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.