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Top of MindIssue 60The rundown on runoffElNearly nine years since it first launched Quantitative Easing(QE), the Fed is finally set to begin shrinking its 4.5tn balancesheet. What this uncharted process means for policy, assetmarkets and the banking system is Top of Mind.conviction in inflation remaining low and runoff substituting forrate hikes, even a small shift in investor expectations could leadto a sharp sell-off in bonds. Again, this is not our mainline view,but a risk to keep in mind.We kick off with a retrospective from GS Chief Economist JanHatzius on the lessons learned from QE. In short, he concludesthat balance sheet expansion was an effective policy tool thatcame with fewer costs than many observers had predicted. Atthis point, he sees just one potential unknown downsideassociated with QE: the difficulty of exiting it. But with financialconditions easing this year even as the expected timing ofnormalization has been pulled forward, Hatzius is optimisticthat the process will be orderly and manageable.Looking beyond the markets to the banking system itself,some observers have raised concerns that draining QE-relatedliquidity could trigger deposit outflows, potentially leading tofunding stress. However, our Financials equity analysts take amore sanguine view. Their analysis suggests that banks havetreated most deposits created by QE as short-term liquidityrather than reliable, longer-term funding. Moreover, post-crisisrules require that banks hold safe assets against these depositsdollar-for-dollar, further preparing them to manage anyoutflows. Slower deposit growth as the Fed unwinds QEshould therefore be fairly manageable for banks. Butnormalization may have other effects: The team flags higherinterest rates for consumers and a likely uptick in bank M&A astwo likely consequences.Brian Sack of the D.E. Shaw group, who helped design andoversee QE while at the New York Fed, is similarly confidentthat balance sheet runoff will go smoothly, even if it ultimatelyoverlaps with ECB tapering as we expect. In Sack’s view, thisis not only because the Fed has clearly communicated its plans,but because the expectation that QE is redeployed in the futuremay keep some downward pressure on the term premium (thecompensation for duration risk in long-term bonds). He alsoreiterates his long-held view that the balance sheet’s “terminalsize” should be larger than in the past, and doubts the balancesheet will ever dip below 3tn again. Our US economics teamgenerally agrees, and digs further into the mechanics ofbalance sheet policy on pgs. 8-9.So what would such an orderly normalization look like for bondsand other assets? We expect QE’s fading portfolio balanceeffects to add an estimated 20bp to 10-year Treasury yields thisyear, 15bp next year, and 10bp/year from 2019-2021, which webelieve should prove digestible for both US equities andcorporate bonds (see pg. 11). And in the EM space, GSstrategists Ian Tomb and Lorenzo Incoronato see little risk ofanother “taper tantrum,” as solid growth and improvedexternal balances have put EMs in a better position than beforeto weather increases in US/core rates. That said, they see amore favorable outlook for EM equities, FX, and credit spreadsthan for local bonds, where investors will need to be moreselective going forward.Even in mortgage-backed securities (MBS), where the Fedowns roughly 30% of outstanding agency securities, we thinkthe impact of runoff will most likely be limited. Indeed, GSSenior Mortgage Strategist Marty Young points out that,against expectations, MBS spreads have actually tightened thisyear. He anticipates only modest spread widening from here—not enough to justify a short position. A more notable outcomeof the QE unwind, in his view, could be its effects on volatility;Fed ownership of MBS has likely suppressed rate vol in recentyears, suggesting that vol could eventually pick up as moresecurities shift back into the hands of private investors.So what could go wrong? For one, future changes to Fedleadership have the potential to alter the FOMC’s runoff plans.And GS Co-Chief Markets Economist Francesco Garzarelliemphasizes that the rates market’s reaction to runoff—whichwill likely drive other asset markets’ responses—is entirelycontingent on the macro backdrop. Given the market’sGoldman Sachs Global Investment ResearchGiven that the Fed is not the only central bank carefullymanaging its balance sheet policies, we also take theopportunity to assess the state of asset purchase programs atthe ECB and the BOJ. GS Chief European Economist Huw Pillreminds us that the ECB is no stranger to shrinking its balancesheet, which fell from EUR 3.1bn in 2012 to just over EUR 2bnin 2014. Reassuringly, the process went smoothly—althoughthat contraction reflected reduced demand for central bankliquidity, not a deliberate policy decision. While ECB tapering(which we expect next year) is likely to have bigger implicationsthan this earlier experience, Pill argues that those implicationswill likely depend more on the composition of the centralbank’s balance sheet than the size.While all eyes are on the Fed and the ECB, it’s worth pointingout that the BOJ has already been quietly reducing itsJapanese government bond purchases for almost a year. Thishas led some market participants to expect the BOJ to lower orabandon its purchase target. However, GS Chief JapanEconomist Naohiko Baba believes that the central bank has nointention of doing so, lest that result in appreciation of the yen.Instead, he expects the BOJ to proceed with the status quo fornow, as reaching even 1% inflation, let alone the 2% target,appears all too remote. That said, with a new BOJ governortaking the helm in April 2018, this is a place to watch.With all of this talk about exit policies, a closing thought aboutfuture easing (whenever the economy next requires it). AsHatzius points out, even if rates ultimately rise to the 3.253.50% range as we expect, this may not leave enoughconventional easing capacity to sufficiently address the nextshock. In other words, an eventual return to balance sheetexpansion may very well be in the cards.Allison Nathan, EditorEmail: allison.nathan@gs.comTel:212-357-7504Goldman Sachs and Co. LLC3

Top of MindIssue 60QE: what we’ve learnedElJan Hatzius argues that balance sheet growthachieved its aims at relatively low costs—andmay eventually return as a policy toolThe Federal Reserve stands on the cusp of balance sheetrundown, and the ECB is moving gingerly toward the exit aswell. What lessons have we learned about quantitative easing(QE), and what are the implications for the future conduct ofmonetary policy?QE is quite effectiveThere is now a great deal of research covering the effects ofQE in the US, the Euro area, the UK, and Japan. One strand ofthis research focuses on the impact of surprise QEannouncements on bond yields and other financial variables.This is a good approach for showing that QE has significantshort-term effects on financial conditions but is less suitable forpinning down magnitudes and long-term effects. Anotherstrand of research estimates equations for the level of bondyields or the term premium as a function of QE and othereconomic control variables. This allows us to quantify themedium-term effects of asset purchases and therefore nicelycomplements the first approach.Taken together, these studies suggest that QE lowers the levelof bond yields by 3-5 basis points for each 1% of GDP.Moreover, it is generally the expected stock of central bankbond holdings that matters, not the ongoing flow of centralbank bond purchases. This is particularly clear in the US, whereflow effects are largely absent in the data. In the Euro area, theevidence is m

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