THE Federal Reserve is engaged in a colossal transformation of the financial economy. Yet, scarcely anyone is noticing.
What it’s doing is like walking a herd of elephants through mid-town Manhattan without attracting much attention. That used to happen in New York in the wee hours – when the circus came to town and elephants walked over the city’s bridges and through its tunnels to Madison Square Garden.
I’m not talking about the Fed’s decisions on short-term interest rates, which get the headlines when the central bank meets, as it did on Wednesday (May 1). The Fed kept those rates steady – and fairly high – at about 5.33 per cent, in a frustrating battle to subdue inflation.
I’m talking about a remarkably ambitious and poorly understood Fed project known as quantitative tightening – QT for short. That refers to the Fed’s reduction of the Treasury bonds and mortgage-backed securities on its mammoth balance sheet.
The central bank said on Wednesday that it would start slowing the pace of this asset paring in June, to US$60 billion a month from a maximum reduction of US$95 billion a month. It’s not selling securities, just quietly eliminating some as they mature, without reinvesting the proceeds.
These may look like big numbers. Yet, on a comparative basis, they are piddling.
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Consider that the central bank’s assets peaked two years ago at almost US$9 trillion. That sum is roughly one-third of all the goods and services – the gross domestic product – produced in the United States in one year. Now, after much careful effort, the Fed has cut that total to about US$7.4 trillion.
Yes, it has removed about US$1.6 trillion from its coffers. But even after two years of QT, the amount of bonds and securities that the Fed still retains is stupendous.
This is mind-boggling stuff, but a basic understanding of QT is important for several reasons:
1. The policy is affecting financial markets now and making living conditions harder for millions of people – putting upward pressure on the Treasury and mortgage markets and a host of related interest rates, effectively supplementing the monetary tightening that the Fed put in place by raising the short-term federal funds rate.
2. QT is a perilous operation. Earlier attempts – notably, in 2019 – disrupted financial markets. That could happen again if the Fed is too hasty.
3. If the Fed acts as slowly as current plans project, it will own trillions in securities for years to come. An experiment begun in the 2008 financial crisis is becoming permanent, endowing the Fed – and whoever controls it – with vast expanded powers.
4. The slow pace of quantitative tightening is partly responsible for the Fed’s inability to contribute to the national budget.
That’s because the Fed has also raised interest rates, which move in the opposite direction of bond prices. With its own policies, the Fed has reduced the value of its asset holdings. And by now, it has inflicted more than US$133.3 billion of losses on itself.
Unlike Silicon Valley Bank, which became insolvent last year, the Fed can survive paper losses – but it can’t help the US government reduce staggering deficits.
Quantitative easing
QT is the inverse of an unorthodox approach to monetary policy known as quantitative easing, adopted by the Fed when Ben Bernanke was chair. After the collapse of Lehman Brothers in September 2008, the economy and the markets crashed. Trying urgently to give the economy a stimulative jolt, the Fed lowered interest rates to nearly zero, but that wasn’t enough.
Those were desperate times, and the Fed improvised. Expanding on a programme that the Bank of Japan started in 2001, the Fed began large-scale buying of Treasury bonds and mortgage-backed securities.
The idea, as Bernanke said in his book 21st Century Monetary Policy, was “to influence private-sector decisions, which don’t usually depend directly on Treasury yields”. The Fed, he added, “expected that lower yields in the Treasury market would result in lower yields elsewhere – for example, on residential and commercial mortgages and corporate bonds”.
In addition, Fed policymakers expected that “lower long-term, private-sector interest rates should stimulate business investment and consumer spending on new cars and houses”, Bernanke said. “Lower long-term interest rates would also increase the prices of other financial assets, such as stocks, and weaken the dollar, easing financial conditions more broadly.”
All of those things happened.
But what started as a temporary expedient evolved into a regular part of the Fed’s toolbox, one that the Fed has used too frequently, some economists say.
“The analogy is a terrible one, but what the Fed has done is engender an addiction,” Raghuram Rajan, a finance professor at the University of Chicago, said in an interview.
Rajan, a former governor of the Reserve Bank of India and chief economist of the International Monetary Fund, said that US banks had become “addicted to the easy liquidity” associated with the Fed’s expansionary policies, and that weaning them off this flood of money had proved excruciatingly difficult.
It’s revealing to look back at early official Fed commentary. In February 2010, in a statement before the House Committee on Financial Services, Bernanke said: “The Federal Reserve anticipates that it will eventually return to an operating framework with much lower reserve balances than at present.” His statement was labelled “Federal Reserve’s exit strategy”.
But the Fed never exited its quantitative easing strategy. In fact, Fed records show that when Bernanke testified in 2010 about an eventual end to quantitative easing, the central bank’s balance sheet contained less than US$2.3 trillion in assets. Fourteen years later, the Fed holds more than three times that total, even after its most ambitious “tightening” round to date.
Why tightening is tough
Crises happened, the economy faltered and the Fed engaged in multiple rounds of quantitative easing under Bernanke and his successors, Janet Yellen and Jerome Powell, the current Fed chair.
All tried QT – which, in early Fed planning, appeared to mean a reversal of the Fed’s active intervention in the bond and mortgage markets, a radical reduction in its holdings and a return to precrisis operations. In his 2010 testimony, for example, Bernanke said the Fed could eventually sell the assets it purchased.
But all these years later, it has not done so. When it is not in emergency-response mode and is trying to return to something resembling “normal”, it has allowed maturing bonds and other securities to slowly “run off” or “roll off”, instead of reinvesting the proceeds, which would maintain the size of its asset stash.
It’s moving at an excruciating pace. A report in April by a group within the New York Federal Reserve Bank projected that even with continued QT, the assets on the overall Fed balance sheet will fall no lower than US$6 trillion in the next few years – and then begin rising again.
In the past, when the Fed even hinted that it might swiftly shed assets, financial markets buckled. In a news conference on Wednesday, Powell alluded to the 2019 QT effort that led to chaos in the money markets – and an about-face by the central bank. The Fed is now slowing the already stately pace of balance sheet roll-off precisely “so that it doesn’t lead to financial turmoil as it did the last time”, he said.
Simply put, the Fed’s balance sheet has assets on one side and liabilities on the other – and they must balance. When it buys assets, it creates bank reserves out of thin air, and it has been paying banks to keep those reserves deposited at the Fed. The reserves are available for emergencies as well as for routine operations. In periods of QT, such as this one, both the assets and the reserves shrink – and that has periodically caused major dislocations.
So far in this round, the Fed has been managing the process deftly. Scarcely anyone has noticed it drain more than US$1 trillion from the financial system. Yet, by concentrating so much financial firepower in its own hands, the Fed may be assuring that the potential for major flare-ups, and even worse, will always loom. NYTIMES
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