- Much ballyhoo has been made about the Fed’s recent intervention in the repo market. If these actions indeed signalled a return to QE as some have alleged, this would represent a dramatic change of course and redefine the current market narrative.
- Yet, although the Fed’s repo interventions did increase its balance sheet and triggered effects similar to QE, many features of the program distinguish it from a traditional QE program. Scale, type of operation, trigger and motivation all differ. Concluding that the Fed has made a dramatic U-turn in policy would thus be a mis-interpretation.
- Nevertheless, the two policies intersect: quantitative tightening implies a decline in bank reserves and lower bank reserves in turn have played a part in the recent funding squeeze. The repo operations thus compensate for some of the effects of QT.
Update: On March 9, the Fed announced an increase in repo operations beyond the original amounts offered. This came in response to possible health crisis the spread of the Coronavirus in the US and the dramatic oil price plunge induced by Saudi Arabia. However, the earlier point stands: this is not QE, but an attempt to manage liquidity in the financial system.
The Fed recently announced that it would begin to scale back its interventions in the repo market which many had dubbed a form of Quantitative Easing (QE), if only by stealth. The Fed is set to reduce the amount of cash lent overnight (from $120 bn to $100 bn) and limit the amount of two-week loans to $25 bn (from $30 bn). Yet, more importantly, it did not announce that it would alter its purchase of short-dated Treasury Bills, currently accumulating at a pace $60 per month. As a result, its balance sheet is set to expand further, all else being equal.
This represents a departure from the earlier policy of balance sheet reduction, which had kept the Fed on “auto-pilot” while it pivoted from hiking rates to easing them. For some 20 months, the Fed had let assets roll off its balance sheet, which shrank by $738 bn (16%) from its $4.5 trn peak to the recent trough at end-August 2019. Since then, the balance sheet has increased again, albeit by a smaller $392 bn, a 10% expansion (at the same time, the Fed cut interest rates by 75bps in 2019, reversing part of its previous 225bps of rate ‘normalization’).
Whether this operation qualifies as QE is more than mere semantics. More than ever, financial markets have become accustomed to central bank support and a renewed period of quantitative easing would represent a significant deviation from recent policy that could affect the market narrative dramatically.
The short answer is that the recent T-Bill purchases are not a restart of QE. Chairman Powell made this clear when he announced: “I want to emphasise that growth of our balance sheet for reserve management purposes should in no way be confused with the large-scale asset purchase (LSAP) programmes that we deployed after the financial crisis”. It can of course, somewhat simplistically, be argued that any increase of the Fed’s balance sheet represents some form of quantitative easing. But if that were the case one would have to accept that the Fed has been engaged in QE ever since its creation. Instead, sales and purchases of short term government securities are quintessential components of the Fed’s monetary operations, through which it steers the interest rate to the desired range. More importantly, the recent operations have as their departure point a very different set of circumstances and objectives than those that triggered QE.
The decision to launch QE in 2008 took place amidst a deep sense of crisis, following the Lehman Brothers bank collapse, the realisation that the Fed had attained the “zero interest rate bound” and that it might face a liquidity trap. The intention was specifically to influence the long end of the yield curve (to trigger credit- and portfolio balance effects) and to expand the money supply. More generally, QE aimed to reflate and stimulate the economy.
By contrast, the Fed took action in September 2019 to ensure the smooth functioning of the financial system. The actions were intended to be small in scale and short-lived. Specifically, the Fed responded to a cash shortage in the system that had led to a spike in the repo rate to over 10%. These developments were understood to be the result of the concurrence of the Fed’s prior balance sheet reduction (and consequent decline in bank reserves) and the effects of structural (regulatory) changes.
To appreciate the importance of repo markets consider that one of their prime purposes is to redistribute liquidity between financial institutions (not just banks but also money market funds, insurance companies, asset managers etc). With a daily turnover of $1 trn, repo markets have experienced significant changes in the recent past. As the Fed started to wind down its balance sheet from October 2017, bank reserves began to decline (as intended). At the same time, banks started to accumulate US Treasuries again (nearly tripling their holdings between 2013 and 2019, see chart).
The large issuance of US Treasuries (thanks to a federal deficit rising to $1 trn) then forced repo rates above the IOER (interest on excess reserves) and in turn the US banking system turned from a net provider of collateral to a net provider of funds to the repo market (according to a recent BIS paper). Yet, swings in the US Treasury account held at the Federal Reserve have drained and swung bank reserves with greater amplitude and are said to have reduced the banks’ ability and willingness to lend into the repo market. Against this backdrop, three developments clashed head-on in September: 1) regulation had increased requirements for liquid assets, 2) companies faced a sudden rise in cash needs to settle their quarterly tax payments and 3) large-scale US Treasury purchases had to be settled after Congress had lifted the ceiling on public debt and the US Treasury quickly rebuilt its depleted cash balance via debt sales (see chart). This triggered a funding squeeze in the repo market and the consequent spike in the repo rate.
The Bottom Line
Changes in the size of the Fed’s balances are a common effect of different causes. The test for whether a central bank operation meets the definition of QE is not whether it involves direct buying of US Treasury bills, notes or bonds. Almost every monetary operation involves interventions using varying quantities of securities. Conversely, QE could be conducted purchasing entirely different securities such as equities or ETFs. Further similarities between the two types of operations include the expansion of liquidity, the easing of funding pressures and the reduction of systemic risks. Even asset price implications were similar in the short run: risky assets rallied, long-term government yields declined and gold rose. With so much in common, it is critical to know what the key differences are. Here is a simply checklist for a quick assessment:
- Scale: The scale of interventions needs to be large enough to be able to trigger a macroeconomic effect. In the first instance that is through market rates, in the second through a broader impact on sentiment and activity.
- Instruments: The choice of instrument is not a distinctive factor. But it is perhaps telling that Fed QE first consisted in the purchase of mortgage-backed securities (MBS) from commercial banks and later in long-dated US Treasuries. In contrast, the September market intervention began with offers of overnight cash in the repo market, which was later extended to a one-month period. Only when it sought to find a more enduring solution to the cash crunch did the Fed decide to buy short-dated Treasuries.
- Type of Operation – Purchases vs Lending: A long enough holding period of purchases is required in order to convince market participants that the intervention is not temporary, whose effects will disappear in the near term. Many central bank operations (such as the ECB’s LTROs) involve lending and borrowing rather than outright purchases, which is a crucial distinction. However, by purchasing only short term instruments in this case, the Fed is making it clear that it does not intend its intervention to be for the long term (although it purchases securities, they roll off quickly).
- Trigger and Objective: The three rounds of QE the Fed undertook in the wake of the Great Financial Crisis were motivated by the destabilising effect the crisis had on the economy and the financial system. By contrast, its recent purchases were triggered by a spike in the overnight repo rate as a result of cash shortage in the banking system, part of which was due to regulatory change. The aim was to safeguard the proper functioning of the financial system, which had encountered a temporary liquidity issue, rather than a broader macroeconomic objective.
The Fed’s recent actions were thus part of its reserve management and not a relaunch of QE. Its repo market interventions nevertheless represent a meaningful monetary operation and there is of course an area in which the two policies intersect: quantitative tightening (QT) implies a decline in bank reserves and lower bank reserves in turn have played a part in the recent funding squeeze. In that sense, the recent repo market operations act as a remedy to some of the effects of QT.