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End of an Era? Monetary Policy and Currency Issues in 2014: QE or not QE?

GIC Policy Conference London, UK May 8, 2014

Your basic QE chart: Yep, the balance sheet is large.

2

QE: The users guide.

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Bottom line: Not all QE is born equal.

QE1: The credit policy version.

QE2: Pure form QE. QE3: Cheap-talk insurance.

4

QE1 – A program during full-on crisis.

Dollar LIBOR to OIS* Spread 400 350 300

Basis points

Lehman Fails 9/08 Bear Stearns Fails 3/08

*Overnight Index Swap rate

LSAP I begins (11/08)

250

The Crisis 200 Begins 8/07 150 100 3-month 50

1-month

0 Jul-07

Jan-08

Jul-08

Jan-09

Jul-09

Jan-10

Jul-10

Jan-11

Jul-11

Jan-12

Jul-12

Jan-13

through February 26, 2013 Source: British Bankers Association/Bloomberg

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Why we call it LSAP: The Fed’s balance sheet grew by less than half the size of the “QE.”

Ultimate size of QE1 program: Better than $1.7 trillion Increase in balance sheet, November 2008-June 2010: Less than $2.5 billion

In the end, QE1 purchases mainly replaced the emergency credit facilities.

Federal Reserve Assets (Uses of Funds) $ billions

3,000 2,700

Currency Swaps

The Fed’s asset purchases of Treasuries (the green area) and MBS (the red area) mainly replaced the disappearing alphabet-soup lending facilities.

Agency Debt & MBS Lending to Nonbank Credit Markets

2,400

Short-Term lending to Financials Other

2,100

Treasuries

1,800 1,500 1,200

900 600 300 0 Dec-07

Jun-08

Dec-08

Source: Federal Reserve Board of Governors

Jun-09

Dec-09

Jun-10

Dec-10

Jun-11

Dec-11

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A couple of selective (but representative) QE1effect estimates.

Authors

Estimated Impact

Krishnamurthy and Vissing-Jorgensen (2011) Hancock and Passmore (2011)

Treasury effects: -107 bps MBS effects: -85 bps announcement effect on mortgage rates, -50 bps on actual purchases

Sources: http://www.frbsf.org/economicresearch/files/KrishnamurthyVissingJorgensen.pdf, http://www.federalreserve.gov/pubs/feds/2011/201101/201101pap.pd f 8

With the deflation scare, QE looks like QE. Monetary Base Billions of dollars, seasonally adjusted 3500000

QE2

3000000 2500000 2000000 1500000 1000000

QE1

500000

Unlike QE1 – which was weighted to MBS purchases – QE2 was a Treasury-only program

0

Source: Federal Reserve Board of Governors

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The QE2 environment: Falling inflation, falling expectations.

3.6

Bernanke hints at QE2

QE2 commences

3.4

Inflation swaps

3.2

3.0 2.8 2.6 2.4

TIPS 2.2 2.0

Jan-10

May-10

Sep-10

Jan-11

May-11

Sep-11

Jan-12

May-12

Sep-12

Jan-13

May-13

Sep-13

Jan-14

May-14

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Deflation probabilities (derived from TIPS) jumped in summer 2010, and subsequently moderated.

Probability that reference CPI in 2015 will be lower than today Percent 40

August 25, 2010 35 30

November 2010 FOMC meeting

25 20 15 10 5 0 Apr-10

Jul-10

Oct-10

Source: FRB Atlanta calculations

Jan-11

Apr-11

Jul-11

Oct-11

Jan-12

Apr-12

Jul-12

Oct-12

through January 13, 2013

The important lesson of QE2: Talking is doing (if you mean it).

Bernanke hints at QE2

3.6

QE2 commences

3.4

Inflation swaps 3.2

3.0 2.8 2.6 2.4 TIPS

TIPS

2.2 2.0

Jan-10

May-10

Sources: Federal Reserve Board, Bloomberg

Sep-10

Jan-11

May-11

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The seed of the new era: Twist and shout.

August 2011: Communications enhancements • Specified interest rates are expected to remain low until mid-2013 (extended to late 2014, then mid-2015, then…)

September 2011: Maturity Extension Program (Operation Twist), MBS Rollover

• $400 bil. purchase of long-term Treasuries, “sterilized” by sale of short-terms; maintain size of MBS portfolio (extended to end of year in June)

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The “twin pillar” era (rapidly coming to a close).

September 2012 - present: Open Ended LSAP; forward guidance • Open-ended MBS purchases at pace of $40 billion per month starting in September • MEP replaced by outright purchases of longterm securities in December • Forward guidance – “shout” replaced by explicit unemployment and inflation thresholds (also in December)

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Proof in the pudding? LSAP stocks versus LSAP flows.

10-year Treasury yield weekly

4.25% 4.00% 3.75%

Taper announcement

3.50% 3.25% 3.00% 2.75% 2.50%

Bernanke Testifies to Congress

2.25% 2.00%

June FOMC Press Conference

1.75%

1.50% 1.25% Jan-13

Apr-13

Source: Federal Reserve Board

Jul-13

Oct-13

Jan-14

Apr-14 through May 1, 2014 15

An alternative explanation: Woodford rules.

Forward guidance is key when the policy rate is at its lower bound provided: •There is a credible commitment to stay the course longer than would prescribed by “normal” policy • Credibility should be supported by verifiable, state contingent triggers LSAPs may work, but only if : •There is unusual market segmentation • Purchases reinforce commitment to low rates See: Michael Woodford, “Methods of Policy Accommodation at the Interest-Rate Lower Bound”, http://www.columbia.edu/~mw2230/JHole2012final.pdf

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End of an Era?