After the July meeting of the US Federal Open Market Committee, the Fed announced that it will soon begin reducing its $4.5tn balance sheet built up through quantitative easing. Such a move could make for rough economic conditions in the year ahead as markets adjust to monetary tightening.
Perhaps as early as September, the Fed will start unwinding its balance sheet by $10bn a month by not reinvesting maturing US Treasury bonds and mortgage-backed securities. The Fed plans to increase the amount until it reaches $50bn a month, probably by the end of 2018.
Janet Yellen, the Fed chair, is reassuring investors about the transition but she cannot know what the consequences will be. Never has the Fed started to cut its balance sheet after increasing it on such a scale.
Yellen seems to be downplaying the risk that a large asset and credit market bubble may have been created by the money-printing policies of the Fed and other major central banks. The banks have expanded their balance sheets by a cumulative $10tn since 2008, in effect forcing investors into higher risk activities. They did this by cutting the supply of low risk government bonds in the market and reducing the interest rates that investors could get on those bonds. A bubble, much like the one before the 2008 Lehman Brothers collapse, may well have resulted.
The problem is not simply that American and global equity markets are at lofty levels, or that government bond yields are at record lows, or that house prices appear inflated. It is that credit has been extended to risky borrowers, such as those in the US high-yield market and in emerging markets, at interest rates that do not compensate lenders for the risk of default.
Argentina, a serial defaulter, issued a 100-year bond in June that was four times oversubscribed. Greece, whose government as recently as 2012 defaulted on €206bn of its bonds, was able to access the bond market in July at an interest rate of 4.5%. The government of heavily indebted Italy can borrow money in the market for 10 years at only 2%.
The risk that the asset and credit market bubble could burst next year, placing strain on the world financial system, is real. Monetary policy normalisation could be the trigger or an economic event in an important troubled country such as Brazil or Italy. No longer would markets be buoyed by central bank bond purchases. Rather markets would have to deal with central bank bond sales that would tend to depress asset prices.
Should the bubble burst, the Fed’s balance sheet unwinding will not be as uneventful as Yellen would have us believe. And it is unlikely that the Fed will be able to stick to its tightening programme.
Desmond Lachman is a Resident Fellow at the American Enterprise Institute. He was formerly a Deputy Director in the International Monetary Fund’s Policy Development and Review Department and the Chief Emerging Market Economic Strategist at Salomon Smith Barney.