Taper Tantrum

23/08/2013 at 4:33 pm

The release of minutes from the July meeting of the Federal Open Market Committee generated headlines this week. Fears of the effects of “tapering” – the reduction by the Fed of the amounts of fixed income security purchases it makes under its “QE3” programme of quantitative easing – have continued to unsettle markets.

There was no clear steer from the minutes as to when this will eventually begin. But according to research released by the San Francisco Fed earlier this month it doesn’t matter much anyway. The Fed economists who wrote the study estimate that a QE2-sized programme ($600bn of US Treasuries purchased over two years) without accompanying dovish guidance on interest rates would have added only 0.04% to GDP growth and 0.02% to inflation. Even with this guidance they assessed the impact at a meagre +0.13% on GDP and +0.03% on inflation. As they conclude:

Asset purchase programs like QE2 appear to have, at best, moderate effects on economic growth and inflation … those effects are weaker and more uncertain than conventional interest rate policy. This suggests that communication about the beginning of federal funds rate increases will have stronger effects than guidance about the end of asset purchases.

Moreover, one of their key model assumptions was that QE would lead holders of longer-dated Treasuries to reallocate capital to other asset classes or the wider economy (they assume no impact on holders who are indifferent to bond maturities):

If long-term yields fall, these investors have less incentive to save and may allocate more money to consumption or investment in nonfinancial assets. This boosts aggregate demand and puts upward pressure on inflation.

This analysis will be familiar to readers who remember the numbers involved in our own programme of QE here in the UK. As this blog observed some time ago, however, with the government issuing at least as much debt into the bond market as the Bank of England is taking out, this “helicopter drop” monetary model simply doesn’t fly:

Imagine that you were in the crowd underneath the helicopter and had managed to scramble successfully for £50. Then, as the helicopter flies away and you are about to put the money into your wallet, you feel a tap on your shoulder. You turn to see a man standing in front of you with a knife, who mugs you for it. Would you feel like the beneficiary of a windfall and embark on an inflationary spending bonanza, or would you put your wallet away in bewilderment, feeling as if the whole exercise had been an elaborate distraction?

Unsurprisingly for an economy which has seen the level of public debt to GDP rise from a little over 60% at the start of the Great Recession to over 100% today, the same logic applies over the Atlantic. Since the Fed started QE it has bought $2,196bn of Treasuries. Over the same period, BoA Merrill Lynch data on the Treasury and TIPS markets shows that the face value of the US government bond market has increased by $5,251bn – almost two and a half times as much.

So the numbers suggest US QE has been a monetary sideshow, as does a study made by the Fed’s own specialists. The same is also true if we look at other possible transmission mechanisms which the study ignores, such as the weekly Fed data on loans and leases made by US commercial banks for example, which after a prolonged decline only exceeded their previous (2008) peak towards the middle of last month.

This is not to denigrate the Fed’s whole programme of unconventional policy measures. The purchase of mortgage-backed securities alongside government bonds for instance might well have helped repair bank balance sheets – as well as contribute to lower mortgage rates, and alongside the effect of initial emergency measures such as the Troubled Asset Relief Programme, the Federal takeover and capitalisation of Fannie Mae and Freddie Mac, etc. In fact the speed of the banking sector recovery in the US – as opposed to in Europe (including the UK) – has been one of the great relative strengths of the American economy. The Fed’s activities during the subprime crisis and its devastating aftermath are not to be sniffed at.

Nonetheless, some participants are betting that ending, or merely reducing, a programme whose actual monetary effects are likely to have been trivial will destabilise economic recovery in the US and across the globe.

This appears to betoken an unreasonably heightened level of concern.


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