Jan. 31, 2019
MARKETS AND ECONOMY
Misplaced Worries Over Quantitative Tightening
As the Fed slowly removes accommodative monetary conditions that were put in place during the last recession, there’s some concern about tightening financial conditions spurring a new downturn. But financial conditions and monetary conditions aren’t the same, and the Fed’s recent actions shouldn’t be seen as restrictive.
JIM GLASSMAN, HEAD ECONOMIST, COMMERCIAL BANKING , JP MORGAN
JANUARY 23, 2019
As the top of the business cycle approaches, every action from the Federal Reserve seems to provoke anxiety. After all, the US economy has never held full employment for long until the start of the next downturn. Periods of strength always threaten to generate an overheating labor market, spiraling inflation, or financial imbalances that will eventually tip the economy into a new recession.
Every step of interest rate normalization has been subject to intense debate, with critics questioning whether the expansion can endure higher borrowing costs. However, December’s hike merely pushed short-term rates into a 2.25 to 2.5 percent window, barely ahead of inflation. Unless the true equilibrium for real interest rates in an economy operating near full capacity is negative, rates have yet to move into restrictive territory.
Worries Over Stealth Tightening
Interest rates are not the sole lever for making monetary policy. During the early years of the recovery, the Fed turned to quantitative easing to hasten the recovery. By purchasing large volumes of Treasurys and mortgage-backed securities, the Fed was able to push down long-term borrowing costs and spur a wave of private-sector capital investment. Now that the economy is back on solid footing, the Fed has begun shrinking its balance sheet, allowing its holdings to mature and effectively releasing a new flow of securities onto the open market.
This decision has led to worries that balance sheet normalization represents a stealth mechanism for monetary tightening. After all, quantitative easing brought long-term borrowing costs down, so it’s logical to think its reversal could push interest rates above their natural equilibrium. If rising yields cause monetary conditions to turn restrictive, higher borrowing costs could cut off capital investment and dampen economic activity.
Yields Remain Tranquil
The Fed’s balance sheet is shrinking by some $50 billion monthly, yet the market shows no signs of tightening. A year after the runoff of excess reserves began, the 10-year Treasury yield—often used as a proxy for long-term interest rates—has climbed to just 2.7 percent, less than one percentage point above inflation expectations. Despite the added flow of securities coming onto the market, long-term yields likely rest below their true equilibrium, which has historically held approximately two percentage points ahead of inflation.
It appears that the yearlong climb in yields that began in late 2016 was only partly driven by the Fed’s announcement of balance sheet normalization. Investors were likely also responding to the presidential election results, which brought the hope of tax relief, fiscal stimulus and business-friendly regulatory reforms.
Reducing Idle Liquidity
As the Fed’s balance sheet shrinks, the excess liquid reserves held at the central bank are also declining. This has led to concerns that monetary conditions will tighten as banks no longer have excess reserves to draw upon. However, just as hyperinflation did not follow the creation of these excess idle reserves, their removal should have little impact on monetary conditions for the broader economy. If a liquidity crunch were brewing, it would first become visible in steadily rising bond yields—a sign that is markedly absent today.
Why Aren’t Yields Rising?
No single factor can fully explain yields’ stability through the first year of balance sheet normalization. Central banks abroad are still engaged in quantitative easing, which may be suppressing yields for high-grade debt in the US. The 10-year yield on Japanese Government Bonds sits at virtually zero, and German bunds have climbed barely above 0.25 percent. This may be encouraging investment in US government debt, which is at least ahead of inflation.
However, overseas investors have purchased relatively few Treasurys in recent years—since 2014, international investment in US government bonds has been flat. Instead, foreign capital has been flowing into stocks and corporate bonds. Since 2014, foreign investors have acquired $3.5 trillion in US equities and another $1 trillion in corporate debt and dollar-denominated money market securities. Foreign inflows may have an indirect role in suppressing bond yields, but it doesn’t appear that the US bond market is serving as a refuge from quantitative easing programs in Europe and Japan.
Demand for government debt is broadly spread across the domestic market. Banks and investment funds have purchased $2 trillion of Treasurys since 2014; households and hedge funds have added another $1 trillion of government debt to their portfolios over this period. These purchases may have been driven by higher capital requirements for lending institutions, as well as investors fleeing volatility in the stock market.
Monetary Versus Financial Conditions
The debate over the Fed’s decisions often conflates monetary policy with the broader financial conditions facing consumers. The Fed’s ability to set short-term interest rates gives it great power over monetary conditions, but financial conditions—and the availability of credit to private borrowers—is a function of the free market. Issues like the impact of growing student debt are fundamentally endogenous; they can be affected by policymakers’ decisions, but market forces ultimately control the movement of capital within the private sector.
As the economy strengthens, financial conditions may grow tighter in an absolute sense. But that will reflect strengthening demand for credit as promising opportunities for investors proliferate. The Fed’s mandate is to maintain price stability, not to control the shifting balance of financial conditions as the top of the business cycle arrives.