MI Summit 2013 - London: Quantitative Exiting: The Road Ahead for Monetary Policy

Scale of Central Bank Intervention:

• The Federal Reserve's balance sheet expanded from $800 billion at the Lehman Brothers collapse to $3.7 trillion.
• Total balance sheet expansion across major central banks over the last 5–6 years is estimated at approximately $10 trillion, moving assets from the private to the public sector.

Limits to Balance Sheet Expansion:

• Spencer Dale (BoE): Identifies "democratic legitimacy" and credibility as the primary binding constraints rather than specific GDP percentage thresholds.
• Brian Sack (De Shaw/NY Fed): Views the limit as a cost-benefit calculus balancing uncertain benefits against risks to market function, exit complications, fiscal implications (P&L), and financial stability.
• Jason Cummins (Brevin Howard): Argues that while QE has uncertain effects on real economic activity, it remains the most potent tool for signaling commitment to low rates.

Forward Guidance vs. Asset Purchases (QE):

• Fed Strategy Shift: The September decision to delay tapering signaled a "dovish reaction function" where the Fed prioritized capping interest rates and promoting growth over adhering to a pre-announced exit timeline.
• Market Reaction: The surprise announcement of an additional three months of QE triggered a 1.5% rise in equities, a 15 bps drop in the 10-year yield, and a 40 bps drop in forward rate expectations.
• Jason Cummins: Contends the market reaction reflected a re-evaluation of the Fed's reaction function (becoming more dovish) rather than the literal $100 billion asset purchase volume.
• Spencer Dale: Defines forward guidance as a "one-off" explanation of the reaction function, while QE remains a "scalable" tool for adding stimulus if the guidance proves insufficient.
• Laurence Boone (ECB): Notes that ECB forward guidance had negligible impact on yield curves due to market anxiety over liquidity, ambiguity regarding inflation targets (1% vs 2%), and the complexity of 17-country yield differentials.

Central Bank Specific Strategies:

• Federal Reserve: Relies on a 6.5% unemployment threshold as a hard commitment for liftoff, followed by a forecasted gradual tightening cycle lasting into 2019.
• Bank of England: Explicitly states it will sell gilts back to the market once rates normalize to avoid holding 40% of government debt, deeming continued ownership politically indefensible.
• ECB: Currently maintains the largest central bank balance sheet without QE, using Long-Term Refinancing Operations (LTROs) which are set to decline by Q1 2014 pending asset quality reviews.
• ECB Constraints: Cannot conduct large-scale sovereign QE until the asset quality review is complete in Q1 2014, as it lacks transparency on banks' balance sheets.

Outlook on Exiting and Inflation:

• Inflation Risk: Panelists generally agree that a high monetary base will not lead to price inflation, as the Fed can control financial conditions via short-term interest rates and the new reverse repo facility.
• Fed Exit Mechanism: The Fed plans to maintain a large balance sheet until at least 2020, utilizing interest on reserves and the reverse repo facility to manage liquidity and tighten financial conditions without necessarily selling assets.
• Spencer Dale: Emphasizes that selling gilts is necessary for long-term central bank credibility, even if it risks short-term yield spikes.
• Brian Sack: Views the reverse repo facility as a potential future target variable, replacing the federal funds rate target for controlling overnight risk-free rates.
• Financial Stability Trade-off: Jason Cummins suggests central banks have entered a "Faustian bargain," accepting the risk of asset market bubbles and "reach for yield" to achieve macroeconomic stability.

Forecast Accuracy and Credibility:

• GDP Forecasts: The Fed and other US institutions have persistently overestimated potential GDP growth (forecasting ~3% vs actuals closer to 2%).
• Unemployment Forecasts: Conversely, unemployment forecasts have remained relatively accurate, suggesting the gap between GDP and employment forecasts indicates lower potential growth than previously believed.
• Political Economy: Spencer Dale argues that political constraints (the indefensibility of holding 40% of sovereign debt) provide the necessary credibility to commit to future asset sales, countering the view that markets only trust "action" over "talk."