What Happens After QE?

Attend a speech by any Federal Reserve official, and you will hear this question from the audience: When will the Fed start tapering its purchases of Treasuries and mortgage-backed securities? Currently, the Fed purchases about $85 billion assets each month – $40 billion in mortgage-backed securities and agency debt and $45 billion in Treasuries – as part of its third round of quantitative easing, or QE3.

 But a reduction or cessation of those purchases “depends on the economy, especially labor market conditions,” says Ray Stone, managing director of Princeton, N.J.-based Stone and McCarthy Research.

“A further dip in the unemployment rate, if combined with a couple months of 200,000 or higher of (nonfarm) payroll gains would probably be enough for the Federal Open Market Committee to start paring back the program,” Stone says.

Many FOMC members view Fed asset purchases “as a form of extra insurance” to make sure the U.S. labor market can continue to create jobs in the face of fiscal constraint from the New Year’s tax compromise and the spending sequester, note CME Group economists Blu Putnam and Samantha Azzarello, writing in the April Market Insights.

At the May FOMC meeting, Fed officials kept their options open, indicating in their statement that they were prepared to “increase or reduce the pace of its purchases,” depending on inflation and job growth in the months ahead.

“My guess is that [by] late summer or early fall, the paring will start,” Stone says, with Fed purchases edging down to around $65 billion a month from $85 billion.

While the U.S. economy has been showing signs of growth, Fed officials have repeatedly stressed they want sustained improvement. Although the April jobless rate fell to 7.5 percent, the lowest level since 2008, and nonfarm payroll increased by 176,000, one month of data is not enough to spur a policy change, most economists agree.

Stone says he believes most FOMC members would like to end the Fed purchase program by year-end, but it may take a few months longer.  “The more they do … the more difficult the exit,” he adds.

Several rounds of quantitative easing have increased the Fed’s balance sheet to more than $3 trillion, from less than $1 trillion before the 2008 financial crisis. In the meantime, while long-term Treasury rates and home mortgage rates are lower than they would be otherwise, the full market impact of Fed purchases is hard to quantify, Stone says.

“I suspect that any tapering, or near-term expectations of tampering would provide a lift to [fixed income] yields,” he adds. “But it is important to remember that such would not be a tightening of policy, but simply a diminution of the pace of easing.”

The Federal Reserve Board set a threshold unemployment rate of 6.5 percent at its December meeting. Putnam and Azzarello point out the rate is a target, not a trigger, and is tied to forward guidance for the federal funds rate, which has held near zero since December 2008.

The lift-off date for fed funds according to the Fed is after the unemployment rate gets down to 6.5 percent, Stone says. Previously, that was not expected to occur until mid-2015.  However, “the recent declines in the unemployment rate suggest that it could be sooner … perhaps by late 2014 or early 2015, says Stone.

Perhaps more importantly, at least to fixed-income market participants, is when the Fed will sell some or all of its U.S. Treasury and MBS holdings.

“The answer may be never,” say Putnam and Azzarello. The Fed may instead choose to hold its assets until maturity. “Massive MBS sales might disturb a still-fragile sector of the economy (housing),” they suggest. “Similarly, the Fed may also want to avoid destabilizing the U.S. Treasury market.”

The Fed owns about 10 percent of all outstanding Treasury issuance, but that understates the Fed’s influence on the tradable market, they add. If the Fed sold in size, prices of U.S. Treasuries would fall and rates would rise.

“I think if the Fed has a choice, they would prefer not to sell assets,” Stone says. Not only could the sales be disruptive to fixed-income markets, “the Fed would be selling assets at a time when the economy would be stronger and interest rates higher,” he notes.

“The Fed bought securities when interest rates were low,” Stone notes. It does not mark to market and does not record losses (or gains) unless securities are sold. “Their sales would probably result in substantial losses for the Fed and a period of suspended remittances to the Treasury,” he says. “Politically, this could be a little dicey.”

Suzanne Cosgrove spent much of her career at financial wire services and the Chicago Tribune, where she served as assistant financial editor. In 1996, she opened the Chicago bureau for the Market News International wire service and served as bureau chief for four years. In addition to freelance work, Suzanne is an adjunct professor at the Medill School of Journalism at Northwestern University.

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