The Great Unwind

The Federal Reserve faces a difficult path in ending the days of ultra-loose monetary policy. The markets, and indeed the international economy, hold their breath as the world’s foremost central bank decides its next move.

The Federal Reserve appears set on reducing its $4.5 trillion balance sheet this September. This number represents the total amount of money the Federal Reserve has injected into the economy by purchasing various financial assets. In normal times, the Fed’s balance sheet is significantly smaller and contains mostly short-term securities (e.g. two-year Treasury bonds) which influence short-term interest rates. Yet, in the wake of the 2008 crisis, then Fed governor Ben Bernanke embarked on an enormous programme of Quantitative Easing (QE), which involves intentionally purchasing longer term securities, primarily long term government bonds, in order to hold down long term interest rates and reflate the economy. The case for a gradual reduction in QE appears strong – though, as this article will detail, the path is fraught with tensions and conflicts which render the Fed’s job far from easy.

Along with continually raising its benchmark Federal Funds Rate, winding down its balance sheet will signal the beginning of the end for ultra-loose monetary policy in America, and very possibly the world. To understand however, why the Fed is proceeding so cautiously, we must observe its expanded post-2008 mandate. The bank still has its original role of keeping inflation at 2% and unemployment low, yet since the Financial Crisis it has been given significant new powers to regulate banks and curb financial excess. At the moment, these dual mandates are in conflict with one another. With reference to its first role, inflation in America is around 1.5% and unemployment is just over 4%. Such low unemployment indicates limited slack in the economy, but muted inflation and wage growth would seem to suggest otherwise. In this respect, only a very slow reduction in monetary stimulus appears prudent. To complicate matters however, many signs point to over-exuberance in financial markets. The enormous amounts of money pumped into the economy seem to have inflated asset prices and encouraged riskier practices. A basket of junk corporate debt yields just over 6% in America – which is remarkably low for a supposedly risky asset class. Furthermore, hedge funds have recently doubled their exposure to infamous Credit Default Swaps – an asset class which proved pivotal in bringing down the financial sector in 2008.

Thus we see the difficulty – on the one hand, the Fed will be reluctant to scale down its stimulus if the economy softens, yet on the other, it will be anxious to limit QE induced asset price bubbles. For the moment, the bank seems content to use regulation to limit financial excess but if the signs of a bubble persist, that may not be sufficient. Bear in mind the sheer volume of support the Fed has provided to the markets – it has pumped literally trillions into government bonds, expanding banks’ balance sheets and allowing them to plough into other asset classes. This has a knock-on effect of raising asset prices across the board.

There is a further, less cited reason for why continued stimulus may be unhealthy. The OECD recently published a paper titled ‘The Walking Dead? Zombie firms and productivity performance in OECD countries’. The writers look at Europe, North America and Japan to analyse the effect loose monetary policy has had on credit allocation and productivity. The results are striking. They find plausible evidence to suggest that so-called ‘zombie-firms’ – those over 10 years old with high levels of debt and interest payments – have depressed aggregate productivity significantly since 2008. Zombie firms depress productivity because they attract capital and labour that would be significantly better used by younger, more innovative firms. One of the reasons that these firms have been able to survive, the argument goes, is that central banks’ easy money policies have allowed them to service their debts at artificially cheap levels. This has distorted the capital reallocation process – normally, such firms would collapse, allowing labour and credit to flow to more productive firms. The paper thus concludes that QE, among other government policies, may have a hand in the West’s depressed productivity growth since 2008 and seeming lack of creative destruction.

With the OECD’s research we see another tension arise. Whilst QE may be necessary for short-run demand maintenance, the long run effects on capital allocation and productivity may be significant. However, given the country’s economic fragility, anything but a gradual reduction in stimulus would be unwise – large scale liquidity withdrawal could very well provoke a market crash and deflation. This would undoubtedly harm investment and innovation for a sustained period, thus hurting productivity as well.

It is still unclear whether Trump will replace Janet Yellen this year. Given the sheer scale of the job she faces, and the immense policy conflicts surely coming down the pipeline, a part of her may be relieved if he does.