In the great inspirational movie The Shawshank Redemption, Tim Robbins plays Andy Dufresne, a man facing seemingly impossible odds: Wrongly imprisoned for life, former banker Andy has only the books in the paltry prison library, his love of carving stone chess pieces, and his imagination to sustain him. Though the situation seems dire, Andy maintains his focus on his long-term goal of escape and holds on to hope even when circumstances test his mettle. He chips away at the stone wall of his prison cell using a rock hammer, turning his insurmountable obstacle into a trail of dust over the course of several years and eventually returning to life on the other side.
As both a movie buff and an investor, I find myself thinking of what parallels could be drawn between The Shawshank Redemption and the Federal Reserve’s anticipated normalization of monetary policy over the next several years. To be sure, the scope of quantitative easing (QE) in some of the world’s largest economies and the ultralow interest rates globally are unprecedented. The graphs below show the current balance sheet of the Fed.* Since 2008, the Fed has expanded its assets through various QE programs to combat the effects of the global financial crisis and the ensuing weakness in the labor market and inflation metrics.
For some time, I and others at Vanguard have voiced concerns about some of the market “side effects” of QE. In particular, investors’ reach for yield, spurred by suppressed Treasury bond yields, into other segments of the global financial markets (e.g., high-yield bonds, REITs, and emerging markets stocks) that for a time appeared “frothy.” Perhaps the recent marked underperformance of those investments justifies our past concerns. More important for you and me, the Federal Reserve shares reservations about the marginal costs of QE—thus the increased focus on tapering.
What are the two big outstanding questions? First, what may the Fed’s exit timetable look like? And, second, how may it affect the market and the economy?
Current balance sheet of the Federal Reserve
Note: The Fed’s purchases under Operation Twist are included in QE3, as are assumptions of a gradual tapering in the current purchase rate of $85 billion of securities a month through mid-2014.
Tapering ≠ tightening
As I have said before, tapering does not equal tightening. It’s easy to lose sight of the fact that the Fed’s “escape” could be a very long and drawn-out process, much like Andy Dufresne’s plan of painstakingly chipping his prison walls into dust. The framework for the Fed’s exit strategy, which was first presented in the minutes of the June 2011 meeting of its Open Market Committee, stretches across several years, beginning with the tapering of asset purchases, which precedes an eventual tightening of monetary policy. Tapering will consist of a progressive step-down in the amount of assets the Fed is purchasing each month, currently $45 billion in Treasury securities and $40 billion in MBS.
I believe the table below highlights a reasonable timeline of the potential stages of the Fed’s exit strategy. If there is one certainty in this plan, it’s that it will change based on the state of the U.S. economy, although the general order of the stages will likely remain the same. My confidence level in the dates drops exponentially as you move down the chart. Indeed, the Fed may never actually sell securities on its balance sheet but, rather, allow them to gradually mature, while using other tools, such as the ability to pay interest on excess reserves (IOER) and reverse repos, to manage the level of reserves in the banking system.
How will tapering affect the markets?
Some are convinced that the Fed’s great escape can only be bad news for both stocks and bonds. Others believe that it is time to reduce the pace of QE3, citing a combination of diminishing returns relative to its benefits, increases in its marginal costs, and/or a U.S. economy that continues to expand modestly and, thus, is less in need of emergency support. I will admit to being in this camp: In my opinion, tapering is good news for long-term investors.
I am cheering for the U.S. economy, as I did for Andy Dufresne in The Shawshank Redemption, to finally chip through to a better reality. We’re not there yet (trend real GDP growth remains stuck near 2%), but we’re closer than we’ve been since the financial crisis.
Nevertheless, it will likely be quite some time (at least 2015) before short-term interest rates begin to rise above 0% and normalize given still-tepid wage inflation and still-elevated unemployment. And in the interim, savers may continue to suffer, and long-term U.S. interest rates may struggle to rise much further from present levels given a Fed still on hold. But for the first time in years, we are at least contemplating life on the other side of the tunnel.
Just like Andy Dufresne, I have eyes wide open to what may be a long and difficult journey—marked by occasional market setbacks—toward an environment of less monetary policy stimulus. The unprecedented measures undertaken by the Fed and other central banks in response to the financial crisis have left us in uncharted territory. The tools at the banks’ disposal, like Dufresne’s rock hammer, are unproven, since no economy has yet to fully test the unwinding capabilities now under contemplation. Our path is likely to be rocky at times. Just as Dufresne’s heroic getaway was aided by the noise of a fortuitous rainstorm, we too may find that our escape will depend on the evolving economic conditions we encounter.
Still, I like America’s chances.
I would like to thank Andrew Patterson in our Investment Strategy Group for making substantial contributions to this blog post.
*Reserves are a liability to the Fed, but an asset to banks. They can be thought of as an electronic IOU from the Fed to the banks.
Notes: Quantitative easing refers to the government purchase of securities, including bonds, in an effort to increase the money supply. All investing is subject to risk, including the possible loss of the money you invest.