The Federal Reserve announced this week that it is going on a crash diet. For nine years, the central bank binged on bonds in the name of quantitative easing (QE) to push down interest rates and stimulate the economy.
Now, in order to shrink its bloated $4.5 trillion balance sheet, the Fed will liquidate $10 billion of securities each month. After 15 months they will have lost a total of 450 billion pounds, er, dollars, and weigh in at just a tad over $4 trillion.
The best part: The Fed says the diet will be painless. They say they can do the whole thing without selling a single security by simply allowing securities to "roll off" as they mature!
Call me a skeptic but I know two things about losing weight. 1) No diet is painless. 2) What really matters is whether you stay with the program for the long-term, which is really hard to do. It's no different with monetary policy.
The Fed's announcement amounts to switching from the largest extended money-printing exercise in history to the largest extended money un-printing exercise in history. Neither they nor we know exactly how it is going to work because it has never been done before. But we do know the numbers are huge. And the net effect on the economy is pain -- higher interest rates, lower growth, lower stock and bond prices. The question is how long they will stick with the program as the pain level rises. Here are a few things to think about:
First, shrinking bank reserves is absolutely necessary. I know of no example in history of a central bank printing this much money without prices sooner or later rising roughly in proportion. Printing money inflates asset prices first. Accordingly, QE has produced big increases in stock, bond and property prices. It's impact on wage rates, incomes, and goods and services prices has been much slower, the puzzle Janet Yellen was referring to when she said "Our understanding of the forces driving inflation is imperfect." But unemployment is low and labor markets are very tight, prompting the Fed to begin Project Un-QE before final goods prices accelerate.