by investment managers competing to sell assets before their competitors could impact lending rates and economic growth.
As the authors argue, the trade-off to consider as policymakers debate the timing and pace of unwinding QE is “between more stimulus today at the expense of a more challenging and disruptive policy exit in the future.”21
Since 2008, the Federal Reserve has been, in the words of former Chairman Ben Bernanke, involved in the process of “learning by doing.”22 As our economic chaperone, they have steadied the economy through one of the most severe financial dislocations in U.S. history.
By virtue of their actions, the Fed has smoothed the transition from the credit crisis until today. In the wake of the crisis, bond yields have remained low; and inflation has remained below the Fed’s 2% target. These credit conditions have allowed corporate and household balance sheets to be repaired.
The Fed now holds over $4 trillion in government bonds, by far the largest portfolio the U.S. central bank has ever held. Investors and policy makers are waiting to see if the Fed can pull away the punch bowl at the right pace and at the right time to allow the economic party that is slowing gaining heat to flourish.