Monetary Policy Normalization – “Quantitative Tightening”In this post, I thought we would take a look at a few graphs related to the US Federal Reserve’s (FED’s) upcoming shrinking of the balance sheet.
So, let’s start with the obvious question – Why has the FED been conducting Unconventional Monetary Policy (UMP) in the first place? Besides any favorite conspiracy theories we might entertain, I think most economists agree that the main reason for FED UMP is to avoid, or to exit the Keynesian liquidity trap.
Figure 1: The stylized liquidity trap
Note: ‘i’ is interest rate and ‘MD’ is money demand.
Looking at Liquidity
The theoretical relationship above can be easily and neatly approximated if we use the Liquidity Preference, taking into account that base money is non-stationary, but should be stable in relation to the economy at large; to nominal GDP. Since (the perhaps preferred) broad money aggregates often perform poorly in empirical studies I have chosen a narrower definition of Money, that is - Base Money – currency, reserves and other “near monies”.
Figure 2: Becoming liquidity trapped
Note: The red dots are data from before 2007 and blue dots are data from after 2007.
For every dollar of nominal GDP, it seems, people prefer to carry around 5 cents of base money, with some slight variations over time. Until the Financial crisis that is. During the height of the financial crisis, people demanded up to 25 cents of base money per dollar of nominal GDP. Hence, at times of stress (also applicable in pre-crisis times) we move down and to the right. Likewise, when the economy improves people are enticed by the prospects of earning an interest and reduce the amount of money they carry.
If we invert the liquidity preference we get, via the Quantity Theory of Money1, the Velocity of Money. This represents how much (nominal) GDP every dollar of Base Money buys. It goes without saying that if the FED’s QE worked as planned, nominal GDP would rise dramatically as ‘V’ has long been assumed stable (erroneously it would seem).
In the graph below we have plotted the slope of an equation where Velocity is explained by the Monetary Base. As it turns out, the constant is 5.4 which is quite close to the average US nominal GDP-growth of about 6% (in our sample). In addition, the slope is -0.8, which implies that when the monetary base is expanded, velocity contracts almost proportionally. All of which is to say, monetary policy has little to no effect on the real economy (in terms of prices ‘P’ and/or real GDP ‘Y’). This conclusion strengthens further if we exclude some of the outliers in the bottom right hand corner (data pertaining to 2009/10).
1 The exchange equation: M*V = P*Y; where ‘M’ is Money, ‘V’ is the Velocity of Money, ‘P’ is the Price level, and Y is real GDP.
Figure 3: Velocity explained by the monetary base
Note: The red dots are data from before 2007 and blue dots are data from after 2007.
As such, liquidity – QE – seems to have negligible and unsatisfactorily imprecise effects on the real economy. In addition, over longer time spans, it is also hard to discern any clear-cut impact on asset prices, e.g., equity markets, from liquidity expansions/contractions. That being said, when it comes to asset prices, QE appears to have worked some serious magic.
Figure 4: QE made Liquidity and Market Capitalization go together like a horse and carriage
Note: Studying two trending series in levels are of course to ask for spurious correlations. However, even in differences, the effects of liquidity on equity market capitalization post-GFC is striking. For a more rigorous study please read: https://www.federalreserve.gov/econresdata/feds/2015/files/2015005pap.pdf
QE and asset prices
The mechanism for higher asset price impact post-QE stems from the abundant liquidity itself. Under QE, excess liquidity was very high, while real economy investment opportunities have remained scarce. Hence, asset prices "must" rise. Why? – Because intermediaries, e.g. banks, try to reach owners’/investors’ required rate of return (incentives?). So, if you can borrow cheap and buy higher yielding safe assets, you have created the proverbial "money machine". As safe assets have become more expensive, the financial system has gradually moved into ever higher yielding and ever riskier assets, explaining the recurring market theme of “hunt for yield”2. The above might come across as speculative, but is, in essence, a sought-after transmission channel for the FED. In time, they expect the hunt for yield will push investors into the real economy again.
The FED seems to believe this is about to happen, despite investments (besides construction) and wage growth continuing on a weak note.
2 I think this another readable but quite provocative piece on the subject: https://object.cato.org/sites/cato.org/files/serials/files/cato-journal/2015/5/cj-v35n2-1.pdf
Figure 5: Even the sun…
Shrinking the balance sheet
So, how and to where will the FED shrink their balance sheet? – Most focus has, understandably, been directed towards the asset side, in particular the System Open Market Account (SOMA) where the FED’s holdings of Treasuries, MBS and Agencies are accounted for. According to the FED’s policy normalization documentation the FED will start off by decreasing the total holdings by USD 10 billion (USD 6 billion in treasuries and USD 4 billion in MBS and Agencies) and increase the pace of reduction with an additional USD 10 billion every third month until they reach a total monthly drawdown of USD 50 billion (i.e. within a year from starting QT). From then on, reductions will continue apace until…
Yes, until when is still an open issue. There are nonetheless many other considerations to make (will they push the holdings of Agencies and MBS to zero? What does that imply for their treasury holdings?). A recent FRB-study concluded that a long-term desirable level of SOMA was probably around USD 2,5 trillion. If this is true we should expect a rather swift “QT-tapering” (of some sort), of which USD 50 billion in reductions will be ongoing.
Figure 6: The Federal Reserve Balance Sheet
Note: Neither graph shows any official forecast, but rather simple extrapolations of pre-crisis trends in SOMA and Currency respectively. Other projections are built on publicly available information from the FED. Additional information and links are available in the comment field when opening the graphs in the Macrobond application.
looking at the liabilities-side is every bit as intriguing. Regulations and other structural changes in market participants’ behavior have likely increased the future need of holding large balances with the FED. FRB NY’s open market operations desk has made some rough calculations on the assumption of future bank reserves amounting to USD 0,5 trillion but other notable contributions from among others, former FED chairman Ben Bernanke, suggest that bank reserves likely need to be round USD 1 trillion.
To sum it all up
In retrospect, one of my greatest mistakes as an analyst and dismal scientist par excellence was believing that my fellow man – homo economicus – would indeed see that QE would not work, neither in theory nor in practice (to paraphrase Ben Bernanke’s quip). Having been proved wrong on at least the short-term effects of QE, I thought the crisis might come back to haunt us all, once interest rates started to rise and markets were weaned off QE.
The FED, and many other analysts feel differently of course, believing that current economic improvements can be sustained. And, truth be told, economic and financial reactions to the initial interest rate hikes and the announcement of QT seem to agree with a more benign outlook, especially considering that political worries have also been abundant during the past year.
Maybe I worry too much, I often do. But I cannot help contemplating that I am finally going to see the end of the financial crisis of 2008/09. Or, perhaps, the start of a new one…
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