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Get Ready for Quantitative Tightening

by Jim Rickards, DailyReckoning:

Despite yesterday’s market sell-off, the Fed is still on track to raise interest rates in June. Wednesday’s action is no more than a speed bump for the Fed. It will not stop the Fed from moving forward with another 0.25% rate increase.

The Fed is embarking on a new path, a path that started several years with QE (quantitative easing).

QE is the name for the method the Fed uses to ease monetary conditions when interest rates are already zero. Conventional monetary policy calls for interest rate cuts to stimulate growth and inflate asset prices when the economy is in a recession.

What does a central bank do when interest rates are already at zero and you can’t cut them anymore?

One solution is negative interest rates, although the evidence from Japan and Europe indicates that negative rates do not have the same effect as rate cuts from positive levels.

The second solution is to print money!

The Fed does this by buying bonds from the big banks. The banks deliver the bonds to the Fed, and the Fed pays for them with money from thin air. The popular name for this is quantitative easing, or QE, although the Fed’s technical name is long-term asset purchases.

The Fed did QE in three rounds from 2008 to 2013. They gradually tapered new purchases down to zero by 2014. Since then, the Fed has been stuck with $4.5 trillion of bonds that it bought with the printed money.

When the bonds mature, the Fed buys new ones to maintain the size of its balance sheet. But now the Fed wants to “normalize” its balance sheet and get back down to about $2 trillion. They could just sell the bonds, but that would destroy the bond market.

Instead, the Fed will let the old bonds mature, and not buy new ones. That way the money just disappears and the balance sheet shrinks. The new name for this is “quantitative tightening,” or QT.

You’ll be hearing a lot about QT in the months ahead.

QT is now replacing quantitative tightening. The Fed wants to start shrinking its balance sheet by letting the bonds mature, receiving the cash and not reinvesting. That way the balance sheet shrinks and the money just disappears, as I described.

Essentially, the Fed is putting QE in reverse. This is part of the Fed’s effort to get interest rates and its balance sheet back to normal in the aftermath of the 2008 financial crisis. Right now, the Fed’s target interest rate for fed funds (the so-called “policy rate”) is 1%. The Fed’s balance sheet is at about $4.5 trillion, as stated.

Using the Taylor Rule and the pre-crisis trend line, a normal Fed at this stage of an expansion would probably have interest rates at about 2.5% and a balance sheet of $2 trillion. The Taylor Rule is a formula suggesting how the central banks should alter interest rates in response to changes in economic conditions.

Created by economist John Taylor, it’s designed to adjust short-term interest rates to stabilize the economy, while still allowing long-term growth and inflation goals.

Basically, it suggests a fairly high interest rate when inflation rises above the target or under conditions of full employment level. Conversely, the Taylor Rule suggests a fairly low interest rate when the opposite conditions prevail.

As you probably know, the Fed is far from normal today. Interest rates are on track to hit 2.5% by late 2018. The balance sheet might hit $2 trillion by 2020. We’re still a few years away from normal. Meanwhile the current economic expansion is eight years old next month, one of the longest in history.

Here’s the problem. The Fed spent eight years telling us that QE would “stimulate” the economy, create a “wealth effect,” and save us from depression.

Now they’ll want to say that QT is no big deal and not affect the economy at all. For example, Bill Dudley, President of the Federal Reserve Bank of New York, believes that QT can be done gradually and can “run in the background” without disrupting markets.

Read More @ DailyReckoning.com

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