Federal Reserve Chair Jerome Powell announced last month that the Fed would slow its purchases of bonds, most likely by the end of this year. The timing of the cutback will depend on several factors related to the economy, and last week’s disappointing employment report if repeated could push back the date. The financial markets will now begin anticipating the impact of the reduction in the Fed’s asset holdings.
The origins of the increase in the Fed’s holdings of Treasury bonds and mortgage-backed securites can be traced back to the global financial crisis. The Fed’s assets grew from $870 billion in August 2007 to $2 trillion in early 2009. When the Fed introduced its quantitative easing program, it claimed that the purchases of bonds would lead to lower long-term interest rates more quickly than if it relied only on lowering the Federal Funds rate. In addition, the purchases showed the Fed’s commitment to keeping interest rates low in order to boost the economic recovery. This latter form of signaling was called “forward guidance.”
Subsequent quantitative easing programs eventually raised its holdings to $4.5 trillion by 2015. The Fed maintained that level until 2018, when it allowed its holdings to fall as bonds matured. But it reversed course in 2019, and the Fed responded to the pandemic in the spring of 2020 by ramping up its purchases of assets in order to support the financial markets. Its asset holdings now total about $8.3 trillion.
The Fed has not been alone in using asset purchases as a tool of policy. The European Central Bank increased its holdings of bonds during the period preceding the pandemic from 2 trillion Euros at the end of 2014 to 4.6 trillion Euros. It accelerated its purchases last year and now holds about 8.2 trillion Euros in assets. The Bank of Japan and the Bank of England have their own versions of asset purchase programs. Many of these central banks have also announced changes in the pace of their asset purchases.
When then Fed chair Ben Bernanke noted in 2013 that continued strengthening of the economy could lead to a cutback in asset purchases, this was interpreted as a sign that the Fed would also allow interest rates to rise. This led to the infamous “taper tantrum,” as financial markets overreacted to the prospects of higher interest rates. The response included capital outflows from emerging market countries such as India as their exchange rates depreciated and their own asset markets fell in value. Stability was eventually reestablished once the Fed clarified that it had no plans to enact a contractionary policy, but the incident demonstrated the volatility of financial markets, particularly in the emerging market countries.
Powell has sought to avoid such an outcome by explicitly delinking asset purchases from interest rates. He pledged to keep the Federal Funds rate at its current setting until “maximum employment and sustained 2% inflation” area achieved. The (lack of a) response in the financial markets to Powell’s speech seemed to indicate that this promise was seen as credible, despite concerns about inflation.
But there will be consequences when the Fed cuts back on its asset purchases. The increases in the Fed’s balance sheet, as well as those of the other central banks, released a wave of liquidity with wide-ranging consequences. In the U.S. it has kept stock price valuations at elevated levels, which contributes to widening wealth inequality. For example, in 2019 families in the top 10% of the income distribution owned 70% of total stock values. Similarly, the provision of easy credit has contributed to rising housing prices that also reflects demand and supply conditions.
The increase in liquidity also benefited emerging markets and developing economies. In the period immediately before the pandemic the World Bank warned that the world had experienced a rise in debt, both private and government. Total debt in the emerging markets and developing economies had risen from 114% of their GDP in 2010 to 170% at the end of 2018. Part of this increase reflected accommodative monetary policies in the advanced economies and a search for higher yield by investors in those countries. A rising global demand for the bonds of the emerging market and developing economies countries was met by an increase in their issuance.
These countries suffered massive reversals of foreign capital in the spring of 2020. The “sudden stops” confirmed the existence of a global financial cycle that can overwhelm vulnerable economies. But the withdrawals were soon reversed, in part because investors were reassured by the rapid responses of central banks in the advanced economies to the financial meltdown.
There are many who voice concerns about the ending of the current financial cycle. Mohammed El-Erian, president of Queens’ College of Cambridge University, is worried about the excessive risk-taking that the financial sector has undertaken in response to its “unhealthy codependency” with central banks. Raghuram Rajan of the University of Chicago’s Booth School of Business is alarmed about the impact that future interest rate hikes could have on government finances. Jeremy Grantham of asset management firm GMO believes that the stock market will experience a massive crash. And IMF Managing Director Kristalina Georgieva is concerned about a diveregence in the prospects of advanced economies and a few emerging markets versus those of most developing economies that could lead to a debt crisis.
Much of the impact of the policy changes at the Federal Reserve depends on how the financial markets respond to the slowdown in purchases, and whether the Fed is successful in delinking a cutback in asset purchases from its interest rate policy. The lack of a strong response in the bond markets suggests that there has not been a change in expectations of future interest rates. But ouside the U.S. there is always the prospect that a slowdown in economic growth and the continuation of the pandemic imperil the solvency of corporate and government borrowers. These developments would be enough to fuel a debt crisis despite the Fed’s careful footwork.
