The two-day meeting of the FOMC ended on Wednesday with a momentous announcement that has been telegraphed for months: the QE unwind begins October 1. It marks the end of an era.
The unwind will proceed at the pace and via the mechanisms announced at its June 14 meeting. The purpose is to shrink its balance sheet and undo what QE has done, thus reversing the purpose of QE.
Countless people, worried about their portfolios and real estate investments, have stated with relentless persistence that the Fed would never unwind QE – that it in fact cannot afford to unwind QE.
The vote was unanimous. Even no-rate-hike-ever and cannot-spot-housing-bubbles Neel Kashkari voted for it.
The Fed also telegraphed that it could raise its target range for the federal funds rate a third time this year, from the current range of 1.0% to 1.25%. There is only one policy meeting with a press conference left this year: December 13, when the two-day meeting ends, remains the top candidate for the next rate hike.
This has been the routine since the rate hike last December: The FOMC decides to change its monetary policy at every meeting with a press conference: December, March, June, today, and December.
Even hurricanes won’t push the Fed off track.
The Fed specifically mentioned Harvey, Irma, and Maria. No matter how destructive, they won’t impact the economy “materially” over the “medium term” and therefore won’t impact the Fed’s policies:
Hurricanes Harvey, Irma, and Maria have devastated many communities, inflicting severe hardship. Storm-related disruptions and rebuilding will affect economic activity in the near term, but past experience suggests that the storms are unlikely to materially alter the course of the national economy over the medium term.
This Fed is on a mission. There was zero surprise in the monetary policy decision today, which is key: The Fed wants to revive its credibility. It wants markets to take it at its word. But that’s not an easy job.
Starting in 2013 and into early 2016, the Fed engaged in feverish flip-flopping at every squiggle of the markets, first on tapering of QE and then on raising rates. I mused a few days ago:
During this period, they took their credibility out the back and shot it. And when that credibility seemed to still have any life left in it, they shot it again. And even after everyone saw that it obviously had no more life left in it, they shot it again, just to make sure.
Now markets don’t believe anything the Fed tries to communicate. They’re hoping that at the next market squiggle, the Fed will re-flip-flop, cut rates, and restart QE. Markets are dreaming.
“Low” inflation, no problem.
Fed officials see consumer price inflation below their target of 2% for the next two years and are OK with it. The Fed’s favorite inflation gauge, core PCE (ex food and energy), was 1.4% at the last reading. But no big deal. Fed officials lowered their projections of core inflation to 1.5% by the end of 2017, and to 1.9% by the end of 2018.
And yet – despite market rumors and hopes that the Fed would flip-flop – rate hikes keep coming, albeit at snail’s pace; and on October 1, QE will begin to unwind.
Why? Asset prices.
Fed officials have been mentioning asset prices explicitly since last year. Inflated asset prices make inflated collateral values, and the banks are on the hook. Deflating asset bubbles threaten “financial stability” via this mechanism of collateral. They take down banks because collateral values collapse. And they do terrible damage to the real economy. This Fed doesn’t want another big crisis.
In its Implementation Note, the Fed confirmed today how QE will be unwound. It starts slowly, picks up pace over the next 12 months, and hits cruising speed on October 1, 2018. The Fed will “gradually reduce” its balance sheet by letting maturing securities “roll off” without replacement, it said. And these are the amounts of its “balance sheet normalization”:
- In October 2017, it will shed $6 billion of Treasury securities, to be increased every three months by $6 billion, to reach $30 billion a month by October 2018.
- In October 2017, it will also shed $4 billion of mortgage-backed securities, to be increased every three months by $4 billion, to reach $20 billion per month by October 2018.
- Combined, the Fed will unload $10 billion in October 2017 and raise that to $50 billion a month by October 2018.
- The future size of the balance sheet has not been announced yet.
Here’s the schedule:
- Oct – Dec 2017: $10 billion a month.
- Jan – Mar 2018: $20 billion a month.
- Apr – Jun 2018: $30 billion a month.
- Jul – Sep 2018: $40 billion a month.
- From Oct 2018 forward $50 billion a month.
So $300 billion over the next 12 months, and $600 billion a year, starting October, 2018. If this goes on for four years, the Fed will cut its balance sheet by $2.1 trillion.
This is the amount of money the Fed will destroy – just as it created this money during QE. It’s the reverse of QE, with reverse effects.
In basic terms, it drains money from the market like this:
When securities mature, they’re redeemed. Whoever holds them gets paid face value, and the securities become void and disappear. So when the Treasury securities that the Fed holds mature, the Treasury Department transfers the money to the Fed. If the Fed doesn’t buy other assets with the money, that money just disappears.
The Fed creates money, and it destroys money. But it doesn’t sit on trillions of dollars in a cash account. Here’s an explanation of Fed balance sheet accounting.
Since the Treasury Department doesn’t have the money to pay off maturing bonds – as the US government runs a big deficit – it raises this money in advance by selling bonds at regular auctions. In other words, the bond market gives the money to the Treasury Department to redeem the maturing bonds. If the Fed holds these maturing bonds, the Treasury Department gives this money to the Fed. And the Fed destroys it.
In this manner, the Fed drains money from the market – when at cruising speed, at a rate of $600 billion a year. This is the reverse of what happened during QE. The purpose of QE was to inflate asset prices. Now the reverse purpose commences.
Yet, the Fed re-emphasized that its monetary policy – despite rate hikes and QE unwind – “remains accommodative,” thus stimulating the economy. What it is doing now is merely removing this accommodation gradually. It isn’t actually tightening yet. So don’t expect this Fed to flip-flop at the next squiggle of the market.
Flip-flopping killed the Fed’s credibility. And that’ll be a problem for the markets.