Something that's been puzzling me for some time has been how, or even whether, the Federal Reserve was going to reverse quantitative easing. And we seem now to be getting the news about how they are going to do it. The answer is slowly. Which seems fair enough really: I certainly didn't expect them to dump $3 trillion of Treasuries on the markets one fine Monday morning as an alternative. However, the explanation of how they're intending to do it also shows what I'd missed in my earlier musings on this. For while the Fed says that it has stopped QE, stopped the expansion of its balance sheet, it's still actually buying bonds. For some of the bonds on its balance sheet mature and it replaces those that do. So, while they're not currently increasing the size of QE they are maintaining it by topping up for matured bonds. And that then explains how they're thinking about how they will shrink the balance sheet back down again. They can simply reduce the replacement rate of those maturing bonds in their stock. This does seem sensible :
The Federal Reserve is sketching out plans to prevent an abrupt contraction in its massive balance sheet next year, when some $500 billion in bonds expire and risk disrupting markets and the U.S. economic recovery.
Though it ended a stimulative asset-purchase program last October, the Fed is still buying mortgage and Treasury bonds to replenish its $4.5-trillion portfolio as holdings mature. The central bank has said it will keep reinvesting until some time after it begins raising interest rates later this year.
Asked publicly and privately about the longer-term strategy, Fed policymakers say they are in no rush to shrink the portfolio, suggesting they will seek to avoid a "cliff" - a disruptive end to reinvestments that might come if bonds are simply allowed to run off through maturity or prepayment.
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The central bank can always sell bonds, but it said in September it will rely primarily on run-off to reduce holdings in a "gradual and predictable manner."
OK, that solves the puzzle for me. I had been wondering whether they would "reverse" QE before they raised rates. On the grounds that the bonds will fall in value as rates rise, so you'd think they'd want to sell them before they do raise rates. However, if they're going to hold them all to maturity this doesn't matter: there will be no loss from selling them before that maturity date.
Then there's the next step. They want to run off that holding rather more slowly than those bonds will mature. So, they will keep buying bonds but at some point will buy fewer than are maturing. That gradually shrinks the size of the balance sheet. This also gives them a much finer level of control over the money supply doing it this way.
All in all it looks like a very good way of doing it. And it also finally answers one of those major public policy questions. Not so much for the US but over here in the UK people have been saying that the QE debt doesn't really exist. The Bank of England owns the Treasury's debt, they're both bits of government so why not just cancel it all? Assuming the BoE is going to do the same as the Fed (a pretty safe assumption I would say) they're not in fact going to do that. So, the debt is real, is part of the national debt and we have not just miraculously cut 50% of that national debt by the simple expedient of just never paying it.
