Investment Strategy and Portfolio Expertise. QE Explained. VBA bijeenkomst over Kwantitatieve Verruiming Mary Pieterse-Bloem.

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1 Investment Strategy and Portfolio Expertise QE Explained VBA bijeenkomst over Kwantitatieve Verruiming Mary Pieterse-Bloem 12 oktober 2017

2 Role of monetary policy in the economy the conventional world Money supply Taylor Rule Inflation Independence Monetary policy Fiscal policy Dividend (key short term) interest rates i Tax Income Government spending Budget deficit financed with debt 2

3 Then enter the shock: the global financial crisis in

4 Initially, central banks coordinated policy to prevent a total burn down GDP growth during Great Depression in 1930s 20,0% 15,0% 10,0% 5,0% 0,0% -5,0% -10,0% -15,0% -20,0% -25,0% -30,0% What the Fed did in the 1920s: Spring 1928 Fall 1931 What central banks did in the 2000s: Liquidity injections Interest rate reduction Assisting banks Assisting sovereigns (EU) Spring 1932 Summer 1932 Tightening in order to prevent equity market bubble, despite lagging fundamentals Commodity prices only slightly up, little hint of inflation Further tightening, responding to speculative attacks on the USD (gold standard) Speculative attacks helped create panic in the banking system. Depositors withdrawing funds bank runs No stabilization of the banking system by aggressive lending or increasing money supply Slight loosening (after pressure from congress) However, in deflationary environment, real rates remained high despite lower nominal rates Fed starts tightening again By year end the economy relapsed dramatically 4

5 Did it work? Yes, it did prevent a total meltdown GDP growth during Great Depression (from 1925) and global financial crisis (from 2002) 20,0% 15,0% 10,0% 5,0% 0,0% -5,0% -10,0% -15,0% -20,0% -25,0% -30,0% GDP growth GDP growth World economy facing headwinds from: Fiscal austerity Lack of structural reforms Increased regulation Weak bank balance sheets Demographics 5

6 Later, unconventional monetary policy needed to fend off deflation Deposit rates 7,0% 6,0% 5,0% 4,0% 3,0% 2,0% 1,0% 0,0% -1,0% They hit the zero lower bound That makes interest rate steering ineffective/exhausted ECB Fed BoE Eurozone GDP growth vs 5y German government bond yield 6,0% 4,0% 2,0% 0,0% -2,0% -4,0% -6,0% -8,0% GDP growth YoY 5Y German Government Bond Yield Reviving nominal growth (long term) Long term interest rates higher than the growth rate ugly deleveraging Debt ratio= (budget deficit + i) growth Fiscal austerity depresses the budget deficit but it also depresses growth 6

7 A sliding scale down into unconventional monetary policy Conventional monetary policy IR OMO FG QE Determination of short term interest rates Assumption of the Taylor Rule Liquidity injection by increasing the money supply Forward guidance on future interest rate policy Influencing market expectations Demand stimulation and raising inflation expectations by issuing liquidity through asset purchase programs Quantitative easing influences market prices throughout the curve, creating asset price inflation Unconventional monetary policy NIR DM OMF Removing the lower bound by charging negative interest rates on deposits Incentivizes banks and households to lend/spend money Reduction of the debt burden through debt monetization Permanent government bond purchase of highly indebted countries Facilitating tax cuts or increased spending ( Helicopter Money ) by overt money financing Sovereign financing by permanent government bond purchase 7

8 Unconventional monetary policies pursued by the main central banks FG QE NIR DM OMF Helicopter money was discussed by the BoJ but neither they nor any other major central bank has decided to go here

9 Quantitative easing what did central banks purchase? ECB Fed BoE BoJ EUR denominated assets such as: USD denominated assets such as: GBP denominated assets such as: JPY denominated assets such as: Investment grade sovereign bonds (currently 18 countries eligible) Supranational bonds Covered bonds Asset backed securities (ABS) Investment grade corporate bonds ex financials US Treasuries Agency mortgage-backed securities (MBS) Agency debt Gilts Investment grade corporate bonds ex financials Japanese government bonds Asset backed securities (ABS) Commercial papers Investment grade corporate bonds (real estate issuers rating at least AA) Equity ETFs (tracking Topix or Nikkei 225) REITs Sov. Bonds Corp. Bonds Cov. Bonds ABS USTs RMBS Gilts Corp. Bonds JPGs Corp. Bonds Com. Paper Equities REITs Assets of the BoE after 2014 are estimates 9

10 Impact of QE on central bank balance sheets Central Bank Total Assets to GDP (in %) Can a central bank go bust? Are those central banks still independent? ECB (lhs) Fed (lhs) BoE (lhs) BoJ (rhs) Assets of the BoE after 2014 are estimates 10

11 Transmission channels between interest rates and the real economy Transmission Transfer Real Economy Credit channel Banks Corporates Households Higher domestic investments, lower savings Equity Interest rate reduction Wealth effect Capital Markets Bonds Real estate Higher consumption, lower savings International Competitiveness Currency Markets Currency devaluation Higher exports Higher foreign direct investments Higher corporate profit margins 11

12 Central bankers on the effect of QE on the economy While there is substantial evidence that the Federal Reserve's asset purchases have lowered longer-term yields and eased broader financial conditions, obtaining precise estimates of the effects of these operations on the broader economy is inherently difficult, as the counterfactual how the economy would have performed in the absence of the Federal Reserve's actions cannot be directly observed. Ben Bernanke, Chair of the Federal Reserve in his Jackson Hole speech in

13 Why QE, but why no helicopter money? Quantitative easing Helicopter money If you call this (QE) an experiment then this one (helicopter money) certainly is! Money issued via QE can be withdrawn again, while helicopter money is permanent and irreversible 13

14 Central bankers on helicopter money It is hard to imagine helicopter money not ending up in fiscal dominance, the outcome that would obviously be inevitable in its purest form, where interest rates are kept at zero forever. Sooner or later this could indeed erode the value of money, but at the cost of losing the public's confidence in our monetary institutions a trust so painfully gained over the years and with unpredictable consequences. It would be a Pyrrhic victory. Claudio Borio, Head of the Monetary and Economic Department of the Bank for International Settlements from his speech Helicopter money reality bites of Sept

15 Unconventional monetary policies turned the world upside down Central banks determine Yield curve Whole yield curve Bond market (Key short term) interest rates Growth expectations Inflation expectations Central banks react to Actual real growth Actual inflation Actual real growth Actual Inflation 15

16 Where from here is being fiercely debated by economists Central bank independence Taylor Rule Short term impact Long term impact Hang it loose! Secular stagnation Be forgiving! Central banks eat the debt Central banks should not be independent Does independence need to be regained? Should include real economy variables, such as output gap kicking the can down the road soft landing Reduced growth is the result of demographics Tighten as soon as possible! Austrian school debt=debt, always You need to pay it back! No debt forgiveness No debt absorption Restore discipline back to bond market Central banks should be independent Can independence be regained? Should contain only monetary variables such as inflation Going back to the original creative destruction hard jump start Incentivizes misallocation of resources reduces potential growth 16

17 Central bankers on their new toolkit One lesson from the crisis is that our pre-crisis toolkit was inadequate to address the range of economic circumstances that we faced. Looking ahead, we will likely need to retain many of the monetary policy tools that were developed to promote recovery from the crisis. Janet L. Yellen, Chair of the Federal Reserve in her Jackson Hole speech in