All right, according to Menta "we are all turning Japanese". Is QE-exit: mission (im)possible?
"Tapering” has become The Word recently around the Fed and the quantitative easing (QE). I suppose not everyone knows/remembers that there was QE before the Fed, and it was Japan to launch it first just after the dot-com bubble burst. More importantly, not only did Bank of Japan (BoJ) enter QE; it also managed the QE-exit, which is about time to revisit.
Japan’s QE 1 started in 2001, and ended in 2006, and effectively was base money - bank reserve – targeting. The result of the policy can be summarized with the base money, excess liquidity or just simple BoJ balance sheet picture, which we often look at for other central banks today (Figure 1).
Figure 1. BoJ QE 2001-2006
Did Japan’s QE 1 help Japan? There are many criticizing the QEs in general, the good thing the QE did in Japan was facilitate/buy some time for the adjustments in the corporate and banking sector. Whether it helped the economy or not in aggregate – God knows (we don’t have an alternative history to compare it to). Most of research on Japan’s first QE finds limited positive effect, if any (see, e.g. Fed, IMF papers). What we, simple mortals, know is only that Japan experienced its strongest period during 2002-2007 since tits own bubble burst in early 90s; was on its way out of deflation, corporates started borrowing again (Figure 2)….and Japan would have looked much better by now, were it not for the global financial turmoil which already in 2007 sucked the JPY in the carry-unwind spiral.
Figure 2. Japan – corporate borrowing
But coming back to tapering. Given Japan did exit the QE, what where the market effects? A little “event” investigation suggests it went rather smoothly without introducing much volatility in the markets. The money market got revived. As regards the effects on the currency, the JPY strengthened around 8% vs USD in the middle of the unwinding ocess (Figure 3). The Asian currencies depreciated vs JPY too (Figure 4). But the effect was temporary: soon after they recovered and kept on gaining vs JPY (until the music stopped). As regards the interest rates, the Japanese government 10Y yield rose a bit less than 50bps, but then dropped again even before the BoJ was done draining excess reserves. Conclusion? It’s possible to formally exit from the QE without shaking the markets permanently.
Figure 3. Japan QE exit – FX and yields
Figure 4. Japan QE exit – Asian FX
BUT.
The history rhymes – it does not repeat. And this time around we are talking about the US Fed’s upcoming tapering/exit. And thus we are talking about the liquidity of the USD, the currency which takes 62% of world’s FX reserves, according to IMF, in contrast to the Japanese yen with just a tiny 4% share. And while the BoJ’s balance sheet rose “only” 40% during 2001-2006, Fed’s balance sheet has exploded by 280% from 2008. It makes things much trickier for the Fed than for the BoJ back in the days.
And now comes the final catch. Even though BoJ did exit the QE/ “excess liquidity” regime in 2006, they did it via the money market (stopped buying and let the government bills mature). And yet they held on to long term government bonds and even bought more (…happily ever after). Here is an excerpt from the Monetary Policy Meeting statement of 9 March 2006 when the QE-exit was announced:
“The outstanding balance of current accounts at the Bank of Japan will be reduced towards a level in line with required reserves. … the reduction in current account balance is expected to be carried out over a period of a few months, taking full account of conditions in the short-term money market. The process will be managed through short-term money market operations. With respect to the outright purchases of long-term interest-bearing Japanese government bonds, purchases will continue at the current amounts and frequency for some time.” ….“for some time” (2008), “for an extended period” (2009), “at least through mid-2013” (2011), “…late 2014?, “…mid-2015? (2012). Sounds familiar? That’s the Fed from 2008 to date (even though words refer to the fed funds rates, but implication the same). What is Fed? Elephant in a porcelain shop. Could they go the Japanese way – passively let bonds mature? These were Bernanke’s words in the testimony to Senate in late February: “We could exit without ever selling by letting it run off” . Given the composition of Fed Treasury holdings by maturity…that would take some years.
Figure 5. US Fed Treasury holdings by maturity
Overlay it with the fiscal challenges for the coming decade, on the projected adverse demographic and health trends. Put on the prospect of the Chinese consumer-driven and Japanese diaper-dragged economies (hint: 2 largest official US Treasury bond holders). Top it off with the potential capital losses the Fed faces if the exit is not smooth - and credibility implications (given Japan’s past experience – potentially worse than those of just keeping buying bonds)…Maybe there is simply no emergency exit door for the Fed?
But in the meantime. Let’s get back to the real time. In which the US Fed is still buying USD 85bn worth of securities per month, and we are speculating whether it is September or December they are going to begin to taper(?)*. And if there is anything to buy on dips – it’s volatility.
