Thoughts on “unwinding” QE from Frances Coppola

frances_coppola_unwinding_qe.pngFrances Coppola worked in the banking sector for 17 years and did an MBA at Cass Business School in London, specializing in financial risk management. She is the author of the Coppola Comment finance & economics blog, which is a regular feature on the Financial Times’s Alphaville blog and has been quoted in The Economist, the Wall Street Journal, The New York Times and The Guardian. She is also a frequent commentator on financial matters for the BBC as well as a regular contributor to Forbes. She was also one of our Top Economics and Finance Bloggers of 2017.

Visit her blog, Coppola Comment and follow her on twitter

How do you think the Fed will unwind its multi-trillion dollar balance sheet resulting from its stimulus program without severely upsetting the bond and equity markets? 

Clearly, the Fed can’t just sell down its asset holdings in one swoop. Balance sheet normalisation must proceed very slowly, to avoid serious disruption of bond and equity markets. Even if done slowly, we should expect a market correction of some kind, since the present inflated prices are in part due to the Fed’s holdings: “what goes up must come down” is a useful rule of thumb here. It’s not just bond and equity markets that would be disrupted if the Fed moves too quickly: there is a serious risk to real estate and commodity markets too. For the US, the prospect of disrupting the real estate market should give everyone pause for thought. Better not to normalise at all than risk a property market collapse.

Since you wrote to me, the Fed has announced its intention to start unwinding its balance sheet. I think of Fed’s QE holdings as the mirror image of China’s holdings of USTs. China sells them down as and when it needs more dollar liquidity. The Fed should sell its holdings down when it thinks the US needs less dollar liquidity. That would imply rising inflation, tight labour market and a softening dollar. Frankly that is not what I see, so I am wondering what the tearing hurry is.

That said, the global outlook is brighter, so it might be that the Fed is expecting demand in the rest of the world to lift the US economy and thus justify tighter monetary conditions. But I don’t really understand this, since the Fed only has a mandate to consider domestic US conditions. Also, although the global outlook is brighter than it has been for a few years, political risk is so elevated that forecasts are decidedly fragile.

Tightening when the dollar is so strong is a serious cause for concern, since a strong dollar indicates global dollar shortage. Claudio Borio and Hyung Song Shin of BIS have both warned that the Fed’s tightening is causing a global shortage of dollar liquidity, which is already having some very strange economic effects, such as breakdown of covered interest parity. We might find that a sudden squeeze on dollar liquidity forces emerging markets, especially (but not limited to) China, to sell down their UST holdings. Obviously the consequences for their currencies, and for global financial stability could be severe. We might also find that markets are distorted in strange ways that we don’t expect and can’t understand – the covered interest parity problem is a case in point. We are, to put it mildly, in uncharted territory.

To be fair to the Fed, their plan is for balance sheet normalisation to proceed at a glacial pace. But given the strength of the dollar since the taper tantrum in 2014, and the continuing fragility of markets priced in dollars (oil, commodities, metals), even a glacial pace could tighten global monetary conditions too much.

My considered view is that although I understand the Fed’s desire to signal to markets that it intends to normalise its balance sheet, starting the process now – even at a glacial pace – is premature, given the strength of the dollar, below-target inflation expectations, continuing weakness in both the employment participation rate and wage growth, and elevated political risk.  I regard the Fed’s decision to raise interest rates and start unwinding its balance sheet under the present circumstances, both domestic and global, as verging on reckless.

How will the ECB, which is still stuck in a quantitative easing cycle, be able to bring it to an end without plunging Eurozone countries into yet another financial crisis?

I think the decision about when to end ECB QE will be dressed up as responding to market conditions, but the real driver will be inflation expectations in Germany. Inflation forecasts for Germany are rising, so I would expect ECB QE to be ended soon. But not necessarily unwound, since unwinding the balance sheet would be monetary tightening at a level inconsistent with the present path of inflation expectations. The ECB is also unlikely to want a stronger euro while inflation expectations remain below target and output is feeble.

As with the Fed, unwinding the balance sheet would have to proceed very slowly and cautiously. The ECB has all manner of junk on (or pledged to) its balance sheet, much of which does not arise from QE but from the alphabet soup of previous interventions. Initially, the ECB would do well to ignore all of these and concentrate only on selling down assets bought under QE, and strictly in accordance with the rules under which the assets were purchased.

Because of the dominance of banks in the European financial system, there is a serious risk to financial stability if the ECB causes a sudden bond price correction that undermines bank balance sheets. Therefore, I think the ECB should not attempt to unwind its balance sheet until all EU banks have stable and resilient balance sheets and the banking union has been completed. Also, because very low interest rates are a threat to bank solvency, particularly the large numbers of small banks in Germany and Italy, the ECB should raise interest rates some distance above zero before it considers normalising its balance sheet.

If you’d like to read more of Ms. Coppola’s content, we encourage you to visit her blog the Coppola Comment or to follow her on twitter.

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