Our Blog Aug 07, 2017
Quantitative easing has served as a life raft for many of the world’s economies. Now central banks face the prospect of moving on, but the question is: how?
For investors, the implementation of quantitative easing (QE) has had many benefits, but the withdrawal of this extraordinary monetary support is likely to result in some negative effects such as market volatility. However, while investors should be aware of the potential outcomes, the unwinding process will not be fast or easy for any of the world’s central banks.
QE is a form of monetary policy that involves central banks purchasing securities to increase the money supply and encourage economic activity. It first reared its head in 2001 when the Bank of Japan (BoJ) found itself backed into a corner: it needed to stimulate the economy, but it couldn’t lower nominal interest rates any further. So the BoJ became the first central bank to purchase government bonds, financed by creating central bank reserves. Following the global financial crisis, central banks in the U.S., U.K. and Europe followed suit, pumping large amounts of money into the banking system to prevent it from collapsing.
It’s been a decade since the start of the crisis, and it’s time to think about what happens next. Despite a fairly uniform decision to undertake QE across developed markets, the methods have differed and so will the approaches to unwinding it. Let’s consider the likely next steps of central banks around the world.
The United States
The first place we may see an unwinding of QE is in the U.S. QE bond purchases were completed in 2014, leaving the Fed with a portfolio of $4.5 trillion on its balance sheet. It has since maintained this level by rolling over debt and reinvesting any principal. As the Fed considers when it can begin to reduce its balance sheet, it continues to make small rate hikes along the way. Seeking to avoid a repeat of the 2013 taper tantrum, which led to a surge in U.S. Treasury yields, the Fed has also passed a lot of hints to the markets so as not to spook them.
As the Fed continues its gradual rate increases, we’re likely to start to see balance sheet reinvestment slowing down. If all of the debt is allowed to roll off as it matures, there would be a sharp decrease in the Fed’s balance sheet in 2018 until it flattens out in 2024. To avoid such a large shock to markets, a staggered approach to unwinding QE would be more likely and would help the Fed maintain some flexibility to respond to the markets' reaction.
The United Kingdom
The next place to begin the unwinding process would be the U.K. However, any unwind is almost impossible at this time because U.K. banks currently depend on the money supply from QE to meet their prescribed regulatory buffers. Removal of this money will leave financial institutions fighting over any remaining liquidity to avoid falling foul of these regulations. The way around this is to reduce the amount banks are required to hold in buffers, but it’s unlikely that central banks will want to take away that safety net.
QE has also had some unintended consequences in the U.K. that need to be addressed. For example, artificially low rates have inflated house prices, which have led banks to insist on larger down payments, effectively shutting out many potential buyers. Defined pensions are also now at risk. Benefit pension liabilities have risen because interest rates have remained low, but pension assets haven’t risen by the same amount. In addition to these thorny issues, the unwinding of QE is also complicated by the uncertainty introduced by the Brexit process. So perhaps this is not the time for the Bank of England to make its move.
We’re seeing good economic numbers coming out of Europe, which could suggest that further QE isn’t likely. Earlier this year, European Central Bank (ECB) President Mario Draghi stated that policymakers were confident that they had removed the threat of severe deflation. Couple this with a calmer political outlook, and we are likely to see the ECB back off on QE.
The first stage for Europe has been to signal the end of QE bond purchases before an actual halt. Draghi has outlined four necessary conditions for inflation before unwinding QE can be considered: it must be medium-term, durable, self-sustained (not reliant on the extraordinary monetary policy) and broad-based across the eurozone. It may be some time before this happens, and even if interest rates start moving at the end of next year, the balance sheet won't shrink until 2020 or 2021.
As previously mentioned, Japan was the first to use QE and is most likely to keep meaningfully extending its balance sheet beyond 2017. In fact, Japan is potentially decades away from its desired inflation target, and even if it’s reached, it will have to be sustained for a long period of time. The BoJ has faced a great deal of criticism, including claims that it waited too long to implement QE and tightened monetary policy too quickly. When it comes to unwinding, the BoJ may wait for the Fed to move so it can learn from its mistakes.
The bottom line
The inevitable unwinding of QE is getting increasing attention. Although investors should be mindful of the potential for volatility as monetary policy normalizes, it will likely be an extended process and a long road to get there.