MACRO: The End of Quantitative Easing...

This insight was originally published on April 8, 2010.  MACRO intra-day updates are available to RISK MANAGER SUBSCRIBERS subscribers in real-time.

MACRO: The End of Quantitative Easing, As We Know It


“It’s the end of the world as we know it and I feel fine.”
R.E.M. is an iconic American rock band that was founded by Michael Stipe in 1980.  While the band is not known for its thoughts on monetary policy, the line quoted above from their song, “The End of the World Was We Know It”, provides a good metaphor for the Federal Reserve’s recent decision to halt quantitative easing.
While many market observers expected this planned ending of policy to lead to an increase in interest rates, particularly for mortgages, we have seen only a marginal change in rates.  In fact, over the last three weeks 30-year fixed mortgage rates have only increased marginally from 5.05% to 5.25%.  In essence, the quantitative easing world has ended, but those still borrowing via mortgages “feel fine”.
To its credit, the Federal Reserve did an effective job at prepping the market for the end of this policy, so new buyers stepped in and the mortgage market has remained stable.
Backing up for a second, though, what exactly is quantitative easing?
Central Banks have basically two key tools to implement monetary policy:  interest rates and reserve requirements.  By lowering interest rates, central banks can stimulate money supply by making borrowing rates more reasonable to borrowers and the margins from lending more compelling to lenders.  On the reserve front, the central bank can alter the reserve requirements, which is the ratio of cash a bank must hold compared to customer deposits. Any increase in reserve requirements will limit a bank’s ability to lend, or vice versa.
In the scenario where the interbank interest rate is zero and reserve ratios have been maxed out, central banks can initiate another form of policy: quantitative easing.  In simple terms, central banks will begin to purchase financial assets from banks through open market operations.   So the central banks print money to buy assets from banks, which increases the excess reserves on the balance sheet of banks.
Quantitative easing was used by the Bank of Japan in the early 2000s in an attempt to offset deflation with limited results.  In November of 2008, the United States implemented their first ever policy of quantitative easing.  The policy had two aspects to it.  First, the Federal Reserve indicated they would purchase direct obligations of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks.  Second, the Federal Reserve indicated they would purchase mortgage back securities.
The objective of this program according to the Federal Reserve was to, “reduce the cost and increase the availability of credit for the purchase of houses, which in turn should support housing markets and foster improved conditions in financial markets more generally.”  In effect, as credit markets ground to halt in late 2008, the Federal Reserve had to take the extraordinary and unprecedented measure of quantitative easing to offset the potential risk of deflation.
While the program started on a smaller scale with $500 billion of mortgage backed debt, the program was increased in March of 2009.  As the program ended on March 31, 2010, the Federal Reserve had purchased $1.2 trillion of mortgage-backed debt from banks and $200 billion of direct obligation debt of Fannie Mae and Freddie Mac, for total purchases of $1.4 trillion.  As a result of these actions, the Federal Reserve now owns almost 25% of the stock of mortgage-backed securities.
In the chart below, we have charted the increase of excess reserves on bank balance sheets.  The current amount of excess reserves is estimated to be around $1.2 trillion.  Assuming that these excess reserves were turned into loans at a 10:1 ratio, the increase in money supply into the system would be $12 trillion.  This is larger than the current amount of outstanding mortgages in the United States!
The reality is simply this: we have no idea what the consequences of this quantitative easing policy action will be.  It is an unprecedented move that, in time, will have to be unwound.  If the unwinding is natural, which would involve banks reducing their excess reserves to a more normal level, the inflationary impacts on the U.S. economy could be extraordinary.
At this point, I’m not going to predict the “end of the world as we know it” due to this massive increase in excess reserves, but this policy will have to be unwound at some point.  Either the Federal Reserve will have to pay competitive interest rates on these reserves so as to discourage loans, or the banks will begin to lend.  And lend.  And lend.
I can promise you this, if the $1.2 trillion in reserves starts to make its way into the economy, money supply will increase dramatically, and with it, inflation.  While there is increasing discussion of inflationary pressures, very few people are currently considering the unintended consequences of quantitative easing.

MACRO: The End of Quantitative Easing... - Chart 1

Daryl G. Jones
Managing Director