MNI EXCLUSIVE: Fed's Lack of QE Exit Plan a Looming Challenge

The Federal Reserve is worried an eventual move to pare back its hefty bond-buying program could disrupt financial markets that are priced for perfection, fueling tighter conditions that hamper the recovery, former staffers tell MNI.

"No one at the Fed is really sure how, or if, QE works," Rick Roberts, a former long-time staffer at the Federal Reserve banks of New York and Kansas City, told MNI. "I remain very concerned with the implications of our ongoing asset purchases and eventual taper."

Market disruptions from an eventual tapering could force the Fed to suspend the process, damaging the credibility of its entire exit strategy from extraordinary monetary policies deployed in response to the Covid slump. The Fed is now buying USD120 billion a month of debt.

"I cannot envision a situation where the Fed would continue to taper in the face of adverse market reaction," said Roberts.

Unlike the response to the Great Recession, when QE was first deployed in force, the latest round of purchases has not been accompanied by extensive studies on the nature and transmission of its effects -- despite taking the balance sheet to a record and still-rising USD7.7 trillion.

NO GOOD MODEL

"They don't really have a good model of how QE and forward guidance can deal with the transition" towards a tighter policy environment, said Michael Bordo, a former Fed advisor who was a visiting scholar at the Fed board and three regional Fed banks.

The core of the Federal Open Market Committee including Chair Jerome Powell has been open about the reduced effectiveness of monetary policy with interest rates around extremely low levels.

Powell has not entertained any talk of a QE taper for fear of triggering another "tantrum" like the credit-tightening episode that took place in 2013. Over the weekend Powell told "60 Minutes" the economy is now at an inflection point, suggesting the time for a debate on slowing QE may not be so very distant.

Officials hope the economy will be humming along later this year so that bond investors take any slowdown of Fed purchases in stride.

WAITING TOO LONG?

However, a recent spike in the 10-year Treasury yield to 1.7% certainly caught the central bank's eye, particularly with stock markets reacting negatively.

"I can't see them pushing the panic button now because rates are up to 1.7%," Bordo said. "I don't know what number would get them to really pay attention. If they go above 2% that imposes a threat to the Treasury's issuance plans -- that is an issue."

Bordo said the Fed's efforts at forward guidance after the Great Recession were unsuccessful because they required ongoing updates that damaged Fed credibility.

"The worry some of us have is that if the Fed continues to be sanguine in the next year and they do follow through on their plan of not doing anything until 2023 -- that could be the trigger for an overshoot in inflation which could trigger an un-anchoring of inflation expectations," said Bordo.

STOCK VS. FLOW

Joshua Downey, a member of the Fed's Community Advisory Council, will keep stressing the economy remains well short of full employment despite last month's gain of almost 1 million jobs.

Even another two or three reports of job strength won't be enough to merit "putting on the brakes," Downey said in an interview. "We'll be there to tell them that now is not the time."

Richmond Fed Research Director Kartik Athreya told MNI during a webinar this month that any reduction in the pace of bond buying won't constitute monetary tightening, but instead simply a slower pace of easing.

The exit strategy is even trickier because of the lack of consensus on whether QE works as effectively when a central bank targets a total stock of debt or when it's actively setting a pace for new purchases, sources told MNI.

"While the Fed professes the importance of QE flows, it concurrently clings to the importance of QE stock as a potential market-calming wildcard," said Roberts.