How the Fed might handle the end of QE

I also noted that stocks, in the fullness of time, would realize their value and that the Fed, ultimately, would have to back away from its present extremely accommodative policy. After some 18-24 months, the equity rally would need fundamental policy and economic improvements to sustain it. In this column, I will take up one of those fundamental, longer-term considerations: Fed policy. The columns that follow will discuss two other major issues: fiscal policy and energy.

At present, the Fed simply is pouring liquidity into financial markets. It has flooded banks with reserves so that, today, their liquid reserve holdings far exceed the requirements of law. Indeed, more than 90% of bank reserves on deposit with the Fed stand in excess. The Fed, having pushed down short-term interest rates — federal funds, Treasury bills, insured deposits — to about zero in 2008, shows every sign of continuing to hold them at these levels until 2015 at least, according to statements by Fed Chairman Ben Bernanke. The Fed has also held down longer-term bond yields by engaging in outright bond purchases, mostly of Treasury and mortgage-backed issues, in a series of operations broadly described as quantitative easing. The latest version has the Fed buying some $85 billion in such bonds each month.

Since this flood of liquidity has clearly helped lift asset prices, including equities, it is only natural to question what will happen to markets when the Fed changes its policy posture, as it will have to do ultimately. If the Fed were to fail to make such a change, the ongoing flood of liquidity would threaten inflation, a development that surely would destroy the price of assets—particularly bonds—in time. But if the Fed were to change too dramatically, especially in a still-weak economy, the rally would suffer from a recessionary shock. For the time being, both these dangerous, but very different, prospects remain only a distant concern. The slack in the U.S. and global economies relieves any immediate inflationary threat and so lifts any immediate need for the Fed to reverse course. But looking out two years or so, when the policy shift will become inevitable, the risks of one or the other of these dangers clearly rise. A continuation of the rally, then, will depend on a carefully balanced Fed policy turn.

The Fed clearly recognizes this long-term need for balance. Chairman Bernanke and others there have bent over backward to reassure all that they see the dangers of both inaction on one side, and too-dramatic a change on the other. Bernanke focused entirely on these risks in a talk to a major policy forum last summer.
In that talk he alluded to a five-step process that he has laid out elsewhere and that he expects will create the needed balance. At each stage in this process, he has emphasized, policy makers could recalibrate as they assess market and economic reactions. On the face of it, it looks sound:

1. First, the Fed would curtail and eventually end its bond purchases, effectively dispensing with its quantitative easing program. Such a shift would, of course, stem the flow of new liquidity into markets.
2. As a second step, policy makers would cease to reinvest the interest and principal payments the Fed receives on its existing bond portfolio. Such a posture would gradually drain liquidity from markets and the economy.
3. As financial and economic conditions permit, the Fed would begin to sell some of the bond holdings it has acquired over these years of quantitative easing, draining still more excess liquidity from the system.
4. If policy makers can execute step 3 without disruption, the Fed would then raise the rate it pays banks on the reserves deposited with it, encouraging bank managers to leave more reserves idle at the Fed, thereby draining additional amounts of liquidity from the system.
5. Only at the end of this gradual chain of transformation would policy makers look to raise the federal funds rate— the traditional means to constrain liquidity— and then they would do so only gradually.
   Chairman Ben Bernanke claims (hopes) that this carefully orchestrated series of steps can give Fed policy just the right balance to impose the required change when the time comes: measured enough to avoid shocking financial markets and the economy, but substantive enough to forestall any inflationary risk. While the plan seems reasonable, no one can be sure of it until the chairman, or his successor, actually puts it into practice.

For all the obvious uncertainty involved, investors can still glean useful portfolio guidance by anticipating this turn. Because the Fed will only put its plan into effect some time from now and, then, only gradually, investors have no need to twist their portfolios now to accommodate the ultimate outcome. On the contrary; such a move would be misplaced. No one today knows how the Fed’s plan will work, or, if it fails, what consequences that failure would have: inflation or a recessionary shock. Either of which would demand very different portfolio positioning. What is more, the very gradual nature of the implementation plan will give investors time to assess the likelihood of success, or the potential character of any failings, and make adjustments while the Fed is executing its strategy. Because the ultimate outcome is of crucial importance, all need to follow the Fed carefully. But if ignoring things would be a mistake, so, too, would premature positioning.

Related Topics: Federal Reserve