Why and How did the Fed enlarged its balance sheet after 2008?
In 2008, when financial crisis showed its first impacts on both mortgage market and mortgage loans & derivative products in the US, Ben Bernanke, chair of the Fed, started Quantitative Easing (QE) as a respond to the crisis which is deepening and affecting the world. Primary purposes of the Fed’s QE were supporting investment and growth by lowering interest rates that leads market to borrow more easily and cheaply and reinvigorating the economy with the help of increasing amount of dollars in the market.
The Fed has implemented monetary expansion or QE bilaterally and has lowered interest rates and increased dollar supply to both US market and whole world. Fed rate, which was between 5% and 5,25% in June 2006 and between 4% and 4,25% at the end of 2007 has been rapidly reduced to the range of 0% and 0,25% at the end of 2008. At the same time, the Fed started asset purchase program. In other words, they started to purchase Treasury Securities and Mortgage Backed Securities from market and to give dollars to previous owners of these securities. Purchases of these securities, which enter to assets in the balance sheet of the Fed started in 2008 and $1.2 trillion worth of securities was purchased within a year. The program continued gradually until the end of 2014.
As a result of QE, the size of the balance sheet of the Fed that had been approximately $800 billion in 2008 reached to $2.1 trillion in 2009 and $4.5 trillion at the beginning of 2015. Dollars given to the US market as a consequence of this growth, has spread to the whole world over the years; considerable
amount these dollars have entered to
the developing countries including Turkey.
Why and how will the Fed shrink its balance sheet?
In 2014, Janet Yellen became the Chair of the Board of Governors of the Federal Reserve System after Ben Bernanke whose term had ended, and she announced the end of QE on October 2014. The Fed has kept the money supply, hence balance sheet size, constant since by reinvesting principal payments and maturing securities. With the help of the Fed and its interventions, both US economy and global economy have managed to overcome the crisis. In addition, followed closely by the Fed and markets, macroeconomic indicators such as GDP growth, inflation, nonfarm payroll have improved in recent years. As a result of this improvement, the Federal Reserve raised the interest rate by 0,25% in December 2015, December 2016, March 2017 and June 2017 respectively, bringing the interest rate to the range of 1% and 1,25%.
With all these improvements, the Fed's balance sheet reduction program, which is expected to be announced by the markets for several months, was announced by the Fed in September this year. According to the program, Federal Reserve will shrink its balance sheet by decreasing the reinvesting rate of the securities, starting from October 2017. They will begin to let monthly $6 billion worth of Treasury Securities and $4 billion Mortgage Backed Securities to mature. The Fed will also let the values of monthly maturing Treasury Securities and Mortgage Backed Securities rise slowly to $30 billion and $20 billion respectively. They will increase reduction amount of Treasury Securities by $6 billion and that of Mortgage Backed Securities by $4 billion every three months until these levels are reached. Announced that the size of its balance sheet will not be reduced to the levels before 2008, the Fed is expected to follow its agenda for 4-5 years and to reduce its balance sheet to approximately $2 trillion.
How does this reduction affect the world and Turkey?
It is anticipated that there will be various effects of reductions and rise of interest rates the world economy, especially the US if the Fed increases interest rates and makes reduction as planned.
An upward pressure on US bond rates is expected as a result of successful implementation of the balance sheet reduction. This pressure and the likelihood that the Fed will continue to increase interest rates may adversely affect emerging economies. Foreign investors usually invest in developing countries to benefit from high interest rates. Since risk premiums of these countries are higher than those of the US and other developed countries, developing countries try to attract foreign investors with higher interest rates. These countries with higher interest rates and risk premiums can attract foreign funds when global risk appetite is high and interest rates are low in developed countries. (Years between 2008 and 2012 and the first half of 2017 are examples of this scenario.) However, since higher interest rates in US means higher
return in spite of lower risk, some of foreign investments may return to the US from Turkey. Moreover, there is a possibility that some of foreign investors may be out of Turkey as balance sheet reduction will reduce dollar amount. When foreign funds that entered or left government debt securities and stock markets of Turkey are examined, it can be observed that inflows of these funds decrease, or outflows exceed inflows during the periods of financial crisis or the periods when dollar amount is believed to decline (Graph-3). In 2007, 2008, and 2009, there were outflows caused by global crisis. In 2013 and after this year, indirect foreign investments are decreased due to panic which stems from signals given by Bernanke, the chair of the Fed of the period, about the end of the QE (This incident is called Taper Tantrum.). The reduction of Fed’s balance sheet has potential to reduce foreign investments in Turkey and to adversely affect Turkish economy.
In addition, increasing interest rates in the US have potential to put a pressure on central banks of all developing countries to increase their own rates. While in theory, an increase in interest rates in these countries may reduce outflows, an upward movement of loan interest rates may cause negative effect on GDP growth of these countries. When policy rate of Central Bank of the Republic of Turkey and the Fed rate are analyzed together, it can be said that the interest rates in Turkey are parallel to that of the US. (Graph-4)
Along with all these possibilities, reduction in dollar amount caused by balance sheet reduction may put upward pressure on the dollar exchange rates and inflation. Also, appreciation of the dollar means that the products exported by Turkey will become cheaper in dollar terms. This means that Turkish exporters can sell their products at lower prices in foreign markets. This gives a competitive advantage to Turkey and increases the demand for Turkish products in foreign markets. Higher demand and competitive advantage positively affects exports and trade balance of Turkey.
Furthermore, the other three world’s most important central banks, the European Central Bank (ECB), the Bank of England (BoE), and the Bank of Japan (BoJ) are continuing their monetary expansion programs. In the medium term, it is expected ECB and BoE to tighten their monetary policies. On the other hand, BoJ has announced that it would continue its ongoing program. Since Euro Zone is Turkey’s one of the largest trade partners, the fact that ECB is not starting any tightening at the same time with the Fed, will continue to make positive contribution to Turkey’s exports. The ECB's monetary tightening in the medium term may cause pressure on Turkey's trade figures when tightening begins.
Apart from all these scenarios, there is also the possibility that the reduction of the balance sheet may not be made as planned by the Fed. Moreover, Fed may have to end the reduction program at any time before reaching desired balance sheet size. There may be a panic in the market as Bernanke announced that the end of the QE had come in 2013. This will force the Fed to make changes in its plan. If the Fed manage the panic well and slow down its tightening policy, the emerging countries like Turkey may be able to benefit from QE for a longer period of time.
Although it is considered as a very low possibility, if reduction is canceled shortly after its start due to market reaction, many currencies may appreciate against dollar. Apart from that, extended period of monetary expansion or QE may reduce the pressure on Turkish economy and cause an increase in foreign capital inflows.
Finally, not only policy makers but also companies and managers should consider all these scenarios because revenues, debt levels, foreign trade figures are vulnerable to all these scenarios. It is important to take necessary precautions against these scenarios for financial health of a company.