Will the Great Unwind be as dull as advertised?

Markets shrugged off this week’s Federal Reserve announcement, and no wonder: it doled out surprise and relief in roughly equal quantities.

On the surprise side, against market expectations of a pause, the Fed made clear its intention to raise the target rate again this year. On the relief side, it lowered its longer-term rate expectation to an average of about 2.7 per cent in 2019, down from its June expectation by 20 basis points. And in announcing that the unwind of its US$4.5-trillion balance sheet would begin next month, the Fed surprised pretty much nobody.

Ho-hum, business as usual. When she talked in June about the still-unscheduled Great Unwind, Fed chair Janet Yellen promised it would be about as exciting as “watching paint dry.” This week, markets seemed to be taking her at her word.

Yet, to use another cliché, the proof of the pudding will be in the eating. Despite the calming words and assurances the U.S. economy (and by extension, a good chunk of the global one) is healthy enough to withstand the withdrawal of extraordinary stimulus, what the Fed is embarking upon now is a great experiment, one whose outcome is hardly assured. When it comes to stimulus, it might find that it’s far easier to give than it is to take away.

Let’s consider the Fed’s ratehiking path. The latest Federal Open Market Committee dot plot, which maps out governors’ rate expectations, puts the average target rate at about 2.1 per cent next year and 2.9 per cent in 2019. By historical standards, those rates are still incredibly low in absolute terms, and only 85 and 165 basis points above the current Fed funds rates of 1.25 per cent. Yet the relative impact could be significant. If the Fed makes good on its dots, the cost of borrowing would be 70 per cent higher in 2018 and 130 per cent higher in 2019.

How much will that hurt businesses and consumers who have grown used to super-cheap money, spending it on share buybacks, new houses and home renos?

Outstanding total debt in securities issued by U.S. non-financial corporations has risen by nearly 75 per cent since the recession, according to Bank for International Settlements data. (Here in Canada, where the central bank is also on a hiking path, the corresponding measure has risen by nearly 90 per cent since Q1 2009.)

Meanwhile, mortgage debt outstanding held by U.S. consumers has been rising towards pre-recession levels, increasing by more than 25 per cent between Q1 2013 and the first quarter of this year; median new home prices are far higher now than during the pre-recession real estate bubble. The degree to which rising rates will hurt is anybody’s guess, but some pain seems likely. (Same goes for Canada, by the way.)

At least rate-hiking falls into the realm of conventional policy levers. On the other hand, the Fed’s balance sheet unwind, while it appears it will take place at a somnambulant pace, might be more problematic.

On the sleepy side, the impact on long Treasury yields could be muted, even though the Fed is likely to have freed up a trillion dollars plus in bonds by the time the Great Unwind ends. (We don’t know when that will come, or how much will be left on the Fed balance sheet when it does.)

For one thing, the pace will be like a trickle — US$10 billion a month to start, rising eventually to US$50 billion. As well, other central banks, most importantly the European Central Bank and the Bank of Japan, are still buying their own bonds, which should support demand for U.S. Treasuries as the Fed unwinds, which should suppress yields.

That’s if everything goes according to plan. The ECB is talking about tapering its quantitative easing program; how to do it will be under discussion at the bank’s October meeting. If it picks up the pace, the trickle of the Fed’s unwind could start looking more like a creek, or maybe a stream, or maybe a deluge.

Then there’s the question of the impact on the real economy. That would be easier to answer if anyone was really sure quantitative easing had any real benefit in the first place. To the extent it expanded the money supply, QE should have stimulated the economy; withdrawing it should, theoretically, do the opposite. Yet the empirical evidence for QE’s benefit is questionable. Stephen Williamson, an economist with the Federal Reserve Bank of St. Louis, recently wrote that “there are good reasons to be skeptical that (QE) works as advertised.”

If that’s true, then maybe we can safely discount the potential recessionary effects of the unwind. But it’s impossible to know what economic growth and inflation would have looked like if the Fed hadn’t undertaken QE. Maybe we’re about to find out.

Of course, there is one area where you can legitimately argue that quantitative easing has had a clear impact: share prices. By effectively creating trillions of dollars and helping keep yields low, the Fed has helped to fuel the post-recession equity rally. Maybe the economy is strong enough to withstand the Fed’s withdrawal. But can the bull market?

Again, we’re about to find out. Watching paint dry might never be considered boring again.