PRESENTER: With a focus on central bank monetary policy, I’m joined by Leila Butt, Senior Economist for Prudential Portfolio Management Group. So Leila it’s good to have you with us today.
LEILA BUTT: It’s lovely to be here, thank you for inviting me.
PRESENTER: Let’s start with the effects of QE, what have we been seeing?
LEILA BUTT: So immediately when the global financial crisis struck, the Fed pretty much implemented a very aggressive monetary policy which included quantitative easing, or QE, and it basically swelled its balance sheet from about $1trn to about $4.5trn at its peak. So that was roughly about 26% of GDP. That represented about a 20% point expansion from pre-crisis levels. Now I think what’s probably unequivocal is that QE lowered borrowing costs and the term premium, which was of benefit to governments because it lowered their borrowing costs, and it was also of benefit to consumers because of the positive wealth effects.
What is less obvious is the impact of QE on the real economy or real GDP growth. Firstly because it’s very difficult to posset what would have happened to the global economy had there been no QE and the second is that the effects of QE are very difficult to disentangle from other factors that were affecting the global economy. But the unequivocal effect was this rise in asset prices and also the positive effects on fiscal balances for governments.
PRESENTER: So talk me through the mechanic then of quantitative tightening.
LEILA BUTT: So the Fed announced around May of last year or formally announced that it was going to begin to unwind quantitative easing and start to shrink its balance sheet. That process started formally in October of 2017 when the Fed shrank its balance sheet by about $30bn in the fourth quarter. That pace accelerated slightly, this quarter, so it’s up to $60bn, and it’s expected to increase incrementally until the Fed is tapering by a total of $150bn per quarter. That process starts in the fourth quarter of this year. That pace is expected to be maintained until the Fed thinks that the balance sheet is at a good level for maintaining an effective monetary policy.
Now the Fed hasn’t told us what that level is but we can take an educated guess. We don’t think that the balance sheet is going to shrink back to those pre-crisis levels of about $1trn. The main reason for that is that as an economy grows then the demand for cash and credit grows and that results in the Fed’s balance sheet continually increasing. So at the moment the cash sitting on the Fed’s balance sheet amounts to about $1.5trn, and with the economy expected to grow, that amount is going to increase in the future. So even two or three years out, you would expect the Fed balance sheet to be at least $2trn.
PRESENTER: Well what could be the possible implications of this tightening?
LEILA BUTT: So there’s several implications for the tightening. The first is quantitative easing is estimated to have shaved off about 100 basis points off the term premium for US 10-year treasuries. So if you take it at face value you might say well a reversal of QE should lead to the same cumulative increase in the term premium on 10-year treasuries. Now we don’t think that’s going to be the case, we think it’s going to be less than that, and there’s several reasons. The first is that, as I’ve said before, the size of the Fed’s balance sheet is going to be much bigger than it was pre-crisis, so the amount of reserves it created on its balance sheet are not going to be fully unwound.
So that’s going to exert some dampening pressure on the term premium. The second I think is, and this is quite important is that with interest rates still very low, it’s probably likely that once we go into the next recession the Fed is going to have to implement another round of quantitative easing, and that expectation will probably also act to dampen that rise in the term premium. And thirdly at the moment we’ve got two major central banks, the ECB and the Bank of Japan which are still in easing mode, less aggressively than in the past but they still are easing, and that policy is exported in effect to US treasuries, also dampening the US 10-year term premium. So we don’t expect that full cumulative 100 basis point rise as QE reverses as is estimated to have happened while QE was being undertaken.
PRESENTER: And the risks, what are we facing?
LEILA BUTT: So our baseline basically is that the Fed is going to be very careful in communicating its policies going forward. I mean it’s been doing that for several years now. It really learned I think from the 2013 taper tantrum. So it’s been very careful about how it calibrates and communicates its policies since then. So we expect that to continue and that should ensure that the reversal should be carried on in a very smooth way. The other thing that’s been of benefit has said global growth has been quite strong and quite synchronised, and that’s also generally lowering or keeping volatility contained. But there are risks out there.
Inflation has been relatively subdued in the advanced economies. A sudden unexpected spurt would mean that current Fed policy is likely to be too benign or perceived to be too benign to control that spurt in inflation. And it could cause an aggressive repricing in markets, so a lot of volatility potentially there. Another factor is even central banks don’t quite know how QE worked, and therefore we don’t quite know what the effects really are going to be as it’s unwound. So there is a sort of uncertainty across market participants about how this process could unfold and that may cause jitters. And then lastly we still have quite a lot of expected turnover at the Fed, and were that to lead to a change in policy, direction or communication, then that might cause market jitters as well.
PRESENTER: And when will other central banks follow suit?
LEILA BUTT: Not in the short term. So the BOJ is expected to continue to ease; albeit at a sort of slower pace. The ECB we expect to continue to purchase assets until the end of the year and then to stop its net purchases in December of this year. But we do not expect any reversal of QE in the Eurozone until interest rates start to rise and really well after interest rates start to rise. And we don’t expect the ECB to raise its policy rate until at least the middle of 2019. And for its part the Bank of England is likely also to stand pat for the time being. Central banks have really communicated that they want interest rates to be at a certain level before they start reversing QE. This is very much what the Fed did. It waited until it felt that interest rates were at a comfortable level before beginning to reverse. That pattern is likely to be followed by the other major central banks as well.
PRESENTER: So advanced economy central bank policy moving forwards, what’s your overall assessment?
LEILA BUTT: Well in terms of net asset purchases, the big four, so the Fed, the ECB, the BOJ and the BOE combined, are likely, those net asset purchases on the part of these four big central banks are likely to basically fall to zero by the end of this year, and then there will likely be an overall tightening stance from 2019. But that rise in interest rates or this normalisation of policy is likely to be extremely slow. In the Eurozone, for example, the ECB will want to make sure that growth is sustainable and inflation is also sustainable before it begins to tighten. The BOE is very unlikely to embark on a conventional monetary policy tightening cycle. Because of this trade-off it’s facing between the supply and the demand side of the economy, so we expect one rate hike in May of this year and another one next year, but really not a conventional tightening path for the BOE.
PRESENTER: Leila, thank you.
LEILA BUTT: Thank you very much.