QUANTITATIVE EASING AND THE FED’S ASSETS TAPERING
Commentary
In financial news today, much concern and discussion is being held about the US Federal Reserve System (Fed) tapering its asset purchases. Tapering in the world of finance, refers to the rate at which central banks reduce the volume of assets they purchase on the open market. The decision for the central banking authority in an economy to purchase assets on the market on a consistent basis is usually seen as a drastic measure necessary to maintain some level of stability in the economy in the face of some severe economic uncertainty, such as the Great Recession or the current Covid-19 pandemic. This monetary policy is known as Quantitative Easing (QE).
History of Quantitative Easing
QE has been utilized by a number of economies such as in the UK, the Eurozone and the U.S. in the 21st century. QE was first used by the Bank of Japan (BoJ) in 2001, an unprecedented monetary policy move at the time, following the Asian Financial Crisis of 1997 known as the Asian Contagion. The BoJ was faced with a stagnant economy, years of deflation and a sharp decline in asset prices that caused severe contractions in real GDP. After exhausting fiscal policy measures and more orthodox monetary policies such as adjusting short-term interest rates to combat the prevailing economic realities at the time, the BoJ finally decided that a more drastic measure was needed, hence the decision for QE. This lasted from 2001 to 2006 and was deemed to not have been as successful as hoped.
In 2008, for the first time in American history, QE was used in an attempt to keep the economy afloat. This was done in response to the well documented sub-prime financial crisis, known infamously as the Great Recession, that sparked a global financial crisis. This period was marred by GDP growth contracting at the fastest rate in 50 years and significant monthly job losses. While interest rates in the U.S. were already near zero, the FED saw it necessary to take unprecedented measures by launching QE as a last resort, which led to the purchases of trillions of dollars of government bonds and mortgage-backed securities to resuscitate the economy. Though interest rates in the U.S. were already near zero, the asset purchases were instituted to inject more liquidity into financial institutions to foster increased lending and spur economic activity. The Fed launched four rounds of QE between 2008 to 2015 to battle the financial crisis that pushed their balance sheet from less than USD1 trillion to USD4.5 trillion. The mechanism was largely successful and steered the economy back onto the track of recovery.
QE RESPONSE TO THE CORONAVIRUS PANDEMIC
At the onset of the coronavirus pandemic in March 2020, volatility skyrocketed in the U.S. financial markets when investors panicked and pulled their money out of the stock markets and sought financial safe havens such as treasury instruments and gold. Financial markets crashed with the S&P 500 index falling by 30% within a space of only 22 trading days, wiping out nearly USD10 trillion of value off the U.S. stock market. Treasury yields plummeted as the rush for government bonds saw prices climb and the price of precious metals such as gold soared.
Since March 2020, the Fed has been buying USD120 billion worth of assets per month through the purchase of USD80 billion of Treasury securities and USD40 billion of agency mortgage-backed securities (MBS). This was implemented with the objective of driving down long-term interest rates, cushioning the economic and financial impact of the COVID-19 virus and preserving investor confidence. The Fed has stated its commitment to asset purchases until the economy reaches full employment and achieving a target inflation rate of 2%.
By August 2020, the S&P 500 index reversed the losses from earlier in the year and closed at a record high on 18 August 2020. The S&P has continued its momentum into 2021, albeit with some expected hiccups, as it continues to climb to new highs with its latest record high being 4,536.9 recorded in early September 2021. In the U.S. QE has played a vital role in restoring investor confidence as well as fostering economic growth. The country’s job market is improving while the inflation rate has already hit its target sooner than expected as prices rose due to supply chain bottlenecks and limited supply of goods across various industries.
THE “TAPER TANTRUM”
History has shown that the decision to taper asset purchases may not necessarily be received well by investors. In 2013, as the economic and financial impact of the sub-prime financial crisis subsided, the Fed signalled that they would start tapering its asset purchasing. The reaction of investors to the news is known today as the “Taper Tantrum” which saw investor sentiment fade that led to a large global sell-off in both stocks and bonds.
In response to the COVID-19 pandemic, the Fed initially envisioned that their QE stance would last well into 2022. However, the better than expected recovery in the U.S. economy and inflation at its highest in over 30 years has seen the Fed indicate that asset tapering could commence as early as December 2021.
Much speculation has been made in terms of the effect that tapering asset purchases will have on the economy with some economists questioning whether it would derail the notable recovery that was already made. Economists and financial analysts largely agree that if QE persists for too long, there is the risk of the economy overheating that may cause severe inflation, weaken the US dollar and may cause bubbles in the stock market (stock prices reaching unprecedented highs, then crashing). However, if it is ended prematurely, it may not produce the desired effect on the economy.
WHAT WE CAN EXPECT
Since early 2021, Fed officials have openly discussed reducing its asset purchases, effectively giving markets advance notice of their intentions in order to limit any potential disruption as occurred in 2013. The Fed also acknowledged discussions regarding tapering at both its June and July 2021 meetings and hinting in the latter meeting that tapering may begin at the end of the year, as evidenced by the Committee minutes. If the tapering begins, it means that the Fed will start reducing the amount of government bonds it buys.
There is evidence to support such an action. Year to date, the US economy has progressed towards the US Fed’s goals of improved economic performance, a stronger labour market and stable consumer prices. Against this backdrop, there has been support from the wider economy for a shorter taper timeline.
In 2014 when the Federal Reserve tapered for the first time, it took roughly ten (10) months to complete as monthly purchases fell by USD5bn per month for Treasuries and MBS each. With the economy rebounding faster and at a higher rate, there is the expectation that the tapering may move at a faster pace.
Theoretically, tapering may lead to higher interest rates. As the volume of bond purchases fall, the supply of bonds for the market to absorb will increase which leads to a fall in bond prices and a subsequent rise in interest rates, given the inverse relationship.
Riskier segments of the bond markets and asset classes such as stocks, including bonds with credit ratings in the Non-Investment grade sphere, may experience some volatility as QE would have provided investors with an incentive to take on more risk. With the withdrawal of this safety net with the reduction in the asset purchases by the Fed, investors may be spooked and dump their holdings of such bonds and reduce their exposure to stocks.
Despite these expectations, the reaction in the financial markets may be tempered as both market participants and the Fed have experience with the prior asset tapering in 2014.
While the Fed has indicated asset tapering may come soon, it is not yet set in stone. There are concerns that the impact of the Delta variant could convince the Fed to reconsider the asset tapering if the economy’s recovery begins to become compromised. Thus far, the U.S. economy has remained resilient despite the resurgence of Covid-19 cases with a strong sense of the avoidance of further lockdowns. Inflation pressures continue to reduce while employment data continues it positive trajectory. If things remain as is, we can expect asset tapering to proceed without affecting the general recovery of the U.S. economy.
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