There have been many discussions in recent months about the possibility of the Federal
Reserve performing quantitative tightening. We expect this topic will reappear in financial
media and in central bank speeches frequently in the near future, so this video will serve
as a basic introduction and an overview explanation of what this situation is all about.
That will set up the foundations that will then allow us to get into more detail and
explain the complexities at a later point as more details and repercussions of the situation
become apparent.
Following the financial crisis of 2007 to 2008 the U.S. Federal Reserve took an unconventional
monetary policy action in an attempt to stimulate the troubled economy.
This was an expansionary policy known as quantitative easing, or QE.
In short, quantitative easing involves buying assets on a large scale.
These will typically be financial instruments or government bonds, which therefore inflates
the value of those assets while also increasing the money supply in the economy, as funds
are created in order to purchase the assets. This has led many people to refer to QE as
'money printing'. The Fed ran various iterations of quantitative
easing from the end of 2008 until 2014. Leading to a dramatic increase in its balance sheet
size from $869 billion to nearly $4.5 trillion. This $4.5 trillion is predominantly made up
of US Treasuries and Mortgage Backed Securities.
So far, the Fed has maintained the size of its balance sheet by rolling over their investments.
This means, when coupon payments are received from the bonds or the investments mature,
they will reinvest these funds into more assets. However, more recently it appears that the
Federal Reserve is finally looking to set the wheels in motion for reducing their huge
balance sheet. This, in effect, means that they will be reversing
or unwinding quantitative easing. In other words, they will be embarking on
a period of quantitative tightening, otherwise known as QT.
At the time of releasing this video, it is currently unclear what quantitative tightening
will actually involve, as nothing on this scale has ever happened before. Although there
is plenty of speculation. Jamie Dimon, CEO of JPMorgan Chase has stated
that the Fed raising interest rates, which has somewhat of a similar effect on the economy
at quantitative tightening, would not cause a disruption in the markets since that action
is also a sign of a growing economy. However, quantitative tightening, on the other hand,
could be disruptive.
People focus on interest rates and I think you should always think with interest rates
is why they are going up. If interest rates are going up, and I'm talking about the United
States now, this would be true for Eastern Europe too at one point, if interest rates
are going up because the economy is strong... the strong economy is more important than
the fact the rates are going up and you've seen that in the past.
I think the reversal of the actual monetary, you know, selling securities in the market
place, that, I think when that happens of size and substance, it could be a little more
disruptive than people think.
The most basic way to look at Quantitative Tightening is that the Fed will allow their
older bonds to mature, without reinvesting into new assets.
As a result of allowing this to happen, the balance sheet will be reducing and the funds
will not be added back into the money supply. This means, as a result of this, the money
supply will also be reducing. However, it has been signaled by members of
the Federal Reserve that the approach is going to be extremely slow, in order to make sure
the markets remain stable and not to cause unnecessary negative repercussions.
Therefore, it's quite likely that rather than halting the reinvestments completely, they
will just taper their reinvestments instead. That means, they will let some of the bonds
mature without reinvesting the funds, but not all of them. Someof them will still be
reinvested. It's expected that whatever action they take,
it will continue until the Fed manages to reduce its $4.5 trillion balance sheet down
to around $2.5 trillion. Although this figure is not confirmed, it's what top sources currently
expect to happen.
Obviously there are positive effects of quantitative tightening. Namely that the Federal Reserve
will lighten the load on its balance sheet, which gives them more ammunition in their
arsenal for tackling any future recessions. However, the main concern is what the negative
effects may be. As mentioned previously, this is an unprecedented action and therefore,
even if the Fed moves slowly and tries to maintain stability, the actual effects in
reality are relatively unknown. If we consider broadly-speaking what took
place as a result of quantitative easing, there was a reduction of supply for financial
assets which then pushed the prices up, including risky assets.
So if the reverse is taking place now, we can expect that risky assets are going to
experience a reduction in prices. And the reduced demand for bonds will also lead to
a reduction in bond value, while yields will rise.
If quantitative easing is an unconventional measure that's intended to have a similar
effect to a further reduction in interest rates, the opposite is true for quantitative
tightening. As this will effectively be similar to interest rates increasing, beyond the actual
rate hikes that the Fed has already been doing and plans on doing in the future.
It's safe to say quantitative tightening will not be at the same accelerated pace that quantitative
easing was, especially if they are waiting for bonds to mature rather than selling them
back to the market. However this does seems to be in line with their current rhetoric
that creates the image of it being in line with the process of watching paint dry. In
any case, we will still be keeping a close eye on how they proceed, as the faster they
unwind their balance sheet, the more impact we're going to feel in the markets.