Central Bankers on the Ground

NEW DELHI – Markets are in turmoil once again, following the US Federal Reserve’s indication that it might reduce its bond purchases toward the end of the year. The intensity of the market reaction was surprising, at least given the received wisdom about how the Fed’s quantitative-easing policy works. After all, the Fed was careful to indicate that it would maintain its near-zero interest-rate policy and would not unload its bond holdings.

The dominant theory of how quantitative easing works is the portfolio-balance approach. Essentially, by buying long-term Treasury bonds from private investors’ portfolios, the Fed hopes that these investors will rebalance their portfolios. Because a risky asset has been removed and replaced with safe central-bank reserves, investors’ unmet risk appetite will grow, the price of all risky assets (including remaining privately-held long-term Treasury bonds) will rise, and bond yields will fall.

A central element of the theory is that the stock of bonds that the Fed has removed from private portfolios, not the flow of Fed purchases, will determine investors’ risk appetite. Unless investors thought the Fed was going to buy bonds forever, news about a reduction in Fed purchases should have had only a mild effect on their expectations of the eventual stock of bonds the Fed would hold. So why such a violent reaction in markets worldwide?

One possible answer is that the volume of monthly Fed purchases also matters for global asset prices. Another possibility is that investors around the world read far more into the Fed’s statements than the Fed intended. Either answer is worrisome, because it would suggest that central banks – which are now holding trillions of dollars in assets – have less ability to manage the process of exiting quantitative easing than we would wish. Perhaps Winston Churchill might have mused about quantitative easing, “Never in the field of economic policy has so much been spent, with so little evidence, by so few.”