As Fed’s QE Dismantling Begins, Questions Around Growth, Asset Prices Linger

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The U.S. Federal Reserve has announced the October start of the slow reversal in the unprecedented expansion of its balance sheet following the 2008 Global Financial Crisis. Chairwoman Janet Yellen declared the Fed’s asset purchases, commonly known as “quantitative easing” (QE), successful in “stimulating a faster recovery than we otherwise would have had.”

That’s debatable. QE no doubt kept the economy from falling off a cliff after the crisis broke. But critics point out that the 1.6% average yearly growth since the recovery began is historically sluggish. And after expanding its balance sheet to $4.5 trillion from less than $900 billion, the liquidity generated has reflated asset prices to levels that fundamentals may be hard pressed to justify, leaving markets vulnerable to destabilizing pullbacks.

Fed officials—not to mention their peers at other major central banks—seem increasingly sensitive to that danger. Signs are growing that they are factoring to a greater degree the potential impact of their policies on financial market stability. In any case, QE’s unwind should in time reduce its market distortions and allow for risk to be priced more appropriately.

QE and ground-level interest rates have no doubt helped push unemployment to less than longer-run targeted levels. As joblessness fell, the Fed gained sufficient confidence to halt its buying binge in 2014 and start raising its key interest rate in late 2015. Following that first post-crisis hike, the Federal Open Markets Committee (FOMC), the Fed’s monetary policy panel, raised the Federal funds rate another 25 basis points last December and so far this year lifted it two more times, each by the same amount. Although policy makers kept it at 1% to 1.25% at their Sept. 20 meeting, they signaled in their “dot plot” assessments of future rate levels that another quarter-point hike is likely this year. The rate futures market is aligning with that expectation, pricing in a 71% probability of a quarter-point hike this December.

That’s still very accommodative by historical standards. If economic growth hasn’t taken off to the degree expected by the Fed in recent years, neither have the predictions of Fed critics that inflation would come roaring back. To the contrary, the Fed’s preferred Personal Consumption Expenditures Index, excluding food and energy, hasn’t hit the 2% target in more than five years, and sagged to 1.4% in July from 1.9% in January (Chart 1). That has made Yellen’s repeated characterization of weak inflation reports as “transitory” feel stretched, especially as some Fed officials publically question whether low inflation is a cyclical or structural challenge. But a consensus-beating headline August Consumer Price Index (CPI) of 1.9% annual growth no doubt bolstered FOMC members to vote unanimously on the latest rate decision and balance sheet reduction plan, which lets $10 billion a month roll off over the fourth quarter, rising each subsequent quarter until it reaches $50 billion per month after a year.

CHART 1: CORE PCE COMING UP SHORT 9/30/2011 - 7/31/2017

Source: FactSet

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