With the US economy appearing to be returning to a decent pace of economic growth plus rising house prices, jobs being created at a solid pace, retail sales growth accelerating and the unemployment rate falling, attention is now turning to how the Federal Reserve will implement a so-called exit strategy from the most stimulatory monetary policy settings ever seen.
It will not be easy.
The main issue in normalising monetary policy is how the roughly $US3 trillion of securities on the Fed’s balance sheet will flow back into the market without major disruption to financial markets. The market fear is that the Fed will unwind these holdings relatively quickly. This would mean, effectively, selling bonds into a market that is already likely to be trading bearishly because the economy is returning to sustainable growth – and with it inflation risks will build.
At the moment the Fed is still easing with securities purchases of around $US85 billion a month as it aims to keep interest rates and bond yields low. Moving to a position where it no longer buys securities will be an issue in itself – but it should be doable when there is indisputable evidence that the economy is entrenched in the recovery cycle.
The Fed may choose to scale back and then halt these purchases at any time, given the positive momentum in the economy. Indeed, some staff at the Fed are suggesting these bond purchases should end soon. How financial markets react to such a policy tightening – or rather, a partial reversal of the loosening – will be critical in determining the steps the Fed takes after that.
Unwinding the $3 trillion in assets should be a long run process. The chairman of the Federal Reserve, Ben Bernanke, said recently that the Fed may even hold the bonds to maturity – meaning that the run-off may take a couple of decades. This would also ensure that there would be no realised financial loss for the Fed, which bought bonds with yields generally below 2 per cent (for the 10-year as a benchmark in this example). It would also mean the unwinding of the asset base would be slow and digestible for markets.
Of course, the Fed may wish to accelerate the sale of securities into the open market but this would only be done, it seems, if the market could absorb such selling pressure.
It is not just unwinding quantitative easing that the Fed will need to negotiate. There is also the issue of how and when the federal funds rate will be hiked from its current, near zero level.
The financial community was dumbstruck in December 2008 when, with the US economy and financial sector on the cusp of a depression, the Fed cut the rate to a zero to 0.25 per cent target range. Let’s call it zero.
At the time, the Fed was scared and would do anything to arrest the turmoil. It said: “The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.”
It added: “The focus of the Committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level.”
And that is exactly what they did.
In its recent commentary, the Fed has committed to keeping interest at these exceptionally low levels until 2015, or until the unemployment rate falls to around 6.5 per cent. When that happens, the market will be well prepared for interest rate hikes but, like the unwind of the balance sheet, the Fed will act with a soft touch when the hiking cycle commences or else risk undoing some of its good work in getting the economy growing again.
Sharply narrower budget deficits in the near term would help the overall situation of unwinding the Fed’s balance sheet, followed by budget surpluses thereafter. This would necessarily see the slowing – and then even reversing – of growth in the supply of new bonds coming onto the market, allowing the Fed to satisfy some of the market’s demand for bonds from its balance sheet. While surpluses seem to be many years away, the current trends do point to smaller budget deficits in the next few years.
It remains to be seen exactly when and how the Fed will scale back its quantitative easing, then stop it, then reverse it. Within that is also the question of when the first interest rate hike in the cycle will occur.
Based on what Bernanke has said (and hopefully this will remain the case with whomever succeeds him), the unwind will be very slow, with a focus on market and economic stability. In the most extreme, the bonds will simply be held to maturity, during which time the US should have its fiscal house in order – meaning, next to no disruption at all.