What are the implications of even “tapering” Quantitative Easing expectations?

Events last night brought me back to my first entry into the blogging world as the actions of  Ben Bernanke and the US Federal Reserve reminded me of it. Back on the 13th of November 2009 I pointed out this about Quantitative Easing.

Also I have heard no coherent policy on how this policy is going to be reversed

This concept was fairly quickly labelled under the category of exit strategies and to my mind a successful policy action required you to be as sure how you would reverse it as how you would start it. However it was and indeed still is my opinion that thoughts and plans about exiting QE were left for another day, presumably being hidden in any recovery then taking place. There has been a marked shortage of official pronouncements pointing out that it was another action designed to borrow from the future. After all that might lead to minds wondering about the consequences of the future not being as “bright” as the picture invariably painted by official forecasts.

Rather ironically the departing Bank of England Governor Mervyn King introduced elements of such a line of thought at his Mansion House speech last night.

The present extraordinary monetary policies cannot, however, continue indefinitely

Although as ever there is a contradiction between his words and his deeds as if we look at the latest Monetary Policy Committee minutes we see this.

Three members of the Committee (the Governor, Paul Fisher and David Miles) voted against the proposition, preferring to increase the size of the asset purchase programme by a further £25 billion to a total of £400 billion.

Yes Mervyn King had just done his best to keep it going indefinitely!

Asset Price Bubbles

Back on January 10th 2010 I pointed out this as I discussed what was a dilemma for central bankers.

The sums spent have contributed to the rise in asset prices such as stock markets and commodity prices. It may have contributed to an asset price bubble here. I would remind you that part of its role is to help control and avoid bubbles not create them.

This theme developed two strands. The first was that we saw asset and commodity price bubbles develop in many places. The second was that central bankers increasingly took credit for rises in equity markets. The latest version of QE in Japan called Abenomics has taken this unhealthy development even further as it seems to regard the level of the Japanese equity market (Nikkei 225) as a policy tool in itself. Both of these were dangerous and the latter in particular fed into the concept of this being a junkie style culture with the central banks operating as a type of dealer/supplier. This leads us to the issue of withdrawal symptoms and maybe even cold turkey depending on circumstances.

The US Federal Reserve

The latest meeting statement was released last night and it would be an understatement to say that it was eagerly awaited. Here are the relevant excerpts.

The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes.

When the Committee decides to begin to remove policy accommodation

These hints were backed up by stronger economic forecasts which as I will discuss later impacted strongly on financial markets immediately.

Ben Bernanke

In the press conference the current Chairman of the US Federal Reserve kindly defined what tapering meant to him.

If the incoming data are broadly consistent with this forecast, the Committee currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year.

So we see that he is publicly admitting to contemplating a reduction in the current US 85 billion of QE purchases per month. Indeed he then went further.

And if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around mid-year.

So around the middle of 2014 the policy could be stopped. There is a get-out clause in that this will depend on changes in the US unemployment rate as the objective is for it to decline to 6.5%. As an aside I still think that they made an error here as it would have been more logical to target the employment rate.

An Exit Strategy At Last?

I am reminded of the words of Winston Churchill after the battle of El Alamein in 1942.

Now this is not the end. It is not even the beginning of the end. but it is, perhaps, the end of the beginning.

Because if we review what has taken place we see that rather than an exit strategy we are seeing only the probability of a reduction in purchases accompanied by the possibility of an end to QE purchases. There are no plans for any sales of the mortgage and government bonds purchased. Perhaps of course the intention is in fact not to sell them and let them mature and kick the can of dealing with the monetary expansion forwards to another yet unspecified day. Currently according to the St. Louis Fed this amounts to 1,906 billion US Dollars (and rising).

So at best this is a passive type of exit strategy that in effect hopes that the problems created will melt away over time. The history of the credit crunch would lead even the casual observer to decide that this was unlikely and I am of the view that there will be problems. Exactly how many depends on events.

Speaking of events

Whilst the media is concentrating on equity market falls which have continued this morning – The UK FTSE 100 has dropped 2% to 6222 as I type this- the more significant impact was felt elsewhere.

US Treasury Bond prices fell heavily and yields surged in response to the news. The ten-year benchmark yield has reached 2.4% now which is up from more like 1.6% at the beginning of May. This has been something of a rout in bond markets which has spread to UK Gilts (government bonds) as our market has dropped to 2013 lows as our ten-year yield has risen to 2.28%. Furthermore interest-rate expectations have changed in futures markets ( confusingly called short sterling) and they are now pricing in the prospect of a rise.

We will have to see if markets are overshooting in the short-term but bond markets changed course a month and a half ago and longer-term interest rates have risen. In the United States this has raised mortgage rates for example with the thirty-year hitting 4.17%. The impact in the UK is slower and of course will clash with the Funding for Lending Scheme which is trying to drive lending higher and mortgage rates lower.

Remember Hilsenrath?

For those unaware of the name, Jon Hilsenrath is an economics reporter at the Wall Street Journal who is widely considered to be a mouthpiece for the US Federal Reserve. At the end of last week I was very critical on twitter of the way that the Federal Reserve appeared to be using him again to conduct monetary policy by newspaper articles. I guess now I will at least be joined by those who thought it was safe to return to bond markets.

Comment

The world has moved into a new phase of the credit crunch where the central bank of its reserve currency has begun to talk of reducing its previous “More,More,More” strategy. So far it is just talk and as I have pointed out earlier we are currently only facing a reduction in the rate of QE expansion as opposed to an end to it or a reversal. But in the junkie style culture that has been developed by it we are already seeing one or two signs of indigestion and an amber light or two.

The rise in bond yields we have seen may well be opening a new front in the analysis of QE. For example the Bank of England tells us that one of the ways that QE operates is via this.

That lowers longer-term borrowing costs

As you can see they are now rising. Some care is needed as they fell by much more than the recent rise but we perhaps are getting an insight into QE which is aligned with something I have long suspected. If it is to have an effect on bond yields and keep them (ultra) low it looks as though “More,More,More” will be required. On that road there is no possible exit strategy without interest-rates bouncing back strongly. Will that reverse any nascent recovery and plunge us back into the gloom?

 

 

 

 

 

This entry was posted in General Economics, Gilts, Interest rates, Quantitative Easing and Extraordinary Monetary Measures, The US Economy, UK Inflation Prospects and Issues and tagged , , , , . Bookmark the permalink.
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  • forbin

    hi Shaun,

    I guess we’ll see the level of what real market activity there is .

    expect U turns if the markets start to tank – its all expectations.

    so another bubble might pop , or lucky if it slowly deflates

    still does nothing for the debt issue and those costs rise…….. oooh er missus!

    Forbin

  • Drf

    Hi Shaun,

    “Will that reverse any nascent recovery and plunge us back into the gloom?” Yes, of course that is utlimately now inevitable, eventually; but no one can predict when it will occur. The only thing which can be predicted with certainty is that the longer it is before that occurs, the greater will be the eventual collapse and the velocity of that collapse.

  • Mike from Enfield

    Shaun,

    Notwithstanding the reaction of the markets, I don’t see these announcements as being very significant in themselves. Far from providing any insight into what is really in the minds of the policy-makers, they serve merely as little dabs on the brake as a complement to the simultaneous acceleration provided by money printing/debauchery.

    It will only get really interesting when/if the whole thing ever goes into reverse. With so many zombies feeding on all the fresh blood, it isn’t going to go down well when it stops!

  • Joe

    Hi Shaun, what about the possibility of letting the QE bonds run to maturity and then just cancelling the debt? Wouldn’t that be just a small extenson on what the BoE has already done, when it gave the interest on the bonds, the so-called profits, back to the Treasury?

  • Justathought

    Hi Shaun,

    Excellent article,

    Our policies makers are, at last realising, that to borrow from the future is to cut the branch they are sitting on….Thanks to their cleverness, but also thanks to insightful commenters such as you Shaun… We had
    few years to organise and protect ourselves (Indeed Sir Mervin King your new title as Lord is well deserved!). The saddest part is for the “losers”,
    unfortunately the proverbial horse lead to the river but refusing to drink from it… The storm might finally be at sight, how strong and destructive would it be? That’s the question?

    How grateful I am to my grand Dad (A very simple but wise man) for having followed his advices all my life…”Never trust any governments and banks…”, “Always live with less than what you earn” and the most important one; “Think for yourself! Read everything, listen to everything, but believe nothing no matter where you read it or who said it, not even if I said it, until you’ve researched it yourself and it agrees with your own reason and your own common sense!”

  • forbin

    actually can they do that ?

    seems wonderful if they can – but inflationary ,

    oh come come , Forbin, inflation has not really been an issue , has it now?

    Forbin,

  • Noo 2 Economics

    Hi Shaun,
    An interesting piece to think about – Thanyou. I suspect Bernanke could yet reverse direction as Forbin says if markets fall too far, so uncertainty still rules. The CB’s are bent on stopping the equity markets falling and ensuring their respective Governmants continue receiving cheap funding so this could be a very very long taper.

    They can’t give definites because they are calibrating their measures according to information flows re unemployment and inflation. That’s only to be expected and I think it’s good they do this, rather than setting out a plan and then slavishly sticking to it no matter how events change and how much damage it does a la the boy George at No 11.

  • Midge

    Hi Shaun and thanks for this excellent blog which I read after seeing the latest employment figures in US missed expectations.
    Has anything changed? In a way no has it has always depended on the unemployment figure being 6.5%.I think your Churchillian quote after the end of fighting in North Africa however fits the bill.I believe “tapering” will begin this year as Bernanke will be desperate to start this process before the end of his tenure at the end of January.Of course it will be still adding to the Fed’s balance sheet which is estimated to be around $3.5 trillion,Will bond purchasing end mid 2014? Only if projections for the economy were to come about and that’s a big if.When will the “exit strategy” be concluded I will leave that to Johnny Mathis- Until 12th of never and that’s a long,long time.

  • Anonymous

    Is it? QE has been used not to build a mountain of credit but to fill in a mountain of debt that could not be paid. I’d argue we have seen the inflationary phase under Labour with house prices trebling. Now we are seeing the absence of genuine wealth creation biting as the credit expansion slows.

    The credit is already out there and has been spent. The debt remains. It’s asymetric – injecting mortgage/education debt into the economy has an immediate effect, then we see the drag over 25 years as it’s slowly paid back.

    So you get all the benefit in the current electoral cycle and most of the pain in the next guy’s.

  • Anonymous

    I agree with your sentiment and practice what your dad preaches, but I’m not sure on the conclusion. Those living on debt have enjoyed far superior lifestyles over the past 15 years, relative to comparable earners who exercised restraint. That may not continue but they can only go bankrupt once and most, living hand to mouth, have nothing to lose.

    Meanwhile those who saved have obtained scant reward. The one thing it has bought me is piece of mind – I find being indebted rather stressful.

  • Anonymous

    Hi Forbin

    The UK got a tweak of the nose on its national debt today. We issued some 5 year Gilts at a yield of 1.42% which is the double the yield it was trading at as recently as the beginning of May.

    Last summer our five year yield dropped below 0.5% for a bit…

  • Anonymous

    Hi Mike

    To my mind it would have been much simpler for the Federal Reserve to have changed its policy. It could have said the economy is showing signs of recovery so we will reduce our QE purchases from US $85 billion to say 75 billion. The so-called QE Infinity had that option..

  • Anonymous

    Hi Joe

    That is certainly a possibility and some have argued for that. There are enough issues with that for a post on its own! So let me give you a taste of the main one.

    In the UK there is £375 billion of cash (strictly speaking liquidity) which has been added to the monetary system by the Bank of England as it has paid for the Gilts it has bought. Because our monetary system is broken (very low velocity of money) that does not have anything like its full potential impact right now. However in a recovery……

    Those who argue for cancelling the Gilts claim that the surplus liquidity could be mopped up easily. The economic history of the UK reads quite differently.

  • Anonymous

    Hi Noo2

    We are in a subsection of game theory with central bankers on one side and the “markets” which these days often have major central bank involvement on the other. I do not find that entirely reassuring!

    This may well turn out to be the most dangerous episode of the credit crunch.

  • Anonymous

    Hi Midge

    It was quite a day and I note that US Treasury yields which had the opportunity to drift back after yesterdays post-Fed surge instead rose….

    Also as I type this there are developments in Greece where the ruling coalition looks as though it will carry on but only just with a thinner majority. Ironically PM Samaras cannot go on live tv because the live feeds were processed by ERT. What irony!

  • David Lilley

    Shaun,

    I hope that I’m not being a little eccentric but tell me if I am.

    I was very keen on QE four years ago, but coordinated QE, following coordinated interest rate cutting at the first G20, which saved the world from a great depression. My cute/naive solution at that time was that the G20 central bankers agree coordinated QE and then meet three months latter, put their negative chips on the table and agree how many chips can be put in the bin. The PIGGS debt would be significantly reduced and those with sovereign wealth funds would have them increased. Global inflation would rise affecting the G20 countries equally and also contribute to reducing debt.

    The first great contraction cost 55m lives and a second must be avoided.

    Returning to an other idea, World 5 ( where World 1 was the introduction of matter, World 2 life, World 3 mind, World 4 Objective Knowledge and World 5 the limited liability company, the entity that puts World 4 to use and has created enormous benefits for mankind. For the last 20 years China has benefited from “naked capitalism” whilst the west has been immersed in “Big State” or “state interventionism”. China has been building Worlds 4 and 5 that are the wealth creating entities whilst we have been taxing World 5 with “big state interventionism”, peaking with the UK state spending 51p in every £ and currently 46p.

    Go to a graduation congregation anywhere and see the Chinese taking all the engineering and science degrees and taking home World 4. See China buy Rover and Volvo and get all the intellectual property overnight, more World 4.

    But the cutest thing has been what Niall Ferguson calls Chimera. The Chinese save, buy US Treasuries, provide the credit to the western debt laden consumers and then our smart investment bankers return the money to China to fund their World 5. A UK textile worker costs £10 per hour versus 50p per day in China and a US car worker costs $36 per hour versus £2 per day in China (my numbers are a little old).

    You get into debt due to a combination of bad money management and not being able to make ends meet. The west is mired in massive debt and QE is contributing to the perception that debt is not problem.

    The UK successfully turned off QE some two to three years ago. Funding for Lending is QE but it is better targeted at World 5. The US should do the same instead of floating non-World 5 entities such as the big state and house prices.

    I didn’t think Ben Bernanke would turn off QE (and he hasn’t) because it would drive up the cost of massive US state borrowing. A rise from 1.6% to 2.4% is a 50% rise when the US has to borrow 50% of every state employee’s salary. Their QE now stands at $3.3t.

    The good news, however, is that World 4 is growing exponentially and therefore World 5, wealth creation, will grow exponentially. But not in the “Big State” western world.

  • GusBmth

    Hello Shaun
    Firstly a big thanks for your excellent commentary, which I have enjoyed reading for several months.
    A couple of points on QE. It has been been my opinion for some time that QE would be a permananent feature of UK monetary policy, because it is inconceivable that the BofE (and indeed the Fed) could be large sellers of government debt for anything more than short, exceptional, periods. ‘Exceptional’ monetary policy has become the new normal and variance from it will be the new exceptional.
    Second, the new governor of the BofE wants the economy to reach ‘escape velocity’. The big risk is that real growth picks up a little, to say 2% per annum, but inflation reaches escape velocity. Given the fact that the Bank has been comfortable with inflation at 5%, we can be guaranteed that they will be late to react. Tight monetary policy would cause a severe downturn and most likely a property crash. I hope I am wrong about inflation, but the BOf E’s own surveys show that people’s assessment of actual inflation is already above 4% – and that is after 3 years of virtually no growth!

  • Anonymous

    Hi Gus and welcome to my corner of the blogosphere

    I agree that an exit from QE involving selling Gilts for the UK is likely to be problematic. I argued from the beginning that the danger is that you end up selling into a falling market which presents a real problem as you mention. The last couple of days where Gilts have fallen heavily (the 10 year Gilt yield has risen from 2.28% when I wrote this post to 2.4% at the week’s close) have given an illustration of this concept.

    It has been easy also for the Bank of England to figuratively bask in capital profits from its QE but they have shrunk and the last £100 billion will be at an outright loss right now.

    Going forwards we wait to see what Mark Carney does. The view of Andrew Baldwin who comments on here and follows Canadian economics and statistics is that he is much less keen on nominal GDP targeting than the UK media have so far assumed.But QE has raised he dangers of inflation for any recovery in the UK and could choke it off.