Market uncertainty is accompanying the wind-down of the second round of the Fed’s quantitative easing policy. This concern is hard to understand, as we will explain, and it is likely due to a fundamental misunderstanding of the process.
The Federal Reserve embarked upon its program of quantitative easing because of the so-called zero-bound problem. The FOMC had cut its Federal Funds target to near zero (between 0 and .25%) and simply couldn’t lower nominal interest rates below zero to further stimulate the economy. So it started to engage in asset purchases to inject liquidity into the system. Estimates are that every $100 billion in asset purchases would have the same impact as lowering rates by between 3 and 7 basis points. Over the course of QE 1, which spanned from November 25th, 2008 to about March of 2010, the Fed purchased about $1.75 trillion of assets. This translates into additional easing of from 52.5 to 122.5 basis points.
At its most recent meeting the FOMC reaffirmed that it will finish its second round of $600 billion in additional stimulus, known as QE 2, at the end of June. This has provided an additional estimated 18 to 56 basis points of easing, theoretically bringing the total stimulus for the two programs to between 70.5 and 178.5 basis points.
People are acting as if stopping the program is an end to monetary ease. But this is far from the case. Think of it this way: much of the current reaction seems to liken the Fed’s programs to pumping air into a leaky tire, where the Fed would need to keep pumping to maintain a constant tire pressure. But if this were true, then the Fed’s balance sheet would remain constant in size as liquidity leaked from the system. The better analogy is to liken the stimulus programs to blowing up a balloon. The injections of funds keep pumping up the balloon, which has gotten bigger and bigger. In the process, the Fed’s balance sheet has grown from $2.2 trillion in December of 2008 to $2.9 trillion presently. This leaves about $1.2 trillion in assets unaccounted for, based upon the amount of assets purchased during QE 1 and QE 2. Where did those funds go? Did the balloon spring a leak? The answer lies in the fact that while the asset purchases were being made, other emergency lending programs were simultaneously being wound down naturally as demand receded. About $450 billion is due to the wind-down of the Term Auction Facility, another $225 billion is due to the wind-down of outstanding discount window credit and other loans, about $300 billion is due to the run-off of the Commercial Paper Funding Facility, and the remainder is due to the decline in central bank liquidity swaps.
What this means is that far less liquidity and stimulus has been injected into the system by the two QE programs than is commonly believed or that the basis point estimates would suggest. The net addition is more like $600 to $700 billion, or roughly about 18 to 56 basis points. Of course, there was also a term structure implication, because the programs that were phased out involved mainly short-term credit, whereas QE 1 and QE 2 involved purchases of long-term assets, a kind of “operation twist” if you will. The important point, however, is that the net additional stimulus remains in the system, even if the Fed stops its asset purchases. The Fed is not backing off of its desire to stimulate the economy, all it is doing is backing off of its policy of steadily adding to that stimulus. The air is not, on net, leaking from the tire, it is still in the balloon. That stimulus is still working and the key question is how effective it has been and will be.
