Quantitative Easing 3 has ended and a slight hawkish tone

Posted: October 30, 2014 in Uncategorized

QE has ended. The document was not as dovish as expected pointing at Labour market on track to achieve its. So hint at rates lower for longer.

The biggest change in the Fed statement is that the reference to significant underutilization in the labor market “has been downgraded,”.

It is interesting to note that the market recovered when Fed’s Bullard hinted to the fact that QE could end December not October. This did not happen and everyone is wary.

Also another wariness to take into account: does this means that the Fed ends also the Open Market Operations?

Risky times and currency movements.  As we digest the news it will take a bit of time to “filtrate the market. Potentially also because tomorrow the release of the US GDP will positive. So next week the real effects.

Funny enough, at the same time Alan Greenspan, one of the longest serving Fed Chairmans, was being interviewed. Notably he said that he thinks  it is not possible for FED to end its easing monetary policy trouble free.

Some research from UBS

The Fed will meet this week and determine the future of QE, UBS has analysed the likely rate policy globally and its implications for markets.

UBS believe that this focus on QE misses the point of modern central bank policy. In the post crisis world, central bank policy rests on three pillars: quantitative policy; regulatory policy; and interest rates (or monetary policy). Action in any one of these areas can constitute a tightening. Modern central bank policy has therefore become more sophisticated than it was under a straightforward interest rate regime. The macroeconomic conclusions of central bank policy being tightened may be the same whichever pillar is used, but the combination of policy options will make a difference to markets and to microeconomics.

UBS have found that judging the stimulus provided by quantitative policy is difficult, because the degree of stimulus depends not just on the supply of money from the central bank but also on the degree of liquidity preference that exists in the economy. The central bank balance sheet to GDP ratio is one proxy for the degree of central bank accommodation via quantitative policy – albeit a far from perfect proxy. This is because there is an assumption that the demand for liquidity in some way relates to the level of economic activity that is taking place.

On this measure the Bank of England is clearly tightening, and has been doing so since the end of the first quarter of 2013. The Federal Reserve’s balance sheet has essentially levelled as a share of GDP and should now start to decline (regardless of what the Federal Reserve undertakes to do this week, as the growth of nominal GDP should exceed the growth of the balance sheet). UBS therefore have a consistent tightening of Anglo-Saxon quantitative policy.

The Bank of Japan is at the other end of the spectrum, happily churning out money with little intention of scaling back the escalation of its balance sheet. Indeed, the balance of probability has to be that there is pressure to increase the speed with which quantitative policy is undertaken. Japan’s example provides a good illustration of the limits of the balance sheet to GDP ratio as an indicator of central bank accommodation, however, for a case can be made that liquidity preference has risen to absorb the additional provision of liquidity, in part or in whole.

The ECB’s quantitative policy is perhaps the most interesting, and the banking sector in the Euro area has clearly eschewed the liquidity that the ECB was offering in over the past couple of years. As a result the ECB’s balance sheet has fallen relative to the size of the economy. If this is a function of a weakening of liquidity preference, then the reduction in quantitative policy does not have to be perceived as a tightening of central bank policy in and of itself. However, the position of the ECB has clearly changed, with the intention to restore the nominal Euro level of the central bank balance sheet to its former heights, implying an expansion of roughly EUR1tn. The somewhat larger than expected asset backed purchases announced during the week reinforce the idea of quantitative (liquidity) policy accommodation. It is worth noting, however, that the quantitative policy to GDP ratio will not be completely restored to the dizzying heights of 2012, as nominal GDP is now slightly higher in the Euro area than it was at that point (and the intention is to restore the nominal Euro level of the ECB balance sheet, and not the balance sheet:GDP ratio).

The fact that central bank policy has more facets than interest rates alone clearly does not mean that monetary policy is irrelevant. Depending on the debt structure of an economy monetary policy can be extremely important as a means of controlling debtor’s income (for instance, where there is a floating mortgage interest rate structure). Interest rates will continue to represent the main means by which a central bank can affect the transfer of income between debtors and borrowers – though not the only means, as the section on regulation indicates.

The US Federal Reserve, the Bank of England and the Reserve Bank of Australia are all forecast to raise interest rates over the course of 2015. The Reserve Bank of New Zealand, indeed, has already raised rates. These rate changes will have a bearing on economic activity, and can be seen in the context of managing increases in the velocity of circulation of money and the history of quantitative policy. However, the tendency of markets to obsess on short term interest rates may, at least in the domestic context, be somewhat misguided given the range of policy options that central banks have at their disposal. It may not be possible to arbitrarily determine the terminal rate of Fed Funds or the UK base rate this cycle, for instance, unless one has some idea of how the Federal Reserve or Bank of England intends to approach regulatory and quantitative policy as well. A change in financial regulation could mitigate the need to raise policy interest rates, or indeed could mitigate the need to reduce the central bank balance sheet in absolute or relative terms.

UBS conclude that tightening central bank policy can, through varying the emphasis on the three pillars identified, target new or existing borrowers, short term or long term interest rates, the volume or the price of credit created. This offers a wider scope than just manipulating the short term cost of capital and attempting verbal intervention at the longer end of the yield curve. The combination of policies will produce generally common macroeconomic consequences in that they will accelerate or decelerate growth, and through adjusting aggregate demand will impact the prospects for inflation. Which micro parts of the economy are impacted by policy will vary according to the combination in which the policies are used. Central bank policy can no longer be reduced to a single line on a chart or a single forecast of policy rates. This means that investors need to think in more complex terms about central banks, and be prepared to live in more interesting times


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