A key component of post Global Financial Crisis (GFC) monetary policy has been quantitative easing (QE), or the wholesale purchase of debt instruments, as more conventional policy tools lost their influence.
However, following an extended period of ultra-stimulatory global monetary policy, a number of central banks look poised to begin policy normalisation by raising official interest rates and reducing asset purchases and holdings.
A concern for us is what the withdrawal of QE will mean for global financial markets, and more importantly for the NZ economy. This note provides an explanation of QE, the impact it has had on the global economy, and the risks its withdrawal could pose to the New Zealand.
When central bankers go on a spending spree
Quantitative easing (QE) is a policy tool used by a number of central banks to purchase financial market assets on a massive scale in the hopes of stimulating growth and inflation. In response to the GFC of 2007-2008, central banks around the world co-ordinated stimulatory monetary policy to stabilise the global financial system – including cutting policy interest rates to near-zero levels and opening lines of credit when banks stopped lending to each other. However, despite significant stimulus, both inflation and economic growth remained sluggish in many developed economies in the years following the GFC.
In addition, the prevailing climate of fiscal austerity meant there was reluctance among governments to expand public debt to boost economic activity.
To counter this sluggishness, monetary policy was tasked with doing the heavy lifting and central banks such as the US Federal Reserve (Fed), the European Central Bank (ECB), the Bank of Japan (BoJ), and the Bank of England (BoE) all adopted unorthodox monetary policy as short-term cash rates hit zero lower bounds. Unorthodox policy included tools such as forward guidance (explicitly saying that interest rates would remain on hold for extended timeframes), negative interest rates, and massive asset purchase programmes or QE.
These QE programmes saw central banks hoover up public debt such as government bonds, private sector debt such as mortgage-backed securities (MBS) and, to a lesser extent, corporate bonds. By purchasing these securities, the aim was to inject cash directly into the economic system that would then be used by banks to increase available credit and foster growth.
Central banks’ QE programmes were used to maintain liquidity in the financial system and encourage lending, with the aim of boosting spending and ultimately lifting inflation.
However, the actual impact on the economy as a result of QE is somewhat opaque.
The general view held is that QE has helped drive up the price of debt instruments and therefore lower wholesale interest rates – particularly long-dated interest rates. The concurrent injection of cash from central bank asset purchasing encourages lending, investment, and consumption in an economy.
However, QE has also generated some unintended side-effects, including downward pressure on currencies in countries where QE has been utilised - resulting in claims of ‘currency wars’ whereby each country is trying to lower their exchange rate in order to boost their domestic economy. In addition, lower interest rates led to a search for yield among investors and as such drove up the price of global assets such as equities and real estate.
It has also been claimed that MBS purchases lowered the lending standards of US banks. Easier credit conditions could cause problems down the line if market participants have been under-pricing the risk associated with their investments - indeed this was a key feature in the lead-up to the GFC.
Finally, a key channel that QE operates through is the influence it has on market participants’ expectations for short-term interest rates. A demonstration of this was the so called ‘taper tantrum’ of mid-2013 that saw bond yields spike higher following the then US Fed Chair Ben Bernanke’s announcement that the Fed would start to reduce its asset purchases. Market participants reacted in part to expectations that tapering asset purchases also implied that short-term interest rates would rise faster than had been projected. The Fed had to delay the eventual tapering of asset purchases to December of that year.
The ‘tantrum’ was arrested following Federal Open Market Committee (FOMC) members using forward guidance on policy direction to assure markets that short-term interest rates would remain low well after asset purchases were reined in. Fresh asset purchases by the Fed were wound up in late 2014, but the Fed still reinvests principal payments and maturing securities.
Following the ‘taper tantrum’ episode, central banks have been a lot clearer in signalling the unwinding of asset purchases in order to reduce unnecessary financial market volatility.
Buying up the shop
The scale of some central banks’ QE programmes is staggering. The US Federal Reserve has total asset holdings of around US$4.5trn (an increase of over US$3.5trn since 2007), with the majority accumulated as a result of three purchase programmes named QE1, QE2 and QE3 that began in late 2008 (see chart below). The bulk (55%) of the Fed’s asset holdings are made up of public sector debt (US Treasury bonds) and MBS totalling around 40%. The US Fed started unwinding its asset holdings in October 2017, and has indicated that the process will be gradual and predictable. To do this the Fed is stopping the reinvestment of some of the proceeds on assets that mature.
The amount that the Fed has let roll off has started small, with up to $10bn per month from October 2017, which will be increased by US$10bn per quarter until it reaches US$50bn per month. Both the advance signalling and slow pace of the sell down by the Fed is deliberate to limit any negative fallout in financial markets. Nevertheless, the Fed’s balance sheet is envisaged to end up at a higher level than the circa US$900bn pre-GFC size. This is in part due to the need to meet the growing public demand for currency. However, QE is likely to remain a viable policy tool for the Fed (and other central banks) to help navigate their economies through the next economic crisis.
The ECB has a significant and ongoing asset purchase programme (APP) that includes asset-back securities, covered bonds, government debt and even corporate bonds, to the tune of €2trn and growing. On October 27 the ECB announced that it intends to begin tapering its asset purchase activity. From January to September 2018 monthly asset purchases will be halved to €30bn. The ECB stopped short of announcing an end date of asset purchasing and instead made a cautious statement that it was ready to up the level of purchasing if conditions warranted.
The BoJ has a relatively long history of using QE as a policy tool. Through much of the 1990s and 2000s Japan suffered a period of muted inflation, even deflation at times, and lacklustre growth. As a result, the BoJ undertook a QE programme in the early 2000s to boost lending by financial institutions. Following the GFC the BoJ has undertaken several iterations of QE, boosting its asset holdings (largely Japanese government bonds) to almost ¥500trn – approaching the size of Japan’s entire economy and equivalent in size to the US Fed’s balance sheet. More recently, the BoJ adopted a new policy of yield curve control, or adjusting long-dated bond purchases to steepen the yield curve and promote bank lending – banks typically trade on the margin generated by borrowing short and lending long.
Following the financial crisis the BoE also fired up its own asset purchase programme focused on the purchase of gilts (UK government bonds) from various financial institutions. In addition to UK government bonds, the BoE also purchased some highly-rated private debt. The BoE’s asset purchase programme target reached £435bn, after the Bank decided to boost the limit by £60bn in September 2016 in the wake of the Brexit vote. Since the Brexit vote inflation in the UK has surged as a weaker British pound has seen a jump in the cost of imported goods and services. The BoE has not signalled any near-term withdrawal of QE to counter rising inflation, instead focussing on using interest rates to tighten policy settings. The BoE hiked the official policy interest rate on November 2nd from its record low 0.25% to 0.50%, and signalled a very gradual hiking path – two quarter-of-a-point hikes over the next few years.
All’s well that ends well
The ambiguity over QE’s influence on global financial markets and growth is matched by the uncertainty surrounding the possible fallout from its eventual withdrawal. At the extreme end, the unwinding of QE could cause a sharp correction in asset prices that have been inflated by the ultra-accommodative policy of the post-GFC era. A number of equity market indices (including the NZX) are now regularly punching through all-time highs and price-to-earnings ratios look stretched by historical standards.
Among developing economies, credit spreads (the margin between low risk and high risk borrowing rates) have narrowed to almost pre-GFC lows as investors have been hunting yield in increasingly risky areas. In housing, many markets around the world (including in NZ) have seen house prices diverge from fundamental benchmarks such as income. In Auckland for instance, the median house price-to-income ratio is well over nine times – well above the international affordable benchmark of three times income.
Among all these signals of frothy asset markets, measures of market volatility such as the VIX index (a proxy for risk aversion) are eerily quiet.
If we do see a sharp correction in asset prices, then the implications are severe for the global economy – possibly akin to another GFC. However, there are reasons to believe that a full-blown financial crisis is less likely this time; banks are better capitalised than prior to the GFC, and central banks are battle hardened and more capable at keeping the financial system from seizing up. Moreover, there are signs that the unwinding of policy will be less astringent on the global economy than some believe. For instance, markets look to have taken the US Fed’s process of policy normalisation with grace. The Fed has already lifted the Federal Funds rate four times since late 2015. In addition, the Fed is leading the pack by starting to gradually reduce its vast cache of assets – a process that it signalled many months in advance. The muted response from financial markets to date from the Fed’s policy announcement suggests that the cautious approach is working. The rise in US Treasury bond yields we have seen in the past year has been more a product of the Trump administration’s expected fiscal stimulus package rather than the Fed’s policy tightening.
For the NZ economy, the effects of the removal of QE are likely to be indirectly felt. The RBNZ has not undertaken any QE itself as the OCR, despite sitting at a record low of 1.75%, remains comfortably above an effective zero lower bound. However, financial markets are the main channel that the removal of QE will likely flow through to NZ. As global central banks start to sell down their asset holdings, global yields (specifically longer-dated ones) would be expected to rise and feed through to higher wholesale interest rates in NZ. Local banks would then pay more to source funding from the wholesale market, sending fixed-term mortgage rates upward – adding pressure on indebted NZ households. The other financial market impact is likely to come from a weaker NZ dollar. The withdrawal of policy stimulus offshore comes at a time when the RBNZ has signalled that interest rates will remain on hold until mid-2019 (although we expect interest rate hikes to start from late 2018). Interest rates differentials are likely to move in favour of offshore markets, leading to a decline in the NZ dollar, boosting tradables inflation and the export sector.
While we don’t believe that the NZ economy is in any imminent danger from a QE-induced global recession, it’s worth examining the implications for NZ of such a scenario.
If global asset prices fell sharply in concert, as monetary policy is withdrawn around the world, the next financial crisis could be triggered. Looking at the 2008 GFC for possible cues, there are two key channels that these events could impact the NZ economy.
First, NZ could be shut out of funding markets as global investors rush for safety. Global investors tend to shun commodity-based economies like NZ in times of crisis. This is a serious proposition for a country like NZ that relies on global financial markets to fund its capital account deficit. Difficulty faced by the NZ banking sector to access global funding markets would have significant consequences for the housing market as credit conditions tighten. The economy could then see confidence and spending deteriorate and further worsen a slowdown in the housing market – particularly if highly indebted households are forced to sell housing.
The second channel is via an eventual downturn in global trade, which we saw following the financial crisis of 2008. The export sector would face a hit to incomes and also pullback spending. However, depreciation in the NZ dollar would be expected to cushion the blow somewhat.
Fortunately, local policy makers are well placed to respond in the event of a worst case scenario. For instance, the RBNZ still has some wriggle room to cut the OCR if needed. In addition, NZ government debt as a share of GDP is low in comparison to many developed economies (currently net debt is 22.2% of GDP as at 30 June 2017). There is scope for increased government spending and investment if a global downturn deteriorates, particularly from a new Government that will want to prove its mettle when the chips are down. Moreover, with a shortfall of home building at present (particularly in Auckland), there is clear demand for investment – such as housing and transport infrastructure.
In response to the GFC of 2007-2008, central banks around the world adopted a number of unconventional policy tools, including the wholesale purchase of debt instruments or QE. The widely accepted view is that QE depressed long-dated interest rates and boosted demand for an array of asset classes. Some of the unintended consequences of QE, such as increased risk undertaken by investors in search of yield, may be sowing the seeds for the next global downturn. However, we don’t expect the unwinding of QE will tip the global economy into recession. Given central banks are likely to unwind QE in a controlled and predictable manner. In future QE is likely to be kept in the policy toolkits of central banks around the world as one of the last lines of defence in response to severe economic and financial crises.
The RBNZ did not revert to using QE following the global crisis. Nevertheless, the withdrawal of QE is expected to affect the economy the NZ economy indirectly via financial markets, both through rising longer-dated interest rates and a lower currency. If the unwinding of global policy stimulus tips the global economy into the next global recession, policy makers in NZ have room to manoeuvre to counter the fallout, including cutting the OCR further and instigating expansionary fiscal policy. Let’s hope they don’t need to.
Zoe Wallis is the chief economist at Kiwibank. Jeremy Couchman is a Kiwibank senior economist. This article was first published here, and is re-posted with permission.