In response to the financial crisis of 2008-2009, the Federal Reserve (Fed) engaged in unprecedented monetary policy activities to stimulate the economy. Among them were the large-scale asset purchase programs known as quantitative easing (QE), which were designed to increase the liquidity in capital markets.
The Fed’s actions stoked investor fears of runaway inflation, uncontrollable, volatile policy and other dire forecasts. Yet, in subsequent years, these fears went unrealized. Since 2009, financial markets have stabilized, consumer confidence has grown, and inflation has underperformed relative to expectations— contrary to the hyperbole of worried commentators.
Today, a similar set of fears is playing out as the Fed looks to tighten accommodative policy by raising interest rates and reducing the size of its balance sheet from its record $4.5 trillion level. In our view, these fears are once again exaggerated. While the shrinking of the balance sheet should exhibit upward pressure on sovereign debt securities and mortgage-backed securities, we expect that the impact will be small and well-controlled.
The Fed’s Toolkit Affords Significant Control over Rates
The Fed’s monetary policy toolkit is well equipped to handle periods of expansion and tightening. In the case of post-financial crisis QE, the Fed purchased bonds from the market, and then credited the sellers with a large sum of cash. Under normal circumstances, banks would use this cash for lending. To prevent runaway credit growth and inflationary pressures, however, the Fed created new tools – particularly one called “interest paid on excess reserves” – to constrain banks from lending these newfound piles of cash.
As bonds have been maturing in its portfolio, the Fed has maintained the size of its balance sheet by repurchasing similar bonds of roughly the same value. Today, as the Fed approaches monetary tightening and balance sheet reduction, instead of repurchasing bonds with the proceeds of expiring bonds, the cash will be removed from existence. In the case of Treasuries, the Treasury reissues debt in the amount of the maturing par and sells it in the open market. Since the Fed no longer holds this debt, and the U.S. government still owes this money, the reissued debt reenters the market, thereby increasing market supply and exerting upward pressure on Treasury rates. Importantly, banks’ cash reserves will dwindle over time through the mechanism of monetary tightening. The remaining outlying cash will be neutralized through Fed policy.
QE Has Helped Spur Growth, but not Inflation
We can look at the U.S. unemployment rate and inflation for an example of how investor concerns about QE have not materialized. Several years of accommodative policy helped strengthen the U.S. labor market. Traditional economic theory suggests that a lower unemployment rate is associated with greater price and wage inflation. However, in recent years, this has not been observed despite a 10-year low in the unemployment rate. Rather than runaway inflation, policymakers are grappling with stubbornly low inflation (Exhibit 1).
In our view, accommodative monetary policy has helped boost the recovery and fuel the subsequent expansion. QE has exerted downward pressure on Treasury and mortgage rates and, perhaps more importantly, stimulated renewed optimism in U.S. growth. While today’s economic growth rate is historically low, it appears that the reason is linked more to subdued productivity growth and capital investment than to any other cause. As a result, Treasury rates will likely remain low, even after monetary policy is normalized.
Has the time come for normalization? There’s no question that the extraordinary circumstances of the financial crisis created a need for extraordinary monetary policy. At the trough of the economic cycle, when economic indicators had their worst readings, unemployment was near a 25-year high, credit growth was falling, and a lack of consumption spurred deflationary pressures. But 10 years into the expansion, these indicators are at more normal readings, suggesting that accommodative policy may no longer be necessary (Exhibit 2). Indeed, the Fed has cited improving economic conditions as its reason for tightening policy.
A Plan for Gradual Balance Sheet Reduction
From the moment the Fed embarked on the policy of QE, the question was how the Fed would remove itself from an enlarged balance sheet. Back in 2009, then-Fed Chairman Ben Bernanke was already allaying concerns: “We are monitoring the maturity composition of our balance sheet closely and do not expect a significant problem in reducing our balance sheet to the extent necessary at the appropriate time.” With that time nearly at hand, the Fed has articulated a goal of reducing the balance sheet “naturally” by allowing maturing securities to “roll off.”
The balance sheet “roll-off” program is designed to proceed at a measured, orderly pace to avoid market disruptions. The Fed intends to allow a limited amount of securities to roll off its balance sheet each month. Every three months, the Fed plans to increase the amount of securities permitted to roll off by $6 billion in Treasuries and $4 billion in mortgage-backed securities, with a final cap of $30 billion and $20 billion, respectively. By capping maturing securities each month, we estimate that the Fed would prevent $430 billion in roll off over five years (Exhibit 3).
How should investors react to balance sheet tightening? In short, we believe they shouldn’t. We’ve seen in previous tightening cycles that asset classes across the board can perform well in a rising rate environment. As we often say, time in the market is more important than timing the market. As such, we advocate for investors to remain focused on their long-term strategies.
Follow @OppFunds for more news and commentary.
OppenheimerFunds is not undertaking to provide impartial investment advice or to provide advice in a fiduciary capacity.
Mutual funds and exchange traded funds are subject to market risk and volatility. Shares may gain or lose value.
These views represent the opinions of OppenheimerFunds, Inc. and are not intended as investment advice or to predict or depict the performance of any investment. These views are as of the publication date, and are subject to change based on subsequent developments.