Massive inflation of world central banks’ balance sheet during last recession and only slight and cautious unwind during expansion phase (see “ratchet effect”) raises the question of QE flexibility as a policy tool for smoothing economic cycles. We can conclude that considering the combination of side effects that limit quick adjustment of the balance sheet both upwards and downwards. Quick – in the sense of the average time interval in which economic expansion fits, during which policy tools should be returned to the readiness state. On the one hand, this effect is a bloated valuation of stock market assets, which irrationality (“fake wealth effect”) is tied to QE outlook, on the other hand, these are contraction of banks’ interest margins and liquidity trap, where the marginal efficiency of QE falls and costs of maintaining the policy increase.
The example of hawkish Powell in December and subsequent U-turn in January shows how the Fed can bend under the pressure of stock market, which ultimately led to announcement of early stop of balance sheet tapering. The example of BoJ and ECB – yield curve targeting, TLTRO, and debates on deposit tiering are good examples of central banks’ focus on helping the banking system to live with low rates and narrow profit margins.
Hence, Central Banks’ economists have to get smart and innovative so that during the next downturn they do not find themselves in a powerless position. Wall Street bubble architects and associated QE beneficiaries may be a little upset about FOMC member Lael Brainard’s last speech, “How does monetary policy affect your community?” in which she gave early hints how the Fed will deal with the next economic crisis.
During the next recession, when short-term interest rates again approach the lower limit (i.e., to zero), the Fed may abandon purchases of fixed amount of securities from the market, as it was during the last recession. That is deploying QE as we know it. Instead, if the reduction of interest rates does not give the desired effect, the Fed may declare target interest rates for a longer term, for example for annual rates, Brainard said. If this is not enough, the Fed may guarantee interest rate of 2 or 3 or 4 years ahead, and so on. Pegging and maintaining interest rate at the target level will be done through buying or selling Treasuries in the open market. The mechanism will be described in more detail below.
The first question that comes to mind is how does such a policy differ from yield curve targeting applied with little success by the Bank of Japan? Recall that in 2016, when the Central Bank announced negative interest rates and the yield on 10-year bonds tumbled below zero, which was a great stress for the banking system, the Bank of Japan offered “unlimited purchases” of JGB to keep 10-year rate of 0%.
The key difference in the Fed’s plan, in my opinion, is to preserve the element of surprise in policy. The size of time interval, through which the rate will be pegged, will be initially small (for example 6 months). It can then vary depending on the Fed’s assessment of the economy, with a possibility to withdraw if economic conditions improve. In BoJ’s case, the peg was announced right on 10-year interest rate and it was probably not a policy tool, but emergency measure to calm the moans of the banking system. This can be supported by a small interval between the introduction of negative rates and the start of yield curve control – only 4 months, i.e. from February 2016 – July 2016.
The Fed will not announce specific volumes of buying or selling assets to hold interest rate peg, which will probably help to avoid the moral hazard associated with past QE (when the degree of market guarantees of the Central Bank was sufficient to abuse them). In addition, we can’t rule out “open mouth operations”, i.e., for the Fed being a policymaker with binding commitments, it is enough to only announce a rate peg so that the market forces will bring it to the target level. Who would want to bet against with the Fed?
How will this work?
Suppose that on March 1, 2020, the 2-year interest rate (the yield to maturity of 2-year bonds) is 2%. On this day, the Fed announces that it wants to see the rate at 1% until March 1, 2022. As a buyer on the market, the Fed announces that it is ready to buy 2-year bonds at a price that corresponds to a 1% yield to maturity, that is, at a higher price than it is currently on the market. Such an arbitrage opportunity should quickly bring the rate to the target level. Then everything depends on the Fed’s rhetoric – if it can convince the markets that the peg can be extended, then, in line with expectations, demand will exceed supply and the rate will be held without the need for the Fed to even buy bonds.
Over time, if there is a need, the Fed will buy securities with a maturity date before March 1, 2022, that is, on that day, all bonds purchased will reach maturity – an automatic exit from QE will occur.
The next recession and economic recovery will be very difficult for stock markets since conventional QE “buy” rush may not be available option anymore.
As of April 2019, the Fed reduced the balance of assets by $46 billion, which corresponds to “cruising speed” in tightening policy. In total the Fed managed to sell $580 billions of $4.5 trillion accumulated assets, bringing the balance to a minimum since November 2013.