This would fall under the category of macroeconomics, but since I can't find the Economics sub-thread anymore, I guess I'll put it here.

The US, and much of the global economy, suffered from a severe liquidity crunch in the aftermath of the 2008 financial crisis. The Fed, and later several other central banks around the world including the ECB and the BoJ, embarked on programs of Quantitative Easing (QE) in which they created trillions of dollars out of thin air, and used those new funds to purchase assets (mainly Treasury Bonds) from private banks. Doing this injected money back into the system and encouraged banks to start lending again using the new-found money.

Since the US economy emerged from recession around 2010, it has enjoyed its longest expansion on record, as far as I know. This turnaround is clearly thanks in large part to all the new liquidity (the Fed's balance sheet grew from ~$900 billion in 2007 to $4.5 trillion today) that QE added over the years. The Fed has long maintained that QE was a temporary measure designed to get the economy back on its feet after a generation-level crisis.

However, if the Fed did fully, or even just significantly, unwind QE by selling those assets back into the market, couldn't it cause another major recession given that the whole exercise appears to have been the main factor in rescuing the economy in the first place? Unsurprisingly, many central banks are reluctant to raise even short-term interest rates, much less unwind QE.

But the downside to keeping a central bank's balance sheet massive is that eventually, in theory, the enormous expansion of the money supply will cause inflation. Then the central bank will have to respond by raising interest rates, perhaps dramatically, which could easily pull the economy back into recession.

the fed is currently unwinding QE

I think the liquidity was irrelevant, and possibly even slowed down the recovery. It was good for the stock market though.

Economies bust, economies recover and then boom. Has to do with misallocation of capital, which occurs, like bubbles, partly because of reflexive psychology. Been doing that for generations. This one was a slow recovery, which is why it's been the longest. I think QE is largely irrelevant. Rates are relevant, to the extent to which capital is misallocated or items have been over leveraged (another form of capital misallocation). Rates force a reckoning on those misallocations. I don't have deep insight into the economy to know what the extent of misallocation or overleveraging is. The expert consensus is that it's not bad, but economic experts are about as reliable as the economic opinions of a drunk down the pub. I'm leaning toward the experts on this one though.

fed has made a lot of mistakes but its a smart move selling while ECB and BOJ are still in the middle of their insane plans.

Wasn't the liquidity a major boon for the economy because it propped up housing/stocks and thus created the asset prices we have today? These asset prices create the "wealth effect" which buoyed economic growth.

If this wealth effect goes away then I'd think the economy would be in for some pain but guess it is tough to say.

We're due for at least a medium sized downturn. QE isn't what's going to trigger it though. My money is on operational profit margins tightening while interest rates are rising causing a decent sized correction in asset prices.

I think it's also worth mentioning that another downside of permanent QE is that if the central bank doesn't follow through on its promise to fully unwind QE eventually, it creates a moral hazard.

Private financial institutions are, in a sense, like kids playing with matches. It's usually fun and profitable, so they start to take bigger risks. But one day they set the yard on fire, at which point the fire department (i.e. the central bank) comes to save the day. The children learn that they can continue to take risks because most of the time it's fun and profitable, and if things ever go wrong again, the fire department will always be there to save them from their reckless mistakes.

fyp

The moral hazard already exists and has been around for ages. There is no appetite among elites to see rich people taken down a notch. The fed explicitly will step in to react to systemic shocks, and I'm not confident that they will ignore large idiosyncratic shocks either.

systemic shocks are critical for managing capital inequality and long term productivity growth, but somehow we've all been fooled into accepting that it is a bad thing.

As long as we're just passing it down the generations I don't expect anyone to care.

We've been unwinding QE for a few years now, I think the fed has done a reasonable job despite a lot of noise otherwise. Long rates have stabilized & you would expect the move in the short end given raising the federal funds rate. They have some room to work in case the economy slides unlike a lot of Europe & Japan.

The period of 1983-2007 is instructive in how long we can go without a serious downturn. Just two baby recessions in 1991 and 2002.

The realization of American economic supremacy. The US became the unrivaled global leader in profitable manufacturing and tech and general know how, from pharmaceuticals to electronics to food science.

The lead up to 2007 and the slow growth since was basically from the loss of that via the rise of the Chinese and the outflow of wealth.

It would have gone on a lot longer without that wealth outflow, perhaps until well after the robotics explosion in 2030 or so. We live in amazing times. Computing is transforming everything from business to manufacturing to advanced modeling to medicine to communications.

grunching here..

john cochran, one of the world's foremost financial economists - grumpy economist blog - says QE didn't benefit people that much. sorry, i can't remember if he's talking economy, stock market or both.

if you go to google images there must be tons of graphs showing the S&P 500 and fed's balance sheet (the size of it exploded with QE) correlation. it was pretty high for awhile.

how quickly is the Fed unwinding QE? i knew this was the case but i'm thinking it might be almost indistinguisable from zero

note; when i talk QE, i mean quant easing in general i.e. including QE2 and QE3 if that happened)

https://fred.stlouisfed.org/series/WALCL

not certain this is a representative stat but i think it is........... barely budged from its top end..

is there any reason the fed has to reverse QE at all, let alone very slowly?

https://www.yardeni.com/pub/peacockfedecbassets.pdf

basically put yardeni and any economic subject into google and you get a great pdf report

This sort of stuff isn't terribly intuitive but if expanding the Fed's balance sheet is inflationary then contracting it is deflationary. So clearing out the Fed's balance sheet very quickly might be like jacking up the discount rate from zero to 5% in one go. So they're probably looking at gradually decreasing their holdings while at the same time increasing the discount rate. And because they're contracting their balance sheet while increasing the discount rate, they're probably increasing the discount rate more slowly than the otherwise would.

good comment............ expanding the Fed's balance sheet wasn't very inflationary. at least not as much as some alarmists thought. one reason (there are others) is that the money didn't go out into the economy as bank loans/equity. i think it went through money markets and/or treasury bond market once and/or ended up on reserve at fed anyway. not sure how this differs from nazi germany or zimbabwe crazy money creation that was highly inflationary (at least in Z's case)

I thought the counterpoint to expanding the feds balance sheet wasn't inflationary or hyper-inflationary is that the inflation showed up in asset prices. Real estate and stocks going up significantly and at higher multiples despite the fact the real economy was only growing at 1.5%.

Thus deleveraging quickly will cause major ripples in those areas.

agreed 100%... good comments, thank you

Stupid question: is the Fed losing tens of billions on the unwinding? They bought all these assets when interest rates were 200 basis points lower.

They could lose money, yes. But when the Fed makes money it just turns it over to the Treasury. And so if the Fed sells the bonds at a loss it will just print the money (nice to be the Fed) and then carry that loss as a deferred asset that it will have to make up before it turns over more profits to the Treasury.

If I am understanding your post correctly, your first few sentences answer your last.

As far as I know the worry was always that the increased money supply would circulate throughout the economy thus bringing inflation, and the Fed was careful to not allow this to happen by not allowing the money to be lent out but rather be used as capital reserves for the banks. That is why unwinding QE needs to be careful. The Fed can't just say, ok its over go ahead and use this money now.

This is what people say but it doesn’t make a ton of sense. The stock market also lost 50% when the “real economy” only shrunk by 3%. Why would you think massive growth would be required for stocks to go up 100% to where they were? And higher than average P/E ratios represent a genuine belief, right or wrong, that earnings are going to continue to rise.

Yeah as far as I understand, a major goal of QE was to prop up asset prices, which had plummeted in 2007-08, as a way of rescuing firms' balance sheets that were underwater. Until that was done nobody was lending money because their liabilities all exceeded their assets, causing a credit crunch and a major recession.

Richard Koo explains a "balance-sheet recession" really well, adding that the newly-created money from a QE injection doesn't circulate into the economy during a balance-sheet recession because there are too few borrowers. After all, if your balance sheet is underwater, you're focus is paying down your liabilities, not taking on new ones.