The Federal Reserve will start to shutter its pandemic-era bond-buying program later this year, leaving the US central bank with a balance sheet of more than $8.5 trillion before the purchases end in mid-2022 and a likely debate coming about what to do different next time.
The quick answer may be nothing: By roughly doubling the size of its securities holdings since the start of the pandemic in early 2020, the Fed helped stabilize financial markets, used its ongoing purchases to signal it would battle the economic crisis for as long as necessary, and has now planned its wind-down with no market “tantrum.”
Fed Chair Jerome Powell, speaking to reporters on Wednesday after the end of a two-day policy meeting, said the central bank would start paring its $120 billion in monthly asset purchases “soon” and end them by the middle of next year.
“It served its purpose,” said Tom Garretson, senior portfolio strategist at RBC Wealth Management.
The bigger issue, Garretson and others noted, is that beyond the initial impact on financial markets, it’s not certain the Fed’s bond-buying, or “quantitative easing” as it’s known in monetary policy circles, would have been enough to offset last year’s deep, if short, recession without the massive government spending that was authorized by Congress.
The takeaway? Monetary policy run by the Fed and fiscal programs implemented by elected officials will need to pull together in future recessions as well.
“The dominant lesson ... is that the tools of the Federal Reserve and other central banks are substantially inadequate for dealing with a material weakening of economic activity, and fiscal policymakers need to recognize that,” said David Wilcox, former head of the Fed’s research division and now a senior fellow at the Peterson Institute for International Economics.
Both the Fed’s crisis response and some of the fiscal aid out of Washington are now set to shrink, which could act as a drag on an economy still emerging from the pandemic, with growth expected to slow in 2022 after a healthy rebound this year.
But those programs did produce some unexpectedly fortunate results, notably an increase in household incomes and wealth and a drop in poverty despite the recession.
For the Fed, the pandemic cemented its once “unconventional” purchases of US Treasury bonds and mortgage-backed securities as a core part of monetary policy, the preferred way to continue helping the economy once the central bank’s benchmark overnight interest rate, or federal funds rate, has been cut to zero.
Other programs broadened, temporarily, the type of securities the Fed could buy to include municipal and corporate bonds.
At a congressional hearing on Thursday, Roosevelt Institute economist Mike Konczal said that should be a permanent part of Fed policy.
Those efforts “were more successful than people realize,” in holding down borrowing costs for local governments and companies, Konczal said, and are “an evolution of unconventional monetary policy ... that is likely to stay with us.”
Other central banks have already broadened the assets they can purchase beyond securities issued and backed by governments.
The scale and length of Fed purchases during the pandemic did vex some elected officials, while some policymakers felt the program was providing little benefit in recent months.
That may argue for more flexibility during the next crisis around how and when to end the asset purchases.
The Fed’s pandemic-driven QE was tied tightly to the performance of the job market. With the labor market healing more slowly than the economy as a whole, and inflation now a concern, “they needed an escape hatch,” said William English, a Yale School of Management professor and former head of the Fed’s monetary affairs division.
QE entered the lexicon of US monetary policy in 2009 as part of then-Fed Chair Ben Bernanke’s response to the 2007-2009 financial crisis and recession.
The Fed, unlike the European Central Bank, has not wanted to resort to using negative interest rates to stimulate the economy, so once the “zero lower bound” of the federal funds rate is reached it uses bond purchases to further lower the cost of credit. That encourages purchases of homes, autos and other items that involve longer-term loans, and can raise asset prices and contribute to wealth-effect spending, too.
Just how effective it is, and what risks it may pose, remains a subject of debate.
Fed staff and policymakers on their own have published nearly 80 papers since 2009 arguing about the advantages, limits and risks of QE. The general conclusion is that it helps particularly early in a crisis when the mere announcement of central bank support can lift confidence and over time help anchor interest rates.
One indicator of that impact, what’s known as the shadow federal funds rate is currently estimated at -1.8%, in effect where the Fed’s target rate would need to be to produce the current levels of bond yields.
One of the reasons it may be hard for the Fed to deviate much from the way it did QE during the pandemic is precisely because it is the early promise of open-ended support that seems to be a chief benefit.
The details may differ next time. Policymakers disagree, for example, over the mix of monthly asset purchases - split between $80 billion of Treasury securities and $40 billion of mortgage-backed assets - at a time when home prices are skyrocketing.
But if the pandemic proved anything, it’s that scale matters and that it’s better to plan for the worst and be surprised on the upside. The pandemic looked like a long-lasting, Great Depression-level event in March 2020, when the U.S. central bank slashed the federal funds rate to near zero and made an open-ended commitment to purchase assets that raised its holdings of securities from $3.8 trillion to around $5.9 trillion by late May of that year.
“We can all complain about (QE) being imprecise and not being quite sure how it works and not being sure how much it works,” said Cornerstone Macro economist Roberto Perli.
“But what is the alternative?” Perli said. Come the next recession “you most likely will have to do it again in a decent size and with the same general composition.”—Reuters