On December 18, 2013, amid improving economic conditions and outlook, the Federal Reserve (Fed) began to reduce the pace of asset purchases. This was the beginning of the end for the five-year-old Large Scale Asset Purchases (LSAP) program, more commonly referred to as Quantitative Easing (QE). The seemingly unorthodox policy was intended to give an extra boost to a struggling economy once the more traditional forms of monetary policy failed on their own. Even early in the program, there were doubts and concerns about its effects. Though the Fed has indicated these asset purchases are ending, there are lingering questions about the ramifications of the Fed s policies. In this paper, we hope to assuage the three areas of concern that have garnered the most attention: an acceleration in inflation, a spike in interest rates, and potential income losses for the Fed. The Fed introduced quantitative easing because, at the time, it appeared that the standard monetary policy was ineffective. The primary goal of QE was to restore functionality in the impaired financial markets and banking systems. With the federal funds rate already near zero, the Fed hoped QE would provide additional monetary stimulus. The Fed first attempted QE in November 2008, buying $600 billion in mortgagebacked securities (MBS). Sporadic purchases continued until November 2010, when purchases were expanded to include $600 billion of Treasury securities; this became known as QE2. A third round of QE was announced in September 2012, with the Fed deciding to purchase $40 billion of securities each month in an open-ended program. In conjunction with this third round of QE, the Federal Open Market Committee (FOMC) announced that it would maintain a federal funds rate of zero at least through 2015. In December 2012, the FOMC increased the amount of purchases from $40 billion to $85 billion per month. The Fed s balance sheet ballooned as a result of these policies (Chart 1, page 2). Asset purchases were split into two types: mortgage-backed securities and longterm Treasury securities. The MBS purchases, which also included housing agency debt, were meant to help support the housing market by decreasing yields on MBS, which the Fed expected would, in turn, increase the availability and lower the cost of mortgage loans. The Fed wanted to offer some support to
the sector that not only was a significant cause of the recession but also was one of the reasons the recovery was struggling. Purchases of long-term Treasuries were generally aimed at improving overall financial conditions, such as lowering yields on safe and, therefore, risky assets. The Fed s choice of bond purchases has generally created major fluctuations in the shape of the yield curve. From mid-2011 to mid-2012, the Fed cut its holdings of one- to five-year bonds in half in order to increase its holdings of longer-term bonds (the so-called Operation Twist ). This sharply reduced the seven-year Treasury yield relative to the three-year yield. Beginning in mid-2012, the Fed reversed itself, doubling its holdings of one- to five-year bonds and, in effect, undoing Operation Twist. This widened the three- to seven-year spread back to 1.6%. After a warning from then Fed Chairman Ben Bernanke in May, asset purchases began to be tapered in December 2013. The Fed decided to curtail asset purchases by $10 billion each FOMC meeting, split evenly between Treasuries and MBS. While we feel the improving economic picture was certainly the biggest factor behind the decision, the shrinking federal deficit was also likely a factor. The supply of public bonds for purchase was falling faster than expected, and there were concerns the Fed would soon begin crowding out private buyers. Indeed, the Fed already holds about 40% of the MBS market and about a quarter of outstanding Treasuries. Due to seasonal factors and other vagaries, the Fed sometimes purchased more than two-thirds of all Treasuries at certain auctions (Chart 2). From when the Fed first began discussing QE in 2008, some economists, especially those who consider themselves monetarists, have warned the unprecedented increase in reserves in the banking system will ultimately lead to inflation. These concerns have been raised time and again over the past several years, usually in conjunction with a new round of QE or any step-up, no matter how modest, in the inflation rate. We do not believe that significantly higher inflation is inevitable (for a more thorough analysis see Hawthorn s First-Quarter 2013 Strategy Insights, Get Real: Protecting Purchasing Power). So far, inflation has been of little concern. Credit growth has been relatively soft while inflation and inflation expectations have been low. Since spring 2012, the three-month moving average of the Consumer Price Index has never risen above 2%. Inflation has gotten so weak at some points that the Fed has raised concerns over the possibility of deflation. There are several factors that may be keeping inflation low, in our view.
Some have argued that rather than increasing lending and the money supply, banks are holding higher levels of reserves on their balance sheets and placing excess reserves at the Fed. Others have noted that the velocity of money is well below its historical average, tempering inflationary pressures. Other possibilities include labor market slack, stable energy prices, and global deflationary pressures. Overall, it is clear to us that inflation is not a primary concern at this time. The slower, more drawn-out recovery may aid the Fed in this regard by giving the central bank time to reduce liquidity in the banking system in an orderly fashion, with limited risk of significantly higher inflation. On the other hand, if the global economy suddenly kicks into higher gear, we believe it may not be feasible to drain liquidity fast enough to avoid escalating inflation. We do not take the inflation threat lightly. Fortunately, the Fed has several options available that could help tame price increases. For example, if there is a rapid increase in lending brought about a rise in inflation, the Fed has already proposed raising the interest rate it pays on reserves. Such an increase might induce banks to hold onto cash rather than lending it out; likewise, the increase might raise borrowing costs, tempering demand for new loans. The Fed could also increase the minimum ratio of reserves against deposits that banks are required to hold. For much of its history, the Fed actively managed these reserve requirements as part of its policy arsenal, but it has not done so for a long time. Though it may seem a blunt tool, reserve requirements are potentially quite powerful in controlling the expansion of credit and money and, by extension, inflation. Another possible option for the Fed is large-scale reverse repurchase agreements (reverse repo). In a reverse repo, the Fed agrees to sell a security to a bank or other financial institution with a promise to rebuy that security at some point in the future. These agreements would quickly reduce excess reserves at banks while leaving the size of the Fed balance sheet unchanged. As Bernanke highlighted in his February 2010 testimony to Congress, Reverse repos [would] allow the Federal Reserve to drain hundreds of billions of dollars of reserves from the banking system quite quickly, should it choose to do so. Further, the Fed could consider raising policy rates earlier than the promised late-2015. With the federal funds rate near zero, we think a modest increase, for example, 25 or 50 basis points, could temper inflation while still maintaining a historically low interest rate environment, remaining accommodative to a possibly still-struggling recovery. The Fed could avoid a premature increase in rates, but the option does exist regardless as a likely first move if inflation and/or economic growth is stronger than expected. Once the taper ends, there are some concerns in the market about the effects on interest rates. In our opinion, it is likely that interest rates will eventually rise from their historical lows. However, it is difficult to assess the extent to which rates will rise and the timespan over which these increases may occur.
Some alarmists have warned of multiple percentage-point increases in interest rates in just a matter of months. Certainly, such a rapid spike would likely damage a stillstumbling expansion, but we do not believe such a scenario will occur. Rather than Treasury yields rising as the Fed s portfolio or purchases shrink, some analysts instead believe yields will only respond to new information about the trajectory of the balance sheet. In this view, assumptions about changes in the Fed balance sheet have already been priced into the market. If this is true, Treasury yields would move higher only if the Fed changes its holdings at a pace different than current market expectations. In such an environment, the market typically pays more attention to what the Fed signals in its speeches rather than the operations undertaken at the time. Further, the Fed has emphasized repeatedly that it will remain accommodative even after the taper is complete. Unless the economic outlook changes drastically, the Fed plans to keep policy rates near zero through at least late 2015. Even then, we expect policy rate increases will be measured and modest. Indeed, PNC s Economics team believes the federal funds rate will increase only 1 percentage point in 2016, leaving interest rates well below their historical average. We expect these trends will persist in the medium term. This does not preclude interest rate increases. Many analysts, including ourselves, expect rates to rise over the next few years. However, we think the increases should be consistent with better economic growth. Remember that the intent of QE and its sibling programs, such as Operation Twist, was partly to reduce interest rates. Inevitably, the cessation of these programs will help eliminate the artificial downward weight on interest rates. The increase in yields is not likely to be uniform across all maturities (Chart 3). As the taper progresses and the Fed ends its bond purchases, the maturity of the central bank s holdings should stabilize, putting less downward pressure on long-term bond yields relative to short-term bond yields (Chart 4). In essence, the narrowing of the yield spreads seen in 2011 and 2012 will reverse. Thus, we believe the yield curve may steepen (long-term yields will increase more than short-term yields) but will flatten eventually. It is important to note that we are highlighting trends, and there may be shortterm anomalies that will bring down interest rates. In recent months, despite the taper, Treasury bond yields have declined. These low long-term bond yields may be signaling an economic slowdown. Or, more likely in our view, some flight to safety given concerns surrounding soft first-quarter economic growth in the United States, geopolitical risks in Iraq and Ukraine, and the Fed s purchases of long-duration bonds have kept rates low in bond markets.
As an example, we point to the fact that long-term bond yields have fallen more than shorter-term bond yields. We believe a significant concern is how the Fed will unwind its holdings despite the potential for significant losses. It seems likely that the Fed will bear losses on these policies if rates rise. Bernanke repeatedly hinted as such when first implementing QE policies in 2008. We do not believe losses will be an issue, at least from an operational standpoint. The Fed holds its securities at book value, which misrepresents their resale value. In a higher interest rate environment, the market value will be lower. The Fed has already accumulated $53 billion in unrealized losses, mostly concentrated in MBS, and losses should only grow as interest rates rise. If the Fed were to face operating losses, that would be a sharp turnaround from recent performance: Though it have unrealized losses, the Fed continues experiencing operating profits last year, the Fed remitted $79 billion to the Treasury because interest income exceeded interest expenses. Running a deficit is not so much of an operational concern, in our view. We believe there are many strategies the Fed can implement. For example, the Swiss National Bank (SNB) was able to operate despite incurring losses for more than two years during the financial crisis due to currency intervention. In order to prevent appreciation of the franc, the SNB purchased an equivalent of $179 billion in both euros and dollars amounting to about one-third of Swiss GDP between 2009 and 2011. These operations kept the franc weak but spelled significant losses at the SNB. Despite these problems, the bank continued to operate normally. The Fed may use that experience as lodestar for driving its policies over the coming years. Though losses might be a nuisance for the Fed, we believe the greatest risk to the Fed running an operational deficit is the political fallout. We feel the Fed could potentially face considerable pushback from Congress if the central bank generates negative net income. If such a scenario did occur, the outcome could range from Congressional hearings to legislative changes that alter Fed policies or undermine central bank independence. The potential fallout from selling their holdings at a loss, in addition to the concerns about flooding the market with their securities, may prevent the Fed from unloading their assets. Thus, rather than selling, it is likely the Fed will hold most securities until maturity. This is one reason the unwinding process is expected to take almost a decade: Of the $4.3 trillion held by the Fed, a little more than half of that will mature in 10 years or later. The remaining $2 trillion is fairly evenly split between maturities of 5 10 years and of shorter maturity (Chart 5).
Though we believe that the taper and ultimate unwinding will proceed with only minor hiccups, there are lingering risks. Likely the largest concern is the ramification on incentivizing higher risk investing. Former Federal Reserve Board of Governors member Jeremy Stein, among others, has highlighted the risk that unusually low interest rates over an extended period of time has compelled many investors, including individuals and institutions, to chase higher returns by reallocating their portfolios to favor riskier assets. At the same time, these low interest rates incentivize firms to issue high-risk securities. These actions increase default risk and may expose investors to risks which are inappropriate for their holdings. In our opinion, the greatest risks might be faced by emerging economies. Already, the International Monetary Fund (IMF) has raised concerns about potential asset spirals and withdrawals from emerging markets (EMs): Rising rates in the United States make investing domestically more attractive relative to the EMs, potentially altering capital flows. The IMF has warned EM countries not to fight capital flows and instead to let currencies adjust accordingly, despite the ramifications on near-term inflation and purchasing power parity. The Fed has announced the taper will conclude in October 2014, which is consistent with their current rate of asset purchase reductions. But there are circumstances that could change this timeline. A sharp slowdown in growth, like those seen after the first and second rounds of QE, could easily spell a resumption in purchasing. Conversely, an acceleration in inflation could cause the Fed to hasten the taper. Overall, we believe the taper and subsequent unwinding of the Fed balance sheet will run smoothly with only minimal fallout on the broader economy. There is also historical precedent. In an effort to help ease the money supply during the Great Depression and finance the debt accumulated during World War II, the Fed bought large amounts of bonds in the 1930s and 1940s. The Fed s holdings of securities as a percentage of GDP was as high during the war as it is today. It took two decades to bring the size of the balance sheet back to prewar levels relative to the size of the economy. Like that expected today, most of the securities were held to maturity, though a small amount was sold. Most importantly, there seemed to be no noteworthy impact on the broader economy, despite the vagaries of three full business cycles. Indeed, the 1950s were a period of modest inflation and robust growth in the United States. Further, there was no significant increase in interest rates: The federal funds rate did not surpass 5% (roughly its historical average) until 1966. We highlight that the Fed s post-wwii wind down took two decades, which could lead some analysts to doubt the Fed s ambitious timeline of returning its holdings as a share of nominal GDP to its historical average within seven years. By the Fed s own estimates, it will take until 2021 for the Fed s asset holdings to fall from 25% of GDP today to 10%, its prerecession level. Since
there was no fallout from the drawn-out post-wwii wind down, there is little reason to be concerned should the present-day wind down take longer than expected. Taking this all together, we believe the taper and ultimate unwinding should go smoothly with only a modest fallout to the broader economy. Nevertheless, there are significant risks. We will continue to monitor Fed policy over the coming years. The PNC Financial Services Group, Inc. ( PNC ) uses the marketing names PNC Institutional Asset Management SM for the various discretionary and nondiscretionary institutional investment activities conducted by PNC Bank, National Association ( PNC Bank ), which is a Member FDIC, and investment management activities conducted by PNC Capital Advisors, LLC, a registered investment adviser ( PNC Capital Advisors ). PNC Bank uses the marketing names PNC Retirement Solutions SM and Vested Interest to provide non-discretionary defined contribution plan services and PNC Institutional Advisory Solutions SM to provide discretionary investment management, trustee, and other related services. Standalone custody, escrow, and directed trustee services; FDIC-insured banking products and services; and lending of funds are also provided through PNC Bank. These materials are furnished for the use of PNC and its clients and does not constitute the provision of investment advice to any person. It is not prepared with respect to the specific investment objectives, financial situation, or particular needs of any specific person. Use of these materials is dependent upon the judgment and analysis applied by duly authorized investment personnel who consider a client s individual account circumstances. Persons reading these materials should consult with their PNC account representative regarding the appropriateness of investing in any securities or adopting any investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. The information contained in these materials was obtained from sources deemed reliable. Such information is not guaranteed as to its accuracy, timeliness or completeness by PNC. The information contained in these materials and the opinions expressed herein are subject to change without notice. Past performance is no guarantee of future results. Neither the information in these materials nor any opinion expressed herein constitutes an offer to buy or sell, nor a recommendation to buy or sell, any security or financial instrument. Accounts managed by PNC and its affiliates may take positions from time to time in securities recommended and followed by PNC affiliates. PNC does not provide legal, tax, or accounting advice unless, with respect to tax advice, PNC Bank has entered into a written tax services agreement. PNC does not provide services in any jurisdiction in which it is not authorized to conduct business. PNC does not provide investment advice to PNC Retirement Solutions and Vested Interest plan sponsors or participants. PNC Bank is not registered as a municipal advisor under the Dodd-Frank Wall Street Reform and Consumer Protection Act ( Act ). Investment management and related products and services provided to a municipal entity or obligated person regarding proceeds of municipal securities (as such terms are defined in the Act) will be provided by PNC Capital Advisors. Securities are not bank deposits, nor are they backed or guaranteed by PNC or any of its affiliates, and are not issued by, insured by, guaranteed by, or obligations of the FDIC, the Federal Reserve Board, or any government agency. Securities involve investment risks, including possible loss of principal. Vested Interest is a registered trademark and PNC Institutional Asset Management, PNC Retirement Solutions, and PNC Institutional Advisory Solutions are service marks of The PNC Financial Services Group, Inc. 2014 The PNC Financial Services Group, Inc. All rights reserved.