The Federal Reserve is wrestling with how to step away from the policy that has defined the response to the financial crisis. The end of quantitative easing has been declared many times since the end of the great recession. This week, however, the final act may truly begin.

The US Federal Reserve meets today to debate the possibility of starting to “taper” its third round of asset purchases – known as QE3 – down from the current pace of $85bn a month. A decision to do so is not certain because there are still some doubts about the health of the economy. But it would mark the first step away from the monetary policy that has come to define the aftermath of the financial crisis all around the world.

With economies still weak, governments unwilling or unable to mount further fiscal stimulus, and short-term interest rates trapped at zero, QE became the default policy. Under QE, a central bank buys long-term assets with the aim of reducing the supply of them available to private investors, driving up their price, and thus driving down long-term interest rates in order to stimulate the economy.

The Fed has carried out repeated rounds of the policy. After buying more than $1trillion in assets during the crisis, it launched a $600billion QE2 at the end of 2010, followed by Operation Twist to move into longer-term assets during 2011, and finally QE3 in September 2012. As of last week, the Fed’s balance sheet had reached $3.7trilion, compared with about $1trillion before the recession. By itself, the choice to taper is a small step.

To do so now, rather than at the Fed’s next meetings in October or December; will make a marginal difference of $50billion-$100billion in the total assets that the Fed will acquire by the end of its programme. The Fed thinks that cumulative total is what sets monetary policy.

But the symbolic effect is huge. A taper would signal the passing of “peak QE” in the world’s largest economy. Although it is always possible that the economy will weaken, and the Fed will pick up its pace of asset buying again, that is less likely now the economic recovery is four years old and the unemployment rate down to 7.3 per cent.

 

The big question is where the Fed goes from here. Despite the improvement, the economy is not fixed, unemployment is still high and the growth outlook is uncertain. Interest rates will need to stay low for some time. The Fed and Ben Bernanke, its departing chairman, have to find a way to send this signal on rates even as they start to wind asset purchases down.

How well the Fed succeeds at this delicate task will decide how disruptive tapering becomes. The mere possibility has already caused turmoil in emerging markets and a rush of companies scurrying to lock in low interest rates. Here are some of the main questions the Fed has to answer as it considers whether to turn taper talk into reality.

Is the US economy ready for a taper?

• When the Fed launched its third round of quantitative easing in September 2012, it was different from the earlier programmes in a crucial way: QE3 was open-ended. The Fed would continue its asset purchases, at a clip of $85billion a month, until there was a “substantial improvement in the labour market outlook”.
• That was a masterstroke – markets dubbed it “QE Infinity” and drove interest rates down lower than they have ever gone – but the Fed’s goals for QE3 were actually quite limited. Those goals have been a source of confusion ever since.
• The idea was to give the stuttering economy a shove forwards, not nurse it back to full health. We’re not going to be able to sustain purchases until we’re all the way back to full employment – that’s not the objective. The idea is to quicken the recovery, to help the economy begin to grow quickly enough to generate new jobs and reduce the unemployment rate.
• The Fed began signalling QE3’s eventual end in March. By June, it was concerned enough about overheating markets to spell out a detailed plan, saying it would slow purchases later in the year if the economy kept adding jobs, growth stayed solid and inflation did not fall any further.
• The question now is whether those conditions have been met. In many ways they have. The unemployment rate is 7.3 per cent compared with 7.6 per cent in June; second-quarter growth was stronger than expected; and inflation has stabilized in the past few months. Those are strong reasons to expect a tapering of asset purchases this month.
• The one doubt, exacerbated by a feeble jobs report for August, is whether growth will be strong enough to keep unemployment falling in the months ahead. One way to address such worries is a small taper, then a pause if growth falters.

 

Has QE3 worked?

• The Fed, at least, is convinced that it has. Most Fed officials “agreed that these purchases – by putting downward pressure on longer-term interest rates, including mortgage rates – continue to provide meaningful support to economic growth and job creation”.
• From the mid of 2012 until the summer of 2013, 10-year Treasury notes traded with interest rates between 1.5 and 2 per cent, the lowest they have ever gone. Mortgage rates fell to record lows.
• Further evidence that the policy moved market interest rates came at the first sign of reversing it in May: the 10-year yield is up by more than 100 basis points since then.
• A trickier question is how far those low-interest rates spread. The Fed’s purchases of long-term US Treasury bonds significantly raised Treasury bond prices, but has had limited spillover effects for private sector bond yields, and thus limited economic benefits.
• The Fed thinks that Treasury purchases moved bond yields too and there is some evidence that QE3 spurred the real economy. A boom in mortgage refinancing this year coincided with a pickup in the housing market. The strongest sectors of the economy, such as car sales, have been the most sensitive to interest rates.
• There is no way to know what would have happened without QE3. It did not transform a weak economic recovery into a strong one – growth has remained locked on a path around 2 per cent and the downward trend in the unemployment rate was in place before the policy started – but that may have been the best outcome given the tax rises and spending cuts Congress imposed at the start of 2013.
• What QE3 does seem to have done is reveal the limits of using asset purchases as a tool to stimulate the economy. Growing worries about financial stability risks from QE3 have contributed to the move towards tapering.
• With the UK having recently followed the Fed and adopted a “threshold” for the unemployment rate above which it will not raise interest rates, the focus of central bankers around the world is starting to switch away from QE and towards this kind of “forward guidance” about future policy.

 

How long are interest rates going to stay low?

• What alarmed the Fed most about reaction to June’s tapering talk was the market’s expectation of an earlier interest rate rise. In other words, the Fed’s taper forecast was taken as a reason to doubt its forward guidance.
• As far as most Fed officials are concerned, any decision to taper asset purchases would have nothing to do with the timing of rate rises, which they do not expect to be justified until the economy is much closer to full employment. They are trying new ways to get that idea across.
• There are two possible areas to work on: firmer guidance on when the Fed will first raise interest rates and information on how fast rates will rise once they start to go up.
• For the first rate rise, the Fed’s main communication tool is the 6.5 per cent unemployment threshold, above which it will not raise interest rates. But if a lot of people who dropped out of the labour market start looking for jobs again then the Fed may want to keep rates low even when unemployment falls below 6.5 per cent.
• The Fed could lower the 6.5 per cent threshold, but there is not much appetite for that on the Federal Open Market Committee. An alternative is to add an inflation threshold as well, saying, perhaps, that the Fed will not raise interest rates if it forecasts inflation below its target of 2 per cent. That would help to rule out rate rises in scenarios where the unemployment rate dropped but the economy was still weak enough for there to be little upward pressure on inflation.
• The Fed is starting to debate a broader question: if the damage from the financial crisis – its effect on household balance sheets, for example – could persist for another five years or more. That would mean a slow rise in interest rates back to their long-run level as the economy heals.

The growing importance of forward guidance is a problem for the Fed. While it is hard for central bankers to say something credible about their own plans for the future, it is even harder to say something credible about what other people will do. That makes the importance of forward guidance a problem for 2014.

 

Senior Analyst