October 2012

A PUBLICATION OF CHILTON CAPITAL MANAGEMENT

W W W.CHILTONCAPITAL.COM

To Infinity, and Beyond?

Samuel Rines

ove it or hate it, Quantitative Easing is here. The typical mechanisms of Federal Reserve policyovernight interest rates and small holdings of government debtare relatively dull and easily understood. But QE is esoteric, exotic, and begs to be critiqued and even feared. In better times a simple zero interest rate policy would be enough to arouse inf lationary suspicions. And the trebling of the Feds balance sheet causes investors and politicians to wonder if it is even possible for the Fed to reverse its current stance. However, Quantitative Easing is nothing new to central banksin the U.S. or elsewhereand many have exited without rampant inf lation or drastic consequences to their economies. Quantitative Easing Brief ly Explained The Feds goal with QE is to stimulate the economy even when short-term interest rates, its traditional tool, are near zero. It does this by manipulating the balance sheet. The assets of the Feds balance sheet are typically Treasuries, less-liquid yielding securities (mortgage backed securities and the like), and loans to member banks. The liabilities are currency (the $1, $5$100 bills), bank reserves, and Treasury deposits. QE is undertaken by changing the composition of the balance sheet, the size of the balance sheet, or both. To change the composition of the

balance sheet, the Fed would fund the purchases of an asset (longer dated Treasury or risky asset) with the sale of something on its balance sheet typically a shorter term Treasury. This alters the balance sheets composition by shifting the duration or asset type. The Fed could also change the size of its balance sheet by creating more reserves, a liability, to offset the increase in asset purchasesa Treasury security for example. In this case the balance sheet expands by the amount of the purchase, because the Fed is spending new, previously non-existent money. It is creating a reserveessentially moneyfrom nothing. A change in the composition of the balance sheet is referred to as sterilized; an asset purchase that results in an increased size of the balance sheet is called unsterilized. The goal of QE is to reduce the risk premium and force investors to purchase riskier assets. The theory is that even when yields are zero on short dated Treasuries, the Fed can still ease by pushing risky rates closer to riskless rates. Easing into 1932 and Twisting in the 60s Remarkably little has been made of the Federal Reserves first foray into quantitative easing. In

However, Quantitative Easing is nothing new to central banks in the U.S. or elsewhereand many have exited without rampant inflation or drastic consequences to their economies.

1932, the U.S. was in the depths of the Great Depression and the Fed was still a fairly new (and nave) institution. Nonetheless, the Fed embarked on a $1 billion buying spree, pushing short-term borrowing rates to around one-half of a percent. And the Fed was not acting alone. In 1933, Congress issued an ultimatum: purchase $3 billion in treasury securities or we will issue $3 billion in new cash. The Fed continued to make the purchases through late 1933. When it halted, a rather agitated President Roosevelt and the U.S. Treasury continued the policy. All gold was called to the Federal Reserve Banks and then transferred from the Fed to the Treasury. Once the gold was in the possession of the Treasury, the passage of the Gold Reserve Act increased the price of gold from $20.67 an ounce to $35 and the Treasury began to buy gold with the proceeds. The resulting issuance of gold certificates increased the monetary base significantly, and the Feds balance sheet expanded by around 250 percent. The Federal Reserve dissipated the effects by requiring banks to hold a greater amount of reserves, thus avoiding an inf lationary outcome. Even the policy later dubbed Operation

consequences of lower interest ratesand the outf low of goldcould be mitigated. The original vintage of Operation Twist was orchestrated by selling short term Treasury securities and purchasing long-term Treasuries. And it was done on a large scale, around 1.7 percent of gross domestic producta massive amount for the day. To put this figure into perspective, QE2 was about 4.1 percent of GDP. Like their predecessors, QE2 and Operation Twist had the aim of lowering the yields of longer term securities, and accomplished it by rolling shorter term treasuries to the long end. To Infinity, and Beyond! The creatively titled QE3 is the most recent Federal Reserve action. It will continue the MEP program indefinitely and purchase an additional $40 billion in agency mortgage backed securities, a figure that can increase to $80 or $100 billion. This is intriguing, not only because it is an openended policy, but because the Feds balance sheet is changing in both composition and sizeat least through the end of the year. Can QE really go on forever? Not likely. Someday the economy will actually return to some form of normalcy and QE will no longer be needed. The Feds dual mandate, stable prices and full employment, typically means that easing is done with a fair amount of restraint. However, there is a growing belief that something is in fact different this time, that high unemployment is a product of more than just your typical forces and some jobs are gone for good (a condition known as structural unemployment). There is the feeling that additional stimulus measures can mitigate this structural unemployment. The goal would be unemployment of only 7 percent or so, and the Fed has said it will continue to keep interest rates at zero, and to manipulate the composition and size of its portfolio until this is achieved. The Inf lation Specter There is, understandably, some skepticism as to whether the Fed can emerge from QE without causing significant and persistent inf lation in the U.S. economy. The U.S. has had a zero interest rate policy for a significant period of time and its central bank has tripled the size of its balance sheet. In a normal recovery, the low interest rates would encourage borrowing and the Fed would have little to do besides debate the Fed Funds Rate and monitor the economic recovery. It could then raise rates to keep the economy from overheating as the recovery progressed. But the current jobs picture is different than that of previous recoveries, and it gives the Fed a significant amount of leeway in its easing
2

However, there is a growing belief that something is in fact different this time, that high unemployment is a product of more than just your typical forces.
Twist, can trace its origins to an earlier moment in U.S. history. It was the 1960s, and John F Kennedy was the newly elected president. The economy was in recession, and there was a need to lower interest rates to stimulate the economy. However, the Bretton Woods System of fixed exchange rates virtually nullified the ability of the Federal Reserve to drop interest rates. Why? Well, Europe was doing relatively well in the early 60s and had a higher interest rate on investments than the U.S. This interest rate differential allowed investors to convert the dollar to gold, and transfer the gold to European assets for an arbitrage profit. The Fed needed an outside-the-box solution. It had to address the sputtering economy but could not use the typical stimulus measures without risking a massive outf low of gold. The solution was to keep shortterm interest rates at about the same rate, while lowering the longer term rates. Since arbitragers were primarily concerned with the short-end and businesses and the housing market were primarily concerned with the long end, the economic

doubling the size of its balance sheet with government securities and bank securities. It also pledged to keep interest rates low for an extended period of time. After 5 years of QE, it finally appeared the Japanese economy was escaping the clutches of def lation. The BOJ allowed the assets to run off its books, and the balance sheet began to shrink. And it shrank quickly. This might be the greatest miracle of Japanese QEthat the rapid withdrawal of the excess reserves created by QE from the system did not shock Japan immediately back to def lation, which would not return until 2009. The U.S. housing implosion may well have led to def lation had it not been for Fed intervention. This is likely part of the reason why the Fed is eager to continue easing. It was difficult for Japan to emerge from its def lationary cycle, and the BOJ is still fighting an uphill battle. If the Fed ceased easing now, there is less chance of inf lation Unwinding After a Long Decades Easing than def lation. It is unprecedented for the Fed to make such a It is unlikely the Japanese exit strategy long-term pledge to continue QE. With the size quickly reducing reserves from the system by of the anticipated expansion of its balance sheet selling assetswill be sufficient to shrink the comes the question of how the Fed will soak-up Feds balance sheet. Luckily, the Fed has a the excess reserves it creates to fund its asset host of tools at its disposal. Most likely is the purchases. This is pivotal to the efficacy of the straightforward selling of securities. This, along QE program. If the Fed loses control of inf lation with simply allowing the securities to mature, will or inf lation expectations, it can undermine the shrink the balance sheet. The Fed could also offer entire operation. However, it is not unprecedented for a nation to a higher interest rate on reserves or even term emerge from a bout of QE with its economy intact. deposits, as Ben Bernanke has stated. Although their circumstances differed from the U.S. substantially, Sweden and Japan emerged from their own QE programs relatively unscathed. In the early 90s, Sweden found itself mired in the Nordic banking crisis. To avert financial disaster, the Riksbank began a QE program that doubled its balance sheet. In late 1993, the Riksbank began to allow unsterilized borrowing by banks through its normal liquidity facilities. In early 1997 when the system normalized, the banks repaid the loans and the monetary base shrunk Answering All the Questions back to pre-crisis levels. The wind down was not Will the Fed be able to dodge the specter of devastating to economic growth. Inf lation spiked inf lation and the side-effects to economic somewhat in 1993 as the crisis emerged, but was growth of exiting QE? It is impossible to say, always fairly well anchored. It returned to the but the evidence suggests it can be done. The 2 percent target in 1994 and dipped below zero Fed may commit to QE for too long, missing its in 1996 and 1997. While not perfect, Sweden is opportunity to exit and tighten policy. Tighten an example of a well executed and exited QE too early and the Fed risks def lation and stagnant program (yes, it does exist). employment growth. Tighten too late, and there The Japanese QE began in 2001 and took is the legitimate chance inf lation will pick up a brief pause in 2006 before re-emerging in and run well above the Feds long-term 2 percent response to the Great Recession. The Japanese target. But QE in its various forms has been a experience differs from the Riksbank in that it part of U.S. central banking since the Great was a response to seemingly perpetual def lation, Depression. At least to some extent, there is not an immediate response to a financial evidence that QE worked in the 30s and 60s and meltdown. And it lasted much longer. The Bank that it is working today. The policies to shrink the of Japan undertook an asset purchase program, policy. Structural unemployment is difficult to reduce, which means that the economy will be running well below its full employment level. The current low growth, high unemployment environment, according to economic principles like the Taylor Rule, will ensure inf lation remains low until employment picks up. With QE in force until unemployment falls significantly, we will see just how well the Fed can control inf lation in the face of considerable stimulation. Controlling inf lation during QE3 is important. But so are inf lation expectations. Beliefs about inf lation tomorrow (or in the next 5 years) affect investment and financial decisions today. It is essential that the Fed continues to keep expectations within a narrow window. Otherwise it risks losing the confidence of the market and the public.

Although their circumstances differed from the U.S. substantially, Sweden and Japan emerged from their own QE programs relatively unscathed.

balance sheet are fairly mundane, and the Fed has talked about them openly. Successfully unwinding the balance sheet will be a balancing act, but in the end, it is simply a question of confidence confidence the Fed can unwind its balance sheet, confidence it will not continue easing too long and confidence inf lation will stay low.
Sources: Quantitative Easing: Entrance and Exit Strategies by Alan Blinder. Doubling your Monetary Base and Surviving: Some International Experience by Anderson, Gascon, and Liu. Operation Twist and the Effect of Large-Scale Asset Purchases by Alon and Swanson. The First U.S. Quantitative Easing: The 1930s Richard Anderson. The Impact of Federal Reserve Asset Purchase Programmes: Another Twist Meaning and Zhu

SAMUEL RINES is an a nalyst and Economist at chilton capital m anagEmEnt in houston, tExas. dirEct quEstions or commEnts to: srinEs @chiltoncapital .com ZACH BECK is thE E ditor of chilton currEnts and an opErations spEcialist at chilton capital m anagEmEnt in houston, tExas. for furthEr information on chilton capital m anagEmEnt stratEgiEs and sErvicEs, plEasE contact christophEr l. K napp, cKnapp@chiltoncapital .com for rEprints contact srinEs@chiltoncapital .com www.chiltoncapital .com/currEnts