Desperate times call for desperate measures.
That’s how the Federal Reserve justified the actions it took in the midst of the major market collapse in 2008. That’s when it started to implement its program known as quantitative easing (QE). In a desperate attempt to kick-start the economy and prevent another Great Depression, the Fed started purchasing bonds and other financial assets from banks.
At that time, the additional liquidity provided by the Fed was viewed as a necessary emergency measure. In 2009, most analysts viewed Bernanke as the man who saved the economy from a depression. That’s why Time magazine named him their person of the year.
But what once was a temporary, radical monetary policy has now become permanent.
Since the Fed first started buying assets, the size of its balance sheet has more than quadrupled. As you can see in the chart below, it went from $850 billion in 2008 to around $3.7 trillion.
The last big jump in the size of the Fed’s balance sheet represents the so-called QE III, which the Fed started to implement in September of last year. The Fed said it would keep buying bonds until it saw a substantial improvement in the labor market.
With the unemployment rate dropping from 8.1% to 7.3% over the past year, many analysts thought the Fed would soon reduce the size of its monthly asset purchases. The consensus among economists was that the Fed would cut the size of the program from $85 billion to $75 billion in its September meeting.
Leading up to the meeting, several members of the Fed reinforced the idea it could start reducing the size of QE soon. In other words, the Fed laid all the groundwork for a taper of $10 billion or so. But they shocked nearly everyone by announcing they would keep buying bonds at a monthly pace of $85 billion.
So why didn’t the Fed cut the size of QE?
The Real Reason Behind the Fed’s Decision
Fed chief Ben Bernanke recently explained the Fed’s surprising decision by saying: “the Fed has some concern that the rapid tightening in financial conditions in recent months could have the effect of slowing growth…a concern that would be exacerbated if conditions tighten further.”1
What exactly is the Fed talking about when it refers to “rapid tightening in financial conditions?” The stock market continues to trade close to all-time highs. We’ve also seen record issuance of high-yield debt in the credit market. These are not signs of tightening financial conditions.
The Fed must be talking about the quick rise in the yield of 10-year Treasury bonds, which moved very quickly from 1.65% to almost 3%. This is important because a lot of other key interest rates, such as mortgage rates, are linked to the 10-year yield. The 30-year fixed mortgage rate, for example, jumped from 3.35% to 4.57%.2
This higher borrowing cost is certainly bad news for the housing market, which has been one of the few bright spots of the economy. The jump in mortgage rates caused a sharp decline in mortgage refinancing activity and an overall slowdown in the housing sector.
I bet that was the key reason behind the Fed’s decision to keep the pace of QE intact. But what caused rates to jump higher in the first place?
Well, the yield on 10-year Treasury bonds started to move higher in May, when Bernanke first hinted that the Fed could start reducing the size of QE soon. Through QE, the Fed buys bonds and suppresses yields. So, in anticipation of the Fed’s move to reduce the size of its purchases, the market started to push yields higher.
In other words, the Fed itself created the “tightening financial conditions” by suggesting they would cut the size of QE. And it was this “tightening” that prevented the Fed from cutting the size of its bond purchase program.
This episode suggests it will be very hard for the Fed to unwind QE. If the Fed decides to reduce the size of the program, we could see an even bigger jump in mortgage rates, which would put the recovery in the housing market at risk.
So when should we expect the Fed to reduce the size of QE?
Why Taper will be a 2014 Story
The next Fed meeting will take place on October 17. There will be no press conference after that meeting. I think it’s unlikely the Fed will make a big decision without the opportunity to explain the details in a press conference.
Besides that, Federal Reserve Bank of Atlanta President Dennis Lockhart recently told The Wall Street Journal that he thinks a taper this month is unlikely. He said: “between now and the October meeting, I don’t think there will be an accumulation of enough evidence to dramatically change the picture.“3
The last meeting of the year will take place in December. But, by that time, the Federal Reserve’s books will be closed. So, it’s very likely taper will be delayed until next year.
Another important issue to consider is the debt ceiling debate and the government shutdown. These political events may end up having a negative impact on the economy. In fact, during a speech New York Fed chief William Dudley gave last month, he said the Congressional debate over the federal budget and the debt limit “creates uncertainty about the fiscal outlook and may exert a restraining influence on household and business spending.”4
It’s very unlikely the Fed will reduce the size of QE right in the middle of all these political uncertainties. The most likely scenario is that the Fed will keep purchasing $85 billion a month until at least its first meeting of 2014.
One thing is certain: it won’t be easy for the Fed to begin tapering. The economy still seems to be highly dependent on QE. And instead of treating QE as an emergency measure to be used only in times of extreme crisis, the Fed now treats it as any regular policy tool. So it could be with us for much longer than anyone thinks.
Until the next Pfennig…
Assistant Vice President
EverBank World Markets, a division of EverBank
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1. “Bernanke’s News Conference on Fed Policy,” September 18, 2013, Reuters
2. “Home Mortgage Rates Drop Again,” October 3, 2013, CNNMoney
3. “Fed’s Lockhart: Hard To See Hitting Conditions for October Taper,” September 23, 2013, The Wall Street Journal
4. The National and Regional Economy, September 27, 2013, Federal Reserve Bank of New York