Wednesday, May 28, 2014

Staging the QE exit

Fed officials are hinting that the rate hike could take place before the Fed ends the policy of reinvesting securities that pay down or mature. The order of events would look something like this:

1. Securities purchases end later this year but the Fed maintains its balance sheet at constant level.
2. The rate hike takes place (some time in 2015)
3. The Fed begins to allow securities to mature (or amortize for MBS) without replacing the declining notional.
William Dudley: - ... it would be desirable to get off the zero lower bound in order to regain some monetary policy flexibility. This goal would argue for lift-off occurring first followed by the end of reinvestment, rather than vice versa. Delaying the end of reinvestment puts the emphasis where it needs to be—getting off the zero lower bound for interest rates. In my opinion, this is far more important than the consequences of the balance sheet being a little larger for a little longer.
Fed officials are afraid that if the balance sheet begins to naturally decline, the markets will interpret this as additional tightening. But once again, by delaying step 3, the Fed introduces incremental uncertainty. The markets and the media will be buzzing with "when does the reinvestment policy end?" question. The reality is that this delay will have a minimal impact on the trajectory of the massive balances at the central bank.

Here is a situation in which the policy itself will have no material impact on anything except that it introduces more uncertainty - something the US economy doesn't need. The Fed should just finish the QE program, stop buying any more securities, and focus on normalizing rates. Staging this process is a bit like ripping off the bandaid slowly rather than getting it over with, particularly when the bandaid is no longer of much use.
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