Tag Archives: QE

Good Job, Fed

As I’m sure you’ve all heard, the Fed has decided to cut back on its monthly bond purchases. In the committee’s first unanimous decision since 2011, it has decided to scale down to $65 billion in Treasury and mortgage-backed securities holdings, from $75 billion in January and $85 billion every month last year. It also stated that it is likely to continue cutting down, so we are likely to see the same kind of cut-back in March (likely by another $10 billion). It also confirmed that it intends to hold benchmark short-term interest rates around zero, even after unemployment is below 6.5% (it was 6.7% in December). Many criticize the Fed’s decision, and point to the reaction of the stock market. However, being such a new strategy (or at least to this scale) put into place, the Fed has reason to be cautious.

Its decision is justified briefly in the press release:

“Taking into account the extent of federal fiscal retrenchment since the inception of its current asset purchase program, the Committee continues to see the improvement in economic activity and labor market conditions over that period as consistent with growing underlying strength in the broader economy. In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions, the Committee decided to make a further measured reduction in the pace of its asset purchases.”

In terms of continued stimulus, it states:

“The Committee’s sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee’s dual mandate.”

There seems to be much positivity in their statement, stating that growth picked up in recent quarters. The president of the Federal Reserve Bank of Dallas, Richard Fisher, says he noticed “a better mood than ever” after speaking with business executives, who also claim the fourth quarter was fairly good – better than people expected. There seems to be a positive outlook on recent growth, as well as future growth. On Thursday we will know exactly what that growth looked like, when the fourth quarter reports are released.

As for the stock market: yes, stocks sank in reaction to the news. Yahoo! Inc. fell by 8.7% (the most since July 2009), while Boeing Co. dropped 5.3% (its worst drop in over two years). The Standard & Poor 500 Index lost 1% and the Dow Jones Industrial Average fell by 1.2%. However, the Fed has real reasons to cut back. Should it continue to stimulate the economy at this scale for too long, the consequences of its asset-buying program may result in an asset-market bubble. Destabilizing financial markets in this way could have devastating results.

I agree that they are taking the cautious route, but rightly so. Should the Fed get over-confident about its stimulus-capabilities, the US (and the world) would be in bigger trouble. Quantitative easing hasn’t exactly been around for as long as we’ve had economic models – not at all. And although the strategy isn’t new, it is certainly the first time the Fed has applied it at such a large scale. This being so, I think the Fed has done an excellent job as it is and we will be glad not to see the possible consequences of over-confidence (effects which we may not even be aware of now).




The Fed’s Decision and Reactions from Emerging Markets

To provide a summary of the Fed’s “taper” (the winding down of the greatest financial intervention in history), the Fed decided to stick with its plan and reduce bond purchases to $65 billion. Over the past 5 years, the Fed has purchased more than $3 trillion in bonds to help pull the nation to a state of growth after the financial crisis of 2008. The latest controversy has been whether or not buying bonds with money “conjured from thin air” has either helped the economy or fueled new bubbles.

In December, the Fed announced that it would continue with quantitative easing but decrease monthly purchases. This program was started by Bernanke. As Bernanke leaves, Janet Yellen will now be in charge of managing the taper. This taper was thought of to be only “modest” as near-zero interest rates will continue, but nonetheless there is anxiety of how global markets will react to the Fed’s decisions. I will comment on this in more detail later in the post- but for now- currencies and stock markets in emerging markets have fallen significantly as investors anticipated the rise in U.S. interest rates.

“The idea behind quantitative easing is that you don’t need a printing press to add money to an ailing economy”. With that, the Fed’s usual goal is to push down interest rates that banks charge each other, thus allowing banks to offer cheaper loans to businesses (as Professor Kimball mentioned today in class). Accordingly, the Fed started buying bonds to drive down long-term rates after the financial crisis- which is how the rate was pushed to near-zero. Since September 2012, the Fed has been purchasing $85 B a month in treasuries and mortgage-backed securities. Since the first quantitative (QE) easing purchase, there have been worries concerning inflation and the effectiveness of QE. In regard to effectiveness, some economists view the tapering to have only a modest effect- through lower mortgage rates. Janet Yellen commented that “the pain for savers from low interest rates was more than offset by the help the policy has given to the labor market and the economy as a whole”.

In regards to how the Fed’s decision has effected emerging markets, many currencies have fallen steeply. South Africa’s central bank raised its key interest rate by 50 basis points, Turkey and India raised their rates, and it looks as though investors don’t care if local rates are going up- they just want out of emerging markets. Is it the Fed’s fault? Indirectly. It was cited that in “in spring 2011, it is likely rising grain prices played a role in social unrest”. Also, the Fed’s buying at the time accelerated the impact of poor harvests world-wide. Although we weren’t responsible for years of political repression, the Fed has the power to pose as a threat to global economy. If we were to see a repeat of Russia’s default in ’98, the Fed would have to clean up that mess.


The Fed in Stock and Bond Markets

World is carefully watching this week the FOMC. According to the Wall street Journal, tapering QE  is expected. It is always exciting to see how financial markets react to the Fed decisions. Today I want to talk more about my thoughts on QE.

In my last blog, I talked about my thoughts on the meaning of the QE in terms of the financial markets malfunctioning. I think that malfunctioning of financial markets caused the monetary policy channel not to work properly, and this is the one of the reasons that induces the Fed to move into its balance sheet monetary policy, directly participating in long term bonds buying program. In that sense, in my opinion, if the Fed had directly participated in stock and bond markets, then economy would have recovered earlier. Big credit events like the collapse of the Lehman Brothers greatly increased the counterparty risk in the financial transactions, and money does not flow properly in the financial markets. Financial institutions worried about creditworthiness of counterparts of financial transaction. This time complex financial techniques like asset securitizations makes financial institutions harder to estimate credit risk of counter party. And this greatly reduced money supply to credit markets like stocks and corporate bonds. In this financial markets situation, money stayed in the safe markets. Even though the Fed provided excess money in the markets, and money might not flow
to credit risk markets properly. So, if the Fed directly had bought stocks and corporate bonds, financial markets could have recovered earlier from its credit risk.

I also think about some of the risks related to the Fed’s participating in those credit risk markets. I think there are may be three major concerns. First concern is about causing inflation, but this concern is not a big deal in this economic situation of lower than natural outputs as Professor Miles explained in his blog. The other concerns are increase of credit risks in the Fed balance sheet and moral hazard problems in the financial markets.

In regard to increase of credit risks, if the Fed buys credit risk bearing assets like stocks and corporate bonds, credit risks increase in the Fed balance sheet. But, I cannot think of any big trouble which can be caused by increase of credit risks in the Fed. Even though corporate bonds or stocks that the Fed buys go bankrupt, it does not have any serious impact on the Fed ability to conduct monetary policy. That’s because the Fed ability to conduct monetary policy comes from its authority to provide money and the Fed does not rely on any other financial sources to conduct monetary policy. So the loss in the Fed balance sheet does not any substantial effects on its operations.

Another problem is increase of moral hazard in the financial markets. As the Fed is ready to rescue the plummeting financial markets, then financial institutions are more likely to bear more credit risks and to take aggressive investment behaviors which might cause financial crisis. But I think that this moral hazard problem is indispensable when dealing with financial crisis. Without taking the risk of increase of moral hazard, the Fed cannot revive financial markets. And the way to minimize the related moral hazard is another policy task to deal with. I think one way to reduce the moral hazard is that when the Fed participates in the stock and corporate bond markets, the Fed can buy markets index products which cover various stocks or bonds.

Author: Dimitry Slavin

With a burgeoning American stock market and the Fed’s announcement to start cutting back its bond-purchasing program, the field was set for bond prices to drop in the beginning of 2014. It seemed likely that investors, seeking higher returns, would shift their investments from bonds to equities. As a recent article in The Economist points out, however, this is not the case so far this year. Bond markets are actually doing surprisingly well.

Instead of rising since the end of 2013, yields on benchmark ten-year bonds, which are inversely related to prices, have fallen in America and Europe [see below]. Yields on US Treasuries have slipped from 3.01% to 2.88%; on British gilts from 3.03% to 2.86%; and on German bunds from 1.94% to 1.83%.

Comparison of Ten-Year Government-Bond Yields for Various Countries

Comparison of Ten-Year Government-Bond Yields for Various Countries

So far the story is pretty straightforward: yields on bonds are falling, causing bond prices to increase. Before we go any further I want to pause and ask a couple of questions in order to focus our analysis. (1) Why are bond prices and interest rates inversely related? (2) How are inflation, bond prices, and interest rates related? (3) Given we understand the answers to the previous two questions, why are bond prices rising in the wake of an apparent economic recovery? Shouldn’t demand for bonds fall as investors shift their money to the stock market?

(1) Why are bond prices and interest rates inversely related?

We answered this question in class today, but for the sake of clarity and my own learning I’ll summarize it again here. Purchasing a bond allows you to receive a stream of future cash payments from the borrower in the form interest payments (aka coupon payments) and the eventual repayment of the principal when the bond matures. Ignoring inflation expectations and credit risk, the bond price is calculated by summing the present value of each of these coupon payments plus the present value of the bond at maturity. To find the present value of each of these payments, their future value is discounted (aka divided) by the yield (aka the interest rate of the bond). Thus it is clear why a bond’s price and its corresponding interest rate are inversely related: as the interest rate rises, each coupon payment is discounted (aka divided) by a larger amount, causing the total bond price to decrease.

(2) How are inflation, interest rates, and bond prices related?

This is an important question that I don’t think we covered as much in class. I’m sure most people taking this class know the answer already, but it’s nice to get a quick refresher. Simply put, bonds hate inflation. High inflation and high-expected inflation cause future coupon payments to lose value. As a consequence, lenders demand higher yields (aka interest rates rise) and the price of the bond falls. This explanation, however, is a bit too simple. Inflation expectations affect short-term and long-term interest rates differently, so bonds with different terms to maturity will be affected differently. These effects are summarized quite nicely in a concept/graphic called the yield curve.

(3) Why are bond prices rising in the wake of an apparent economic recovery?

This question doesn’t have as much of a straightforward answer as the other two, but the main two reasons I’d like to discuss are low inflation expectations and poor job figures. As I’ve discussed in previous blog posts, inflation rates across the developed economies have remained low and show no signs of rapid growth:

In America the price index targeted by the Fed (which aims at 2% inflation) has been rising by less than 1%. In Britain consumer-price figures published on January 14th showed inflation hitting the Bank of England’s 2% target, after four years above it. The fillip to bond markets from low inflation is stronger still in the euro zone, where consumer prices rose by just 0.8% in the year to December and core inflation (stripping out volatile items like energy and food) fell to a record low of 0.7%.

These low inflation figures cause long-term interest rates to fall, which, in turn, cause bond prices to rise.

Another reason is the underwhelming jobs figures that were released on January 10th:

Economists had expected employers to add around 200,000 jobs in December; the actual number was a lowly 74,000.

Poor jobs figures may be a sign that the economic recovery is not as strong as investors thought, causing some investors to hesitate in investing in the stock market and buy up bonds instead.

The poor job figures should be especially troubling to the Fed because they may mean that it is too soon to cut back QE. The U.S. economy may not be out of the darkness of recession quite yet. Although arguments have been made that poor weather conditions played a role in the disappointing jobs figures, it is tough to believe that weather had enough to effect to more than halve expected figures.

Global Impacts of Fed’s Jan 29th, 2014 meeting

As I read more financial and economic news lately, I sense that the Fed’s announcements are the world most and influential indicator in finance and economic. Not that I understand clearly, yet it seems what Fed is doing have both direct and indirect effects on moving the world economy forward. As most people have anticipated already, Fed will likely to cut back their bond buying program. Instead of buying $85 billion dollars’ worth of bonds per month, they will buy $75 billion dollars’ worth of bonds per month. Many news reports about Fed’s policy (Quantitative Easing) have intrigued more when I read a WSJ article, Emerging Markets Will Be an Attractive Buy-Later This Year, this morning.

“Emerging markets were supported by the Federal Reserve’s policies,” said Mr. Sri-Kumar. “Now investors are looking to back away from risks, so money is leaving these emerging markets for more developed ones.”

I have thought about why Mr. Sri-Kumar said about emerging market on the above can be a valid statement. By the way, Sri-Kumar has recently resigned from a chief global strategist at TCW. TCW is one of biggest investment management companies operate in the United States. In this, I will give it a shot explaining my interpretation of his words, yet I must warn that readers need to aware of that my assumptions and arguments are not based on years and years of research.

I think the reason why Emerging markets flourished up to September 2013 is partially due to the fact QE made the United States less attractive places to invest for investors. Thus, investors had moved their money and invested in emerging market where they could expect to earn high rate returns on capital assets. According to an article in Economist and graphs provided by World Bank can support my understanding. It shows that capital inflow to those emerging countries has been rise since the beginning of the QE. High inflow of capital brought depreciation in Emerging market’s currency values and they took advantage of their exchange rate against the United States. This advantage accumulated trade surplus on their balance sheets. However, as we now hear and anticipate Fed will cut their buying bonds program based on Fed’s positive outlook on U.S economy. It seems that Investors have pulled out their money from the emerging markets especially where there is more risk on economic volatility. Investors’ expectation has already been reflected in the Emerging markets as most of their currency now appreciated it. Countries like Mexico, Brazil, and India have relatively stronger economy and less economic volatility than South Africa, Malaysia, Indonesia, Turkey and Chile. Countries like Indonesia and Turkey now have their own economic problems, struggling with high unemployment rate, and inflation. If their currency appreciates which make harder for them to export will cause more damage to their economy.

This is one of the evidences that I have found that Emerging countries were benefited from the QE. News about cutting down QE has already pushed up currency values of fundamentally weak economic countries. For example, investors have pulled out of their money in countries like Indonesia, and Turkey and invested in India, and Brazil. Because people believed that those countries had been benefited from QE, now without QE, investors also have lost interests in them. Sometimes, what people believe is all that matters in the world.

United States has the world largest economy. Is this mean that Fed has greater responsibilities beyond their control over the U.S economy? Not necessary. However, there are millions and millions of people who suffer because of the small changes in Fed monetary policies. Of course, sometimes the same people who suffered previously get free rides because of the Fed.



Financial market functioning and QE

Professor Miles explained in Balance Sheet Monetary Policy that as the Fed lowered the federal funds rate to almost zero, the interest rates of short term treasure bills also decreased to almost zero. This zero lower bound on nominal interests led the Fed to search for other way to stimulate the U.S. economy, buying long term assets.

The meaning of the QE can also be thought in terms of functioning of financial markets and monetary policy channel. As we know, current monetary policy mechanism heavily depends on well-functioning of financial markets. For example, the interest rate channel mainly works through interactions between the short term interest rates and the long term interest rates. If the Fed changes the federal funds rate, then the short term interests and long term interest rates change, and eventually its effects reach economic activity.

If the financial markets function normally, I guess that lowering the short term interest rates may be enough to stimulate the economy. In normal financial functioning, financial institutions will borrow short term money and invest them in long term assets such as corporate bonds. Through these financial activities, financial institutions can get revenues. Because term structure of interest rates normally show upward slope, this revenues include the difference of interest rates between long term and short term interest rates and capital gains resulting from decrease of interest rates along the term structure. This will lead to decrease of financing costs of companies and eventually increase investments of companies.

But this time financial markets stopped functioning normally because financial institutions suffered from heavy loss, and credibility of long term assets got severely damaged. These financial markets situations might cause monetary channel not to work properly. Therefore, malfunctioning of monetary policy channel caused by the extremely strained financial markets conditions can be regarded as one of the reasons that make the Fed enter into this new monetary policy territory.

Assuming that risky assets such as stocks and corporate bonds are more vulnerable to economic shocks, economy would have been recovered much earlier if the Fed had bought long term private assets like stocks and corporate bonds. In that sense, the Fed’s decision to buy MBS seems to be very sound in terms of stimulating economy. However, treasury bills, which are regarded as a risk free assets and actually do not need much assistance from the Fed in times of recession, seem to have received most of the benefit from the Fed asset buying programs. Participating of the Fed in stocks and corporate bonds markets may cause other concerns such as moral hazard of those markets and loss of the Fed resulting from the bankruptcy of companies.

As the Wall Street Journal reported, recently emerging markets currencies are weakening partly due to the expectation of beginning of normalization of the Fed monetary policy. The Fed may need to think about directly involving in stocks and corporate bonds markets in preparation of future shocks.

QE: a plus for financial stability?

The Federal Reserve is expected to further taper its bond purchase program, also known as the quantitative easing (QE), by $10 billion on its next meeting on Jan 29, despite of the weaker-than-forecast December jobs report.

The QE is one of the two key strategies that the fed has been adopting to boost economy, while the other one is record-low (nearly zero) federal funds rate. Specifically, through the purchase of longer-term bonds and mortgage-backed securities, the fed aimed to drive down long-term interest rate and stimulate spending, hiring, and investment. Furthermore, as Mr. Bernanke claimed in 2010 at the Kansas City Fed’s Jackson Hole conference:

  “I believe that additional purchases of longer-term securities, should the FOMC choose to undertake them, would be effective in further easing financial conditions.”

Certainly, the unconventional monetary policy has been playing an important role on economic recovery from the financial crisis in 2008, as it injected sufficient (or excessive) liquiditiy to the capital markets and boosted the U.S. equity indexes to record-high in late 2013. However, is it really a magic with no negative effects on financial stability? That is debatable.

First, the market volatility was driven up due to QE’s data dependent nature. Data-dependency meant that the fed would not start taper its bond purchase program unless there was significant evidence in the improvements of economic conditions. Therefore, a piece of good economic news, such as stronger GDP growth or lower unemployment, might be a piece of bad news for the market since it would signal the start of tapering and less liquidity. To make matter worse, to what extent was the economy strong enough for tapering? The fed had its own standards, which might be deviated from market expectations. In late September last year, when almost everyone forecasted the kick-off of tapering, the fed surprised the market by choosing not to taper, after which the fed’s credibility was in doubt and the pace of tapering was even more puzzling.

Second, the fed’s balance sheet is just about five times its precrisis size — a whopping $4 trillion, because of the continuous purchase. Even Mr. Bernanke himself had to concede that “it’s also true that, as the balance sheet of the Federal Reserve gets large, managing that balance sheet, exiting from that balance sheet become more difficult.

Third, given the fact that the QE has a global impact in terms of capital flow, the fed’s exit strategy has been important to the welfare of foreign countries. The market fear created by the uncertainties also negatively impacted the financial stability of others, especially those developing countries.



Does the Fed really need to pour money to lower the interest rate?

Professor Miles strongly expressed his support for Quantitative Easing policy of the Fed in his blog post, Balance Sheet Monetary Policy. These views are shared among many economists and especially the Fed officials. This week, Federal Reserve Bank of Chicago President Charles Evans said  “After four years of weak and inadequate growth with low inflation, we need extraordinary monetary accommodation to finish the task at hand.”

Whatever the pros and cons of the Fed policy, I am happy to witness that the Fed uncharted path of Quantitative Easing seems to be successful in stimulating the U.S. economy as its policy purpose intended. The U.S. economy has shown quite strong economic recovery last year. Especially employment conditions seem to improve substantially with unemployment rate approaching the Fed threshold to consider change of monetary policy stance.

I want to point out a few things while reading professor Miles blog posts. Those are not critical issues, but I think it will surely be beneficial to understand how the monetary policy and financial markets work.

One common myth is that the Fed lowers the interest rate by providing more money in the markets. Does really the Fed need to put more money in the market to lower the interest rate, specifically its target federal funds rate? Realty is that in principle, if market is efficient, then the Fed does not need to actually pour money in the market in order to lower the interest rate. Suppose that the FOMC decide to raise interest rate and announce its policy stance to the markets, the federal funds rate immediately adjusts to the level of the FOMC decision even without any single penny of extra money added to the markets.

Why? Everyone in the market knows that if the federal funds rate is not adjusted as the FOMC directed, then the Fed would show its formidable fire power to suppress any resistance in the markets. And everyone knows that they cannot win the FED in this battle. This result of the battle comes from the fact that the FED is the only provider of legal tender, the mighty U.S. dollar. Actually, in order to manipulate the federal funds rate, the Fed does not have to spend any more than business as usual, which is technically the amount of money to equate the demand and supply of reserve requirement in the banking system. However, the Fed could show its strong determination by providing more money than federal funds markets need. There are some more things that I want to share with you. The next time I want to talk about printing money.