by Asset Allocation Committee

Last week, we discussed the impact of reducing the size of the Federal Reserve’s balance sheet on stocks and bonds.  This week we will discuss the effects of QE on monetary policy.

The FOMC dropped rates to near zero by January 2009.  Although European central banks (including the ECB) have since taken policy rates below zero, in 2009, the “zero lower bound” was considered to be the lowest rates could fall.  Thus, when the Fed wanted to stimulate further, it felt it could not lower rates below zero.  The U.S. central bank was left with nothing but unconventional policy.  The two policy tools employed at this point were forward guidance and QE.  The former was a clear signal from the Fed that rates would be kept low for the foreseeable future.  The latter was the expansion of the balance sheet.

The problem was that it was difficult to determine how much stimulus these tools generated.  One attempt to answer this question came from the Atlanta FRB.  To estimate the impact of unconventional policy, Wu and Xia used the yield curve to measure the impact on borrowing rates.

Based on their analysis, QE and forward guidance were the equivalent of negative nominal rates of nearly -3.0%.  As tapering set in, the “shadow” rate rose rapidly.  The bank has discontinued calculating the rate, suggesting that once the fed funds target rate leaves the zero floor, the applicability of the shadow rate is reduced.  Essentially, they argue that once rates lift off the zero bound, the shadow fed funds rate is no longer applicable.

Using the shadow rate as a guide, we can get a feel for how much policy has tightened relative to earlier cycles.

This chart shows the effective fed funds rate from 1957 to 1982, the estimated and actual target from 1982 to 2009, the shadow rate (shaded in yellow on the chart) from 2009 to 2015 and a return to the target rate after 2015.  We have then calculated the trough and peak in fed funds tied to the end of each expansion from 1960 through 2008 along with the current cycle using the shadow rate.

We have highlighted the current cycle in yellow and excluded it from the average.  To reach the average level that has preceded recessions in the past, the FOMC will need to make around seven more rate hikes of 25 bps.  Excluding the Volcker money-targeting regime years would reduce the average by roughly 125 bps, meaning that the Yellen Fed will be flirting with recession with only two more rate hikes.(Source: Haver Analytics, CIM)

We are quite concerned about this situation because of an unresolved policy debate.  It is unclear if QE stimulation is a function of the level or the change in the balance sheet.  If it’s the level, the balance sheet is quite large; however, if it’s the change that matters, then reducing the balance sheet could create unanticipated risks for the economy and markets.

The balance sheet, scaled to GDP, is off its all-time highs but, at 23.4%, is well above the pre-QE level of 5.8%.  If level is the key determinant of stimulus, then the FOMC can reduce the balance sheet substantially.  On the other hand, the Wu-Xia shadow rate seems to follow the yearly changes in the balance sheet.

Comments from Fed officials clearly signal that policymakers believe the level is the key indicator of stimulus; last week’s report, which compared equity markets to the level of the balance sheet, would support that contention.  However, as the above chart suggests, a case can be made that the change in the balance sheet has an impact as well.

By 2018, it is quite possible the FOMC will have raised rates by another 50 bps and will have started the process of reducing the balance sheet.  The latter policy could tighten monetary policy by an unknown amount.  And, as we noted above, excluding the early Volcker years, two rate hikes may be getting us closer to recession levels than generally believed if the shadow rate accurately represents the actual trough in the policy rate.  It should be remembered that forward guidance was part of the policy as well.  Simply indicating that hikes will occur in the future affects financial markets today.  Although this isn’t an immediate concern, it appears we are gliding into a period of enhanced risk by autumn.  Adding to this issue is that both Chair Yellen and Vice Chair Fischer are expected to leave the FOMC in January.  Depending on who President Trump appoints, we could have a change in the policy stance of the central bank.

We will be watching financial markets closely in the coming months to see how these issues we have raised over the past three weeks will affect the economy and financial markets.  Our concern is that policymakers and markets have never experienced a sustained drop in the Fed’s balance sheet; it may be innocuous or it may be a problem.  History will be of only modest use and thus the potential for a mistake will be elevated.

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by Asset Allocation Committee

Last week, we discussed the impact of reducing the size of the Federal Reserve’s balance sheet on the economy.  This week we will discuss the effects of QE on financial markets.

The relationship between the balance sheet and equities seems rather straightforward; expanding the balance sheet appears to be clearly supportive for equities.

This chart shows the S&P 500 Index regressed against the Fed’s balance sheet.  From 2009 until last year, this equity index closely tracked the level of the balance sheet.  Equities have lifted above the forecast level of the balance sheet recently.  If the relationship holds, equities are vulnerable to a large decline.  On the other hand, there is no evidence to suggest that bank reserves somehow found their way into the equity market.  Comparing the Shiller P/E (CAPE) suggests that the effect of QE was probably psychological; after fed funds reached the zero bound, QE signaled to investors that policy was still easy.

This chart regresses the CAPE against the Fed’s balance sheet; the CAPE’s behavior is similar to that of the overall equity market.  After the election, the market has mostly risen on multiple expansion, rising well above the model’s fair value.

It should be noted that low interest rates could have a similar effect.  However, the fact that equities and the P/E seemed to track the balance sheet does suggest that QE had an impact on market psychology.

The impact on bonds is rather interesting.

The gray bars show periods when QE was implemented.  Especially after QE 1, periods of QE tended to coincide with rising rates.  When QE was ending (shown by the decline in the yearly growth rate of the balance sheet), rates tended to decline.  Despite the FOMC bond buying, rates rose mostly on fears of inflation.  Once QE ended, those fears eased and bond yields declined.  The most recent rise is likely due to expectations of fiscal stimulus that will boost growth and potentially raise inflation.

If the Fed’s expanding balance sheet was a supportive psychological factor for bonds and stocks, will the contraction have the opposite impact?  Simply put, we don’t know.  If the economy and earnings are improving, the drop in the balance sheet probably won’t matter.  Unfortunately, if the economy disappoints, cutting the balance sheet could have a bearish impact on these assets.

Next week we will examine the impact of the Fed’s balance sheet on monetary policy.

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by Asset Allocation Committee

The most recent Federal Reserve minutes indicated that the U.S. central bank is preparing to reverse its experiment with quantitative easing (QE) by reducing the size of its balance sheet.  Although the eventual desire to reduce the size of the balance sheet is no real surprise, the timing was unclear.  It now appears that the FOMC will begin reducing the balance sheet by year’s end.  Over the next three weeks, we will look at the potential ramifications of reducing the Federal Reserve’s balance sheet.  This week we will examine the impact of QE on the economy.  Next week, we will focus on the financial markets.

QE was a controversial policy; as policymakers explained it, there seemed to be two elements to the decision to expand the central bank’s balance sheet.  First, it wanted to boost the level of reserves and lower short-term interest rates to spur bank lending.  Second, it wanted to lift the price level of financial assets to increase economic activity through the wealth effect.  There were always a number of risks imbedded in the policy.  First, if banks aggressively lent the money, the money supply would rise and lead to inflation.  Second, the opposite effect could also occur; banks could simply sit on the excess reserves and hamper the stimulative effect of lending.  Third, the wealth effect could exacerbate wealth inequality.  Upper income households tend to hold more of their wealth in financial assets whereas lower income households usually hold the bulk of their assets in real estate and cash.  By lowering bond yields and lifting price/earnings multiples, higher income families benefit.  If home prices don’t rise, or if lenders prevent cash-out refinancing, the policy’s wealth impact would widen wealth gaps.  Fourth, the support for financial asset markets could lead to valuation extremes and create fragile market conditions.

In practice, the effect from QE was rather mixed.  We suspect that a whole generation of economists will write dissertations on the impact of QE.  However, at this particular moment, we don’t have the benefit of this analysis.  Instead, we will have to focus on what effect the balance sheet reduction will have on the economy and financial markets.  Over the past three decades, bear markets in equities are closely tied to economic recessions; in fact, the last major market decline absent of a recession was the 1987 crash.  History also tells us that modern recessions occur for two reasons, a monetary policy mistake (policy is too tight) or a geopolitical event.  Reducing the Fed’s balance sheet, given the degree of uncertainty surrounding the impact of QE, raises the odds of a policy error.

The impact of QE on the economy: QE appears to have done little for the economy.  Economic growth has been stagnant and it isn’t obvious that low rates alone would not have yielded a similar outcome.

The fear among some analysts when QE was implemented was that it would spur inflation.  This was based on Fisher’s monetary identity, which is that money supply times velocity is equal to the price level times available supply, or MV=PQ.  If Q, which represents the productive capacity of the economy, is fixed, and V is thought to be dependent upon the institutional arrangements for the circulation of money, and thus mostly fixed as well, raising M will only lead to higher P.  If there is slack in the economy, Q could rise with steady prices, leading to higher real output.  However, at full employment, inflation is the only result.  In fact, what happened is that the reserves sat harmlessly on bank balance sheets, while the real economy grew slowly and velocity plunged.  The chart below shows annual velocity of money (GDP/M2, or using the identity, V=PQ/M).  Note that during the Great Depression, velocity plunged then as well.  Economists during this period soured on monetary policy and mostly focused on fiscal policy.  That shift of fiscal policy didn’t occur during the 2008 Financial Crisis.

It is unclear why expanding the money supply failed to boost lending.  However, deleveraging was common to both periods of low velocity.

This chart shows household debt as a percentage of GDP.  The plunge in the early 1930s coincides with a steady decline in household debt; the same is true now.[1]  If there is a drop in demand for loans, injecting reserves into the banking system won’t have much impact on the real economy.  Conversely, shrinking the balance sheet should do nothing more than reduce the level of excess reserves on commercial bank balance sheets.

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[1] It is interesting to note that velocity did rise in the early 1930s during the Great Depression.  This was due to a horrific policy error where the Federal Reserve tightened policy into the teeth of the downturn, triggering a deeper drop in growth.