The questionable pilots behind a QE descent

FT.com

A few weeks ago I had the pleasure of dining with two former luminaries of American economic policy. Unsurprisingly, the issue of quantitative easing provoked heated debate – not so much over the question of whether QE had been a correct policy to implement (they both backed its introduction) but whether the Federal Reserve could ever find a smooth exit.

The argument was illuminating, since it split along two lines. One of the dinner guests – who I shall call “Mr O”, or Optimist – argued that it was entirely possible for the Fed to achieve a smooth exit from QE. After all, he declared, the Fed did not necessarily need to actively do anything to find that exit, such as sell securities; instead, it merely needed to stop buying anything more. For if it duly sat on its hands, the $2 trillion worth of assets it has recently accumulated on its balance sheet would automatically roll off (i.e. come to maturity), enabling the Fed balance sheet to return to pre-crisis levels over the course of the next seven or eight years.

Or to use a memorable image, what the Fed is essentially now doing – in the eyes of Mr O – is akin to a pilot stealthily landing a plane: once it powers down the motors, gravity will take hold, putting the balance sheet on a steady downward glide path. “There will be plenty of time to adjust, and even it’s a bit bumpy sometimes, that can be handled,” Mr O insisted. After all, Ben Bernanke, Fed chairman, has already told everyone well ahead of time to start fastening their seat belts to avoid any element of surprise. Hence this week’s statements.

So far, so reassuring, at least as an image. But there is a catch. As we sat around the dinner table that night, another former Washington luminary – who I shall called Mr P, or Pessimist – was distinctly unconvinced. For Mr P’s own experience of sitting on the flight deck of America’s economy leaves him dubious about whether policy makers can ever deliver such smooth glide paths, particularly over seven years.

Never mind that the proposed glide path, between now and 2021, say, would cut across two American election cycles (or four if you count the midterms too); and ignore the potential for geopolitical shocks (say Iran, North Korea or from the eurozone). Another risk is that other central banks could also be seeking their own descent paths at the same time as the Fed, creating additional turbulence. After all, G7 central banks have collectively put some $10,000 billion of additional liquidity into the system since 2008, according to JPMorgan and Deutsche Bank estimates. That means that there has been an unprecedented level of simultaneous monetary stimulus – and prospective future tightening.

And then, of course, there is the nasty tendency of investors to overreact and panic; and this danger is doubly severe given how addicted global markets have become to cheap money – and the carry trade – in recent years. “Markets don’t adjust smoothly,” muttered Mr P, who pointed out that while asset price increases often build steadily over several years, declines can be brutal.

Of course, the counter argument to this – as Mr O pointed out – is that almost exactly a decade ago the Fed did manage to tighten policy fairly smoothly; unlike 1994, the turning point in 2004 did not cause turbulence. And, in practical terms, it is the pessimists who have often been wrongfooted in the past couple of years. A few years ago, Cassandras were forecasting a dollar collapse, a bond market bloodbath and massive losses as a result of the American banking bailout. However, the dollar has remained strong(ish), bonds have outperformed and the Tarp program has recouped its money. Indeed, if you want to find tangible evidence of how a 'taper' policy can work, just look at how the Fed has been exiting from its holdings of AIG assets and other 2008 financial measures.

But it is one thing to sell a few AIG assets; it is quite another to unwind several trillion dollars of monetary stimulus when the global financial system is addicted to the carry trade. And it could be doubly hard to land that plane given that the pilot is operating in a thick financial fog, with incomplete data dials and a volatile market compass.

So I agree with Bernanke that it is time to start preparing for an exit. I also laud the efforts that the Fed is making to tell markets to prepare. Indeed, in that vein, I would argue that the market whiplash we have seen in the past 24 hours is a thoroughly good thing, since it will force investors to shift their mindsets and portfolios – and unwind their carry trades – as that American policy “tanker” starts to turn, to use the image Gavyn Davies presented in a Financial Times blog. But I (like Mr P) fear the exit will be so much more turbulent than most policy makers want to admit – or hope – that the pilots could struggle to stay in control. Fasten those seat belts tightly.

Copyright The Financial Times Limited 2013