Quantitative tightening: Can trillions of dollars be taken out of the US economy without anyone getting hurt?

Quantitative tightening: Can trillions of dollars be taken out of the US economy without anyone getting hurt?

Quantitative tightening: Can trillions of dollars be taken out of the US economy without anyone getting hurt?

Updated 24 September 2017, 20:40 AEST

Conjuring up the trillions of dollars pumped into the US economy and markets was the easy bit.

So the world didn't spin off its axis and global markets didn't melt down as the US Federal Reserve announced it would start winding back its multi-trillion-dollar experiment in monetary policy.

Even the slightly more hawkish than expected tone from chair Janet Yellen and the firming of another rate hike before Christmas did little if any damage, bar knocking Wall Street down a few points from its record high.

Learning a lesson from former chair Ben Bernanke's misstep that inspired the "Taper Tantrum" in 2013, the market was well and truly softened up this time.

Back in June, the Fed presaged how it would extricate itself from the revolution in monetary policy called Quantitative Easing (QE).

So has QE worked and what impact will decommissioning it — Quantitative Tightening — have?

Briefly, the answer to the first part of the question will not be known until answers to the second part are tabled.

So what was QE?

Back in 2008, the GFC — or the Great Recession as it is known in the US — was causing havoc and the Fed had run out of traditional monetary firepower having cut interest rates to zero with little or no effect.

In desperation, the plan was to conjure money out of thin air to buy mortgage backed securities (MBS) — the toxic sort of stuff that ignited the GFC in the first place — and treasury bonds to drive down long-term interest rates.

The idea was cheap credit would get business back on its feet and save the day. Tidying up the excesses of the money printing party would come at a later date.

That is where the Fed is now.

And it is quite a job to tidy everything up.

The printing presses were effectively turned off in October 2014. But before that three waves of QE, plus the allied Operation Twist, created $US3.5 trillion.

Pretty well all of that debt binge is still sitting on the Fed's $US4.5 trillion balance sheet, while the new money it released is still sloshing around the economy.

What happened?

When QE1 was rolled out the US was mired in recession. It took a few quarters, but the economy did return to growth.

It suffered a couple more negative quarters — most recently in early 2014 — and a couple of near misses, but undeniably the economy is growing again.

The GDP numbers out later this week are expected to show year-on-year growth at around 3 per cent in the March quarter, although 2 per cent appears to be around the current longer term trend.

The impact on employment has been striking, taking the jobless rate down from a 16 year high to almost 4 per cent.

Given maximising employment is one of the Fed's mandates, it can point to jobs growth as one of the successes of its QE regime.

Another part of the Fed's mandate — stabilising prices — has not been so successful. In fact, it has been driving the Fed nuts.

The Fed like most of the key central banks has an inflation target. In the US it is 2 per cent, the RBA gives itself a degree of latitude of 2-to-3 per cent.

Even after pouring trillions into the economy and pumping up asset prices, such as the share market, inflation remains stubbornly low.

The inflation conundrum is particularly evident in the weak wages growth that has not recovered since the Great Recession.

Despite strong job creation, wage growth is half pre-GFC levels.

That result is central to the current debate about inequality and how the recovery has left behind the hardest hit by the excesses of financial engineers and the big banks.

Those investing in the stock market have been the big winners out of the waves of QE and Operation Twist.

The key index, the S&P500, has almost quadrupled since early 2009.

The easy money has driven the second longest bull run in US history as investors piled in looking for yield that the Fed had killed off in the bond market.

The low interest rates had another consequence of allowing companies to buy back swathes of the shares with cheap debt underwritten by the Fed, driving the market ever higher and the inequality gap wider.

So what is Quantitative Tightening?

The huge bull run is central to what could go wrong when Quantitative Tightening kicks in next month.

Basically the Fed plans to destroy a large part of the debt it has built up on its balance sheet by not rolling it over as it matures.

It just disappears into the rarefied financial air where it was created. Magic.

It starts modestly enough with $US6 billion in treasury bonds and $US4 billion in mortgage backed securities a month.

By the end of 2018 that will hit $US50 billion a month, or $US600 billion year.

At that pace, it should take three years to make half of the $US3.6 trillion it conjured up, simply disappear.

But just at QE inflated the market rapidly, it doesn't take much imagination to see what reversing it through QT could do.

It may well be half the money, but it is in half time as well.

Is it a bubble and could burst?

The bears out there say yes.

So far the markets reaction has been muted.

But once QT gets rolling it will gain an almost unstoppable momentum. Only another meltdown is likely to halt it.

Not only will liquidity start drying up, it will be at a time when the Fed is attempting to get interest rates back to something approaching normal.

It has already started conventional tightening, with four hikes since late 2015. The December meeting should see a fifth.

It is a delicate job.

The Fed needs to build up its conventional interest rate buffer to prepare for the next down-turn, but without triggering a new one.

So far that process has seen a few wobbles, but nothing drastic.

Importantly, it hasn't put a brake on either the economy or job creation.

The biggest question is whether QE pushed the US economy up to a self-sustaining speed where it won't fall over again.

In other words did QE work its magic, or was it just all a dangerous and calamitously expensive conjuring trick?

QT is about to provide the answer.

This week

Futures trading points to a modestly positive start to the week despite Wall Street's flat finish.

There are few top shelf items in the calendar. A couple of AGM's including one at AGL and herbicide maker, Nufarm trots out full year results.

The market will be looking at private sector credit (Friday) to see whether business lending is picking up as property lending cools.

Overseas, there is a blanket bombing of speeches from Fed and ECB officials. That doesn't necessarily lead to clarity though.

Commodities are likely to be where a fair bit of interest will centre.

Iron ore had a shocker last week. Spot prices sank another 4 per cent on Friday, bringing the weekly loss to 12 per cent.

It was the fourth straight week of losses and with Chinese demand on the wane and tougher air pollution controls starting in November, it is hard to see where a change in sentiment will come from.

Oil on the other hand, finished strongly, with the global benchmark Brent crude up 0.6 per cent to $56.41 a barrel.

Oil has risen more than 10 per cent in the past three weeks as evidence of the production cut deal between OPEC and Russia is holding.

There were words of caution out of the OPEC meeting in Vienna on Friday pointing to Libya and Nigeria — two troubled producers exempt from the deal — rapidly expanding their pumping, keeping a lid on price rises and slowing the removal of the glut.

Australia

Date Event Forecast

Monday

25/9/2017

Tuesday

26/9/2017

RBA speech Assistant governor Michele Bullock speaks on "Where to now?"
ASX AGM Should sail through, unlikely to be any update on the departure of former CEO Elmer Funke-Kuper
Nufarm FY result Underlying profit of $420m forecast for the big herbicide maker

Wednesday

27/9/2017

AGL AGM Should be more interesting than usual for the company in the eye of the energy price storm
Population data Q1: Should show population growth fairly solid at around 1.6pc YoY

Thursday

28/9/2017

Job vacancies Aug: The labour market remains strong
RBA speech Deputy governor Guy Debelle in London

Friday

29/9/2017

Private sector credit Aug: Holding at around 5pc growth. Hopefully business lending will pick up.

Overseas

Date Event Forecast

Monday

25/9/2017

EU: ECB speech ECB president Mario Draghi speaks in Brussels

Tuesday

26/9/2017

US: House prices CoreLogic CaseShiller series. 20 city index up around 6pc YoY
US: Consumer confidence Sep: Still solid, but may ease back.

Wednesday

27/9/2017

CH: Industrial profits Aug: Going OK
US: Pending home sales Aug: Slowing

Thursday

28/9/2017

US: GDP Q2: Final reading, expected to be 3.1pc YoY
NZ: RBNZ rates No change

Friday

29/9/2017

JP: Inflation Aug: Still below 1pc YoY
CH: Caixin PMI Sep: Manufacturing shows signs of softening again. Official PMI out on Saturday