Many things in life get better with age (wine, cheese, blue jeans), but many others do not (athletic ability, sushi, hangovers). Unfortunately for central banks, the effects of unconventional monetary policy probably fall in the latter category.
-Zach Pandl, senior interest rates strategist, Columbia Management
Many things in life get better with age (wine, cheese, blue jeans), but many others do not (athletic ability, sushi, hangovers). Unfortunately for central banks, the effects of unconventional monetary policy probably fall in the latter category. Unlike traditional monetary policy—in which the central bank only sets short-term interest rates—the impact of unconventional policies likely decays over time. This means that it is not enough for the Federal Reserve to keep its current policies in place—it actually has to take additional action to maintain the same impact on interest rates and the economy.
There are two main reasons for this.
First, as time passes, the point at which the Fed will start raising the funds rate gets closer and closer. All else being equal this will cause longer-term interest rates to drift higher, because longer-term rates imbed expectations about the future path for short-term rates. Chairman Bernanke actually made this point explicitly in his recent speech on bond yields: “long-term rates would be expected to rise gradually … this rise would occur as the market’s view of the expected date at which the Federal Reserve will begin the removal of policy accommodation draws nearer.”
Second, without ongoing policy efforts, the average duration of the Fed’s securities portfolio is always in decline. The theory and evidence on quantitative easing (QE) suggests that the policy works primarily by removing duration risk from private sector hands which in turn reduces interest rates. In effect, the aging of the Fed’s balance sheet slowly adds back this duration risk to the market, putting upward pressure on rates. These changes are quantitatively meaningful. For example, the Fed’s securities portfolio is expected to reach about $3.75 trillion by the end of this year. At that level, a one year decline in the portfolio’s average duration would reduce the Fed’s total duration risk by about $415 billion 10-year equivalents (10-year equivalents measure the amount of current 10-year Treasuries that would total to the same level of overall duration risk). Empirical work suggests that reducing the duration of the Fed’s balance sheet by this amount would push up long-term interest by 15-20 basis points (bps).
