The US Federal Open Market Committee (FOMC) will undergo a significant shift in its composition and leadership in 2014 – as Federal Reserve policy moves away from a reliance on quantitative easing (QE). The new FOMC – led by Janet Yellen after eight years of Ben Bernanke’s chairmanship – must manage the transition to reduced policy stimulus while actively guiding market expectations of future changes in policy interest rates.
We say policy interest rates because it is possible the Fed funds rate is no longer the primary tool of monetary policy after QE ends. The rate the Fed pays on bank reserves and the rate it offers on overnight reserve repos may become at least as important in conducting monetary policy.
Even with a steady tapering of QE, total asset purchases in 2014 would still total USD450 billion
But even with a steady tapering of QE, total asset purchases in 2014 would still total USD450 billion. This is slightly less than half of purchases in 2013 but will still add substantially to the total stock of securities on the Fed’s balance sheet. Policy is still being eased, though at a slower rate.
QE is being scaled back, not because the Fed is getting close to achieving its dual mandate of maximum employment and price stability, but because the FOMC considers the costs and risks are rising while the marginal benefits are falling. If, as we believe, the FOMC tapers its asset purchases steadily over seven policy meetings, the QE programme could end in October. If so, investors should turn their attention to the outlook for policy once tapering ends.
When the FOMC is ready to signal the start of tightening it will likely first stop reinvesting some or all of the payments of principal on its securities holdings. This would drain reserves from the banking system and be a form of tightening monetary policy.
In 2011, when the FOMC outlined principles for exiting QE it indicated that outright sales of securities held by the Fed could start sometime after the first increase in the Fed funds rate. At that time the Fed felt the expansion of its balance sheet should be temporary and sought to return to a more normal balance sheet as quickly as possible.
But the thinking on eventual asset sales has undergone a transition. There are two reasons the Fed may choose not to sell assets after monetary tightening begins. First, sizable asset sales could interfere with the efficient functioning of the fixed-income markets, affecting interest rates and market conditions in a way that is difficult to predict.
Second, successive rounds of QE have ballooned the Fed’s balance sheet to a size not anticipated in 2011. The Fed’s securities holding could be USD4,300 billion by October when tapering ends. The balance sheet will be so large that the run-off of securities when the Fed stops re-investing principal payments could total about USD400 billion a year. Run-off alone would amount to a considerable tightening of policy without any outright asset sales.
Prior to the financial crisis, the Fed’s securities holdings on the asset side of its balance sheet were balanced by currency in circulation on the liabilities side. Getting back to that ‘normal’ state of affairs may take until 2022.
This research was first published on 15 January 2014.