The Federal Reserve announced that it would pursue a program of quantitative easing in November 2008, which is widely credited with stopping the Great Recession in its tracks. It is also credited with:
- Inflating the values of financial assets
- Suppressing financial market volatility
- Exacerbating inequality
In September, the Federal Reserve is expected to begin to reverse the process of quantitative easing, whereas interest payments and principal from maturing securities will no longer be reinvested in the bond market. This is known colloquially as "balance sheet reduction," because as the bonds and MBS mature, the asset side of the Fed's balance sheet will shrink. The whole process is expected to take a really long time, and it is intended not to cause any economic disruption.
You have to wonder, though--if balance sheet reduction is essentially quantitative easing in reverse, then isn't it possible that it could potentially deflate the values of financial assets and increase market volatility? We don't actually know how markets will behave when the Fed stops reinvesting the proceeds of its portfolio of securities, but no matter how hard the Fed tries, it could end up being very disruptive to markets.
Market participants have been complaining angrily about the lack of volatility--both realized volatility, and implied volatility, as measured by options prices. If you simply look at the levels of the VIX, this has been the quietest market in history. People have a tendency to overthink things when it comes to the markets, but don't you think it's possible that volatility could rise--significantly--as the process of quantitative easing goes into reverse?
Some would argue that if that were the case, then it would have already started to happen. Balance sheet reduction was announced months ago, and its effects would have already been priced in. It's true that the effects of quantitative easing were priced in almost immediately--the biggest day the treasury bond market had was the day that QE was announced. One would expect that yields would have risen when balance sheet reduction was announced; they haven't.
One possibility is that the market doesn't believe that the Fed will actually go through with it. Also likely--if the Fed begins balance sheet reduction and meets resistance from the markets, they will probably stop. That would have some pretty profound consequences, because it would mean that the Fed's balance sheet is essentially permanent, along with the increase in the money supply. The thing about QE is that it was always believed to be reversible. If it's not, that has huge inflationary consequences.
There is a lot of confidence in the Fed's ability to pull this off, which is shocking, because the Fed has only managed a handful of rate hikes in the last two years. To say that the Fed's efforts at tightening monetary policy have been cautious would be an understatement. Arguably, balance sheet reduction has a much bigger impact than any single rate hike. It's certainly the most ambitious policy tightening they've tried in a really long time.
The potential for a financial accident is pretty high, amidst a lot of risk-seeking behavior. This is probably one of those times where you should be fearful when others are greedy.
