By Confluence Asset Management
The most recent Federal Reserve minutes indicated that the U.S. central bank is preparing to reverse its experiment with quantitative easing (QE) by reducing the size of its balance sheet.
Although the eventual desire to reduce the size of the balance sheet is no real surprise, the timing was unclear. It now appears that the FOMC will begin reducing the balance sheet by year’s end.
Over the next three weeks, we will look at the potential ramifications of reducing the Federal Reserve’s balance sheet. This week we will examine the impact of QE on the economy. Next week, we will focus on the financial markets.
QE was a controversial policy; as policymakers explained it, there seemed to be two elements to the decision to expand the central bank’s balance sheet.
First, it wanted to boost the level of reserves and lower short-term interest rates to spur bank lending. Second, it wanted to lift the price level of financial assets to increase economic activity through the wealth effect. There were always a number of risks embedded in the policy.
First, if banks aggressively lent the money, the money supply would rise and lead to inflation. Second, the opposite effect could also occur; banks could simply sit on the excess reserves and hamper the stimulative effect of lending. Third, the wealth effect could exacerbate wealth inequality. Upper income households tend to hold more of their wealth in financial assets whereas lower income households usually hold the bulk of their assets in real estate and cash.
By lowering bond yields and lifting price/earnings multiples, higher income families benefit. If home prices don’t rise, or if lenders prevent cash-out refinancing, the policy’s wealth impact would widen wealth gaps. Fourth, the support for financial asset markets could lead to valuation extremes and create fragile market conditions.
In practice, the effect from QE was rather mixed. We suspect that a whole generation of economists will write dissertations on the impact of QE. However, at this particular moment, we don’t have the benefit of this analysis. Instead, we will have to focus on what effect the balance sheet reduction will have on the economy and financial markets.
Over the past three decades, bear markets in equities are closely tied to economic recessions; in fact, the last major market decline absent of a recession was the 1987 crash. History also tells us that modern recessions occur for two reasons, a monetary policy mistake (policy is too tight) or a geopolitical event. Reducing the Fed’s balance sheet, given the degree of uncertainty surrounding the impact of QE, raises the odds of a policy error.
The impact of QE on the economy: QE appears to have done little for the economy. Economic growth has been stagnant and it isn’t obvious that low rates alone would not have yielded a similar outcome.