“The very slow pace may still be contributing to a buildup of various financial imbalances.”
So we have the first Fed Governor and member of the policy-setting FOMC who came out and said that the QE Unwind that began last October with baby steps isn’t fast enough. And because it’s so slow it may actually contribute to, rather than lower, the “financial imbalances.”
In her speech, Kansas City Fed President Esther George pointed at the growth of the economy, the tightness in the labor market, the additional support the economy will get from consumers and companies as they spend or invest the tax cuts, etc., etc. And despite this growth, “the stance of monetary policy remains quite accommodative,” she said.
She cited the federal funds rate – the overnight interest rate the Fed targets. The Fed’s current target range is 1.25% to 1.50%, which is “well below estimates of its longer-run value of around 3%,” she said.
The Fed would have to raise rates at least six more times of 25 basis points each, for a total of at least 1.5 percentage points, to bring the federal funds rate to around 3% and get back to neutral. If the Fed wanted to actually tighten after that, it would have to raise rates further. So far, so good.
And then came her concerns about the Fed’s balance sheet.
Under QE, the Fed acquired $1.7 trillion in Treasury securities and $1.78 trillion in mortgage-backed securities, for a total of about $3.5 trillion. After QE ended in October 2014, the Fed then maintained the levels by replacing maturing securities.
But in October last year, it commenced the QE-Unwind and started to not replace some maturing securities. This has the effect of shrinking its balance sheet. Just like the Fed “tapered” QE by phasing it out over the course of a year, it is also ramping up the QE-Unwind over the course of a year.
But the pace of the QE-Unwind has been too slow, according to George – and this may be destabilizing the financial markets:
By the end of this year, however, only about a quarter of the increase to the Fed’s balance sheet resulting from the first round of large scale asset purchases will be unwound.
These holdings of longer-term assets were intended to put downward pressure on longer term interest rates. Many investors responded, as would be expected, by purchasing riskier assets in a reach for higher yield. As a result, asset prices may have become distorted relative to the economic fundamentals.
The reference to “distorted” asset prices is the same verse we’ve heard from other Fed governors: Asset prices have become inflated. Since assets are leveraged, they have become a risk to financial stability. Then she adds:
The very slow pace of our balance sheet normalization may still be contributing to a buildup of various financial imbalances.
In other words, because the QE Unwind is so slow, it doesn’t really work as an unwind but continues to inflate asset prices, which would be the opposite of what the Fed wants to accomplish:
While until recently, financial markets remained remarkably stable, it is not uncommon to see volatility rise when asset prices become inflated and investors struggle to find a new equilibrium.
And there she left us hanging at the edge of the cliff, without saying more about the QE Unwind and where it should go. Instead, she reverted to less treacherous territory of interest rates. But later, at the very end of the conclusion, she fired her final shot:
Given the current momentum in the economy, the FOMC will need to carefully calibrate its policy to lean against a potential buildup of inflationary pressure or financial market imbalances.
Let me repeat this: the Fed will “need to carefully calibrate its policy to lean against … financial market imbalances.”
Esther George has been one of the more hawkish FOMC members. So it’s probably her job to launch the first trial balloon about speeding up the QE Unwind.
The whole idea of unwinding QE was launched by trial balloon, one after the other, even as people said that QE could never be unwound, that in fact these assets would have to remain on the Fed’s balance sheet permanently. But gradually, it sank in that the Fed was seriously thinking about shedding those assets. In June 2017, it announced the mechanics. In September, it announced the amounts and timing. It took over a year to get there. And because it was rubbed in so gently, the markets barely reacted to it.
George is in a non-voting slot on the FOMC this year. So she is a safe bet to launch the first trial balloon. The markets won’t take her seriously – just another Fed governor talking. But this is how it starts. The Fed no longer administers “monetary shocks,” the way it used to in order to knuckle its monetary policies into the recalcitrant markets. Now it’s all jawboning and “forward guidance” and trial balloons.
But it does show that there is some thinking behind the scenes about speeding up the QE-Unwind. Once the pace is ramped up to full speed by October this year, the Fed will shed up to $50 billion a month in securities — up to $30 billion in Treasuries and up to $20 billion in MBS — for a maximum of $600 billion a year.
But any significant acceleration is impossible to achieve by just allowing maturing securities to “roll off” without replacement: In most months, there are only about $30 billion to $35 billion of Treasuries on the Fed’s balance sheet that mature. For example, in March, $31.2 billion mature; in April, $30.5 billion. MBS come on top of that.
So if she is proposing to increase significantly the pace, it would have to be done by outright selling securities into the market, which would further change the dynamics of the market, just when the US Treasury will be issuing a record amount of new debt to finance the growing deficits. In order to find buyers for all those Treasuries that would flood the market, the yields would have to rise to be very appealing, so that investors would buy Treasuries rather than other securities. When yields rise, by definition bond prices fall. This would ricochet throughout the market with a substantive repricing of all assets.
And it would come at the same time that the ECB will have stopped its QE purchases and that the Bank of Japan is starting to think out loud about an “exit,” as they call it. And this would make for an interesting confluence of factors.
Investors in the corporate bond market, particularly in junk bonds, are still blowing off the Fed. But not much longer. Read… Corporate Bond Market Gets Ready for Big Reset