QE Unwind Is Too Slow, Says Fed Governor, Thus Launching First Trial Balloon

by Wolf Richter, Wolf Street:

“The very slow pace may still be contributing to a buildup of various financial imbalances.”

So we have the first Fed Governor and member of the policy-setting FOMC who came out and said that the QE Unwind that began last October with baby steps isn’t fast enough. And because it’s so slow it may actually contribute to, rather than lower, the “financial imbalances.”

In her speech, Kansas City Fed President Esther George pointed at the growth of the economy, the tightness in the labor market, the additional support the economy will get from consumers and companies as they spend or invest the tax cuts, etc., etc. And despite this growth, “the stance of monetary policy remains quite accommodative,” she said.

She cited the federal funds rate – the overnight interest rate the Fed targets. The Fed’s current target range is 1.25% to 1.50%, which is “well below estimates of its longer-run value of around 3%,” she said.

The Fed would have to raise rates at least six more times of 25 basis points each, for a total of at least 1.5 percentage points, to bring the federal funds rate to around 3% and get back to neutral. If the Fed wanted to actually tighten after that, it would have to raise rates further. So far, so good.

And then came her concerns about the Fed’s balance sheet.

Under QE, the Fed acquired $1.7 trillion in Treasury securities and $1.78 trillion in mortgage-backed securities, for a total of about $3.5 trillion. After QE ended in October 2014, the Fed then maintained the levels by replacing maturing securities.

But in October last year, it commenced the QE-Unwind and started to not replace some maturing securities. This has the effect of shrinking its balance sheet. Just like the Fed “tapered” QE by phasing it out over the course of a year, it is also ramping up the QE-Unwind over the course of a year.

But the pace of the QE-Unwind has been too slow, according to George – and this may be destabilizing the financial markets:

By the end of this year, however, only about a quarter of the increase to the Fed’s balance sheet resulting from the first round of large scale asset purchases will be unwound.

These holdings of longer-term assets were intended to put downward pressure on longer term interest rates. Many investors responded, as would be expected, by purchasing riskier assets in a reach for higher yield. As a result, asset prices may have become distorted relative to the economic fundamentals.

The reference to “distorted” asset prices is the same verse we’ve heard from other Fed governors: Asset prices have become inflated. Since assets are leveraged, they have become a risk to financial stability. Then she adds:

The very slow pace of our balance sheet normalization may still be contributing to a buildup of various financial imbalances.

In other words, because the QE Unwind is so slow, it doesn’t really work as an unwind but continues to inflate asset prices, which would be the opposite of what the Fed wants to accomplish:

While until recently, financial markets remained remarkably stable, it is not uncommon to see volatility rise when asset prices become inflated and investors struggle to find a new equilibrium.

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