Posted by Shyam Moondra
On May 22, 2013, in a congressional testimony, Federal Reserve Chairman Ben Bernanke talked about the possibility of winding down Quantitative Easing (QE) in the next few months which caused the stock market to crash by more than 250 points. This flash crash makes the Fed acutely aware that their biggest challenge now is to flawlessly execute on the question of when and how to end QE.
With the congressional gridlock preventing the government from taking effective actions on the fiscal front to stimulate economy, the Federal Reserve came up with the idea of increasing liquidity via the so-called QE program. On December 16, 2008, the Fed announced that it would purchase up to $600 billion worth of mortgage-backed securities (MBS) and agency debt. On March 18, 2009, the Fed expanded the program by additional $750 billion. The idea behind QE was to push the long-term interest rates down to give a boost to the housing recovery and steer the investors towards more risky investments such as stocks that were being shunned by investors in the aftermath of the financial crisis of 2008. The thinking was that if housing prices recovered and stock prices went up, the wealth effect would lead to higher consumer spending. Since consumer spending accounts for 70% of the U.S. economy, it was thought that asset appreciation would increase the pace of economic recovery. When the Fed started its unprecedented QE program, the biggest fear was that significant increase in money supply over a short period of time could fuel inflationary expectations and bring the economic recovery to scratching halt. Since such a daring experiment had never been undertaken before, no one really knew what unintended consequences might result from QE. However, given the gridlock in Washington, DC, the Fed had no other choice but to find a way to infuse large amounts of funds into the monetary system to stimulate economic growth.
After the initial QE, however, the pace of economic recovery continued to be sluggish. The Fed doubled down and initiated QE2, which involved the purchase of long-term Treasuries at the rate of $75 billion a month over the period from November, 2010 to June, 2011. In September, 2011, QE2 was followed by the Operation Twist, which involved the purchase of $400 billion (later expanded by additional $267 billion) worth of bonds with maturities of 6 to 30 years and to sell bonds with maturities of less than 3 years, thereby extending the average maturity of the Fed's own portfolio. This was an attempt to do what QE tried to do, without printing more money and without expanding the Fed's balance sheet, thereby hopefully avoiding the inflationary pressure associated with QE. On September 13, 2012, the Fed announced a third round of quantitative easing, QE3. This new round provided for an open-ended commitment to purchase $40 billion worth of MBS per month until the labor market improved "substantially". The amount was later increased to $85 billion per month ($40 billion worth of MBS and $45 billion worth of Treasuries). Massive infusion of funds by the Fed into the monetary system finally did have the intended effect; the housing industry started to recover and the stock market zoomed up. The economy grew at a rate of just over 2% which helped create new jobs, albeit at a slower pace than desired, and the unemployment rate came down from 10 percent in 2008 to 7.5% in April, 2013. To the surprise of many economists (including some of the hawkish members of the Fed), inflation remained in check in spite of significant increase in money supply. In addition, QE inspired economic expansion, coupled with higher tax rates for the rich agreed to by President Barack Obama and Congressional Republicans, increased the tax receipts beyond what was expected. Higher tax receipts, in return, reduced the budget deficit to $642 billion (or 4% of GDP), about $200 billion lower than what the CBO had projected only three months ago. It is estimated that sequestration (across-the-board spending cuts) and QE could eventually bring down deficit to the level of 2.5% of GDP which is not considered excessive. The unanticipated large reduction in projected budget deficit has completely changed the dynamics of the gridlock in the Congress on the question of deficit/debt. With the sequestration in effect and Fed’s QE improving economy, the pressure is off for doing a quick grand bargain. The Congress might now focus more on its long-term goal of reforming the tax code and entitlement programs.
The biggest challenge for the Fed now is to decide when and how fast to terminate QE. It’s clear that if economy strengthens to the level of 4% GDP growth rate, the continuation of QE at its present level would most likely increase the inflationary pressures and force the Fed to stop QE in a hurry which could trigger rapid increase in interest rates and destabilize the financial markets. On the other hand, if economy continues to expand at the slow pace of 2.5% to 3% (at a cost of sluggish reduction in unemployment rate, of course), the Fed could devise a plan to gradually reduce the QE amount and eventually start selling MBS and Treasuries to bring down its balance sheet to more traditional levels. The QE disengagement has to be done slowly over a period of couple of years to have minimum destabilization effect on the financial markets. Bernanke was right in refusing to give in on the demands by some conservatives in Congress to terminate QE immediately. If economy continues at its present trajectory, the Fed may still have at least six months before beginning the phase-out of QE and completely unwinding QE by the time GDP growth rate hits 4% rate or unemployment rate falls below 6%, whichever happens first.
Bernanke’s second term as the Chairman of Federal Reserve Board expires in January, 2014. I hope he stays on beyond January, 2014 to finish the job and to make sure that QE is phased-out at just the right time and at just the right pace to ensure soft landing.
