Central bankers around the world undertook unprecedented measures in the wake of the 2007-2008 global financial crisis. The failure of governments and politicians to create demand and keep economies moving during that tumultuous period put the burden of avoiding a second Great Depression on central bankers’ shoulders and demanded new and creative responses. Among those innovations was quantitative easing, the purchase of trillions of dollars of bonds and other assets to insert liquidity into markets. Those central bankers today must figure out how to end and reverse quantitative easing without triggering the effects they sought to avoid nearly a decade ago.
A day of reckoning is approaching. Last week, the Federal Reserve announced that it is ready to end its quantitative easing program. That conclusion is based on an assessment that the U.S. economy is strong enough to stand on its own two feet without central bank assistance. The return of slow but steady growth and lower unemployment rates suggests the Fed’s analysis is correct. What is not clear, however, is how markets will react to the decision to shed trillions of dollars of assets.
The Fed launched its quantitative easing program in 2008 after determining that traditional instruments to influence demand — lowering bank lending rates — would have little effect in a world in which there was no appetite for borrowing. Instead, the Fed opted to create demand by purchasing an estimated $3.5 trillion of Treasury bonds and mortgage-backed securities. By buying assets, the Fed eliminated the need for sellers to offer high interest rates to attract buyers, which would have raised interest rates throughout the economy and made recovery harder still.
The Fed ended that purchase plan in 2014, after its balance sheet had reached $4.5 trillion, about one-quarter of the entire U.S. gross domestic product. The bank has held those assets since, fearful that the economy might not be strong enough to absorb their return. In May 2013, then Fed Chairman Ben Bernanke suggested that it might be time to scale back its purchases. That hint prompted “the taper tantrum”: Companies dumped Treasuries and interest rates skyrocketed to 3 percent, a level that has not been reached for years.
Cognizant that history could well repeat itself, the Fed has made clear that divestiture will be done slowly and carefully, according to a well-defined timetable. Fed Chairwoman Janet Yellin has likened it to “watching paint dry.” The Fed will reduce its stockpile in monthly increments, selling $6 billion of Treasury debt and $4 billion of mortgage-backed securities, and will gradually increase that amount to $30 billion and $20 billion, respectively. The aim is to shrink the Fed’s balance sheet over a period of years to a little larger than it was before the crisis, around $900 billion. The restrained reaction to last week’s announcement among financial indicators, and the steady value of the dollar in particular, suggests that the groundwork has been done.
Unwinding of this scale is unprecedented and it will introduce new uncertainties and risks into financial decision-making. By buying U.S. government securities, the Fed raised the prices of those assets and made stocks more attractive to other investors in comparison; some blame this for the run-up of share prices and fear that a correction may occur as the taper proceeds. Economists anticipate interest rate increases from half a percentage point — an increase that can be easily absorbed — to a full percentage point, the latter occurring at the end of the taper as the supply of assets outstrips demand. At that point, the key question will be the health of the U.S. and the global economy, and whether it can support a rise in interest rates.
U.S. central bankers have a cushion: Their counterparts in Europe and Japan are unlikely to join them in unwinding soon. Most economists expect the European Central Bank — which is making monthly purchases of €60 billion ($71.6 billion) — to start selling assets next year.
Japan, on the other hand, will likely continue its quantitative easing. The Bank of Japan’s goal of 2 percent inflation remains stubbornly out of reach. Prime Minister Shinzo Abe has acknowledged that his government will have to delay its target of balancing the primary budget by 2020 as he announced his plans to expand spending on education and child-rearing support out of consumption tax revenues. The deferred target for fiscal reconstruction effectively commits the BOJ to continued easing to keep government borrowing costs low. Few economists expect the BOJ to end its asset purchases given the persistence of deflationary pressures.
Quantitative easing occurred when policymakers had a single-minded focus on averting a global depression. Today, growth has returned but the list of other risks — economic, political and geostrategic — lengthens daily. The great unwinding is one more factor to weigh in increasingly uncertain times.