Will the Fed Keep Tightening as Banks Fail?
Quantitative tightening is supposed to be boring. That’s by design.
It doesn’t demand attention like a bank failure, emergency government rescue, wildly fluctuating interest rates or uncomfortably high inflation.
But it is the most important Federal Reserve program you rarely hear about.
At its core, it involves reducing the more than $8 trillion — yes, trillion — in bonds and mortgage-backed securities held by the Fed, along with draining money from the financial system. All this shrinkage is part of the Fed’s efforts to quell inflation, which is running at 6 percent a year.
Treasury Secretary Janet L. Yellen once said the slimming process should be as dull as “watching paint dry.” Jerome H. Powell, her successor as Fed chair, said it was so straightforward that it should be on “automatic pilot” and wouldn’t merit close scrutiny.
They were both being optimistic, if not entirely disingenuous, I’d say.
Keeping the enormous asset reduction program boring in a year like this will be a remarkable accomplishment — like parading a barely tamed elephant through city traffic. At any moment, someone could be trampled.
Some damage has already taken place. It’s fair to say that the Fed’s gargantuan operation has contributed to the grave problems faced by regional banks and Treasury traders — and to the high mortgage rates that have made it difficult for ordinary people to afford homes.
Furthermore, by effectively reducing the money supply, quantitative tightening has amplified the impact of rising rates throughout the economy. And by removing the Fed as the biggest buyer of Treasuries and of mortgage-backed securities, quantitative easing has weakened these markets.
Because interest rates and bond prices move in opposite directions, quantitative tightening has cut the value of bonds on bank balance sheets. Such losses were partly responsible for the collapse of Silicon Valley Bank, the biggest bank failure since 2008.
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The decline of the stock and bond markets this year has been painful, and it remains difficult to predict what is in store for the future.
Rising interest rates have also caused the value of the bonds on the Fed’s very own balance sheet to lose value, while increasing its expenses. This makes it exceedingly unlikely that the Fed this year will send the U.S. Treasury its customary $100 billion in annual internal profits. That could become a political flashpoint as the federal debt ceiling approaches.
If you have money in the stock or bond markets, directly or through funds, you have been hurt, too. Quantitative tightening — along with the conventional Fed rate increases — helped set off big price drops over the last year, causing major losses in most portfolios.
Fed policymakers meet again next week. After the bank closures and financial tensions of recent days, speculation has centered on whether the Fed will stop raising the federal funds rate and abandon its focus on curbing inflation — and perhaps even prepare to start cutting rates — to ensure that the financial system is stable.
But economists at Nomura Securities say the Fed should stop quantitative tightening now, too.
How It Started
Quantitative tightening is the flip side of quantitative easing, an experiment that started in earnest during the 2007 and 2008 financial crisis.
The global economy fell into a deep recession then. The Fed engaged in rescue operations that included gigantic monetary stimulus. Under Ben S. Bernanke, it lowered interest rates to near zero. Then, it tried quantitative easing. The idea was to create a “shadow” real interest rate — one that was below zero, effectively in negative territory — providing more oomph for the economy than conventional interest rate cuts could do alone.
In his 2022 book on contemporary monetary policy, Mr. Bernanke described the experiment blandly as “large-scale purchases of longer-term securities,” aimed specifically at restoring the moribund housing market. The Fed did this by buying up mortgage-backed securities in an effort to drive down mortgage rates.
It still has an outsize effect on the housing market. But now, the Fed is playing a negative role.
Over the last year, mortgage rates moved more sharply upward than Treasury rates. But why? The Fed is a quiet elephant in these markets. It holds more than $2.6 trillion in mortgage-backed securities (as well as $5.3 trillion in Treasuries, where it is a giant, too), making it the biggest owner and, until last year, the biggest buyer. Since it started quantitative tightening in June, the Fed has been putting downward pressure on prices and impelling yields — and, especially, mortgage rates — upward.
How It’s Going
Despite previous tightening attempts — including a $675 billion balance sheet reduction from October 2017 to March 2019 — the Fed’s mammoth stake in financial assets grew exponentially over the past 15 years.
The current tightening hasn’t made much of a dent. On March 8, the Fed still held $8.34 trillion in assets. That’s less than the $8.965 trillion peak of last April — but only 6 percent less.
In order to minimize disruption, the Fed is paring some securities when they mature, not selling them rapidly. If even this ponderous pace continues — a questionable assumption in today’s parlous markets — it will take two years to reach the $6 trillion range. That’s still an unfathomable fortune — about $2 trillion more than before the pandemic.
The Fed bought up these assets with its unique powers to create money. This was deliberately inflationary. U.S. government debt is $31.5 trillion, and the Fed financed a big chunk of it.
Now, it is reversing itself. The probable effects — in terms of slowing growth, increasing unemployment and reducing inflation — are hard to calculate, but Solomon Tadesse has tried. He heads North American Quantitative Equity Strategies for Société Générale. In an interview, he estimated that a $2 trillion reduction would be roughly equivalent to 2.4 percentage points of additional increases in the Fed funds rate. “It would have a serious impact,” he said.
Will the Fed ever get there?
It has capped monthly asset reductions at $95 trillion, divided between Treasuries, at $60 billion, and mortgage-backed securities, at $35 billion. But it hasn’t hit those targets, especially for mortgage-backed securities.
By raising rates, the Fed made it imprudently expensive for homeowners to refinance mortgages, and relatively few people have taken out new mortgages to buy homes. As a result, 98 percent of the mortgage-backed securities on the Fed’s books won’t mature for at least a decade, by my calculations. Unless rates drop, mortgages won’t turn over.
If the Fed keeps tightening, it will have to remain a behind-the-scenes giant in the mortgage market for many years — or sell large quantities of securities at a loss. Such sales would risk a new market debacle that could make mortgage rates soar further, adding to the damage in the housing and construction and real estate industries.
Of course, the Fed could abandon rate increases and quantitative tightening. That would mean an end to the Fed’s inflation fighting, and was unthinkable a short time ago. But it could happen if banking problems escalate and a recession is evident.
For the Fed, returning to pre-2008 policymaking isn’t an option. The tandem of quantitative easing and tightening is an essential part of the Fed tool kit. Economic textbooks and teaching plans are being rewritten to incorporate the shift.
Briefly put, the Fed has moved to an “ample reserves” regime, meaning it makes plenty of “reserves” — money — available for banks and money market funds at attractive interest rates. That works only with ample assets on its balance sheet.
It is trimming assets and draining reserves to get into fighting shape. It says it will stop well before the safety of banks and money market funds is impaired. And by “normalizing” monetary policy through shedding assets and raising rates, it is restocking its arsenal for the next economic shock.
If we are lucky, that won’t happen soon. The current turmoil will calm down without much more Fed involvement, and the Fed can continue with its slow and steady quantitative tightening.
But I’d hedge my bets. Invest for the long run, yes, but hold the money you need to pay the bills in F.D.I.C.-insured accounts or in money market funds that own Treasuries. Don’t take excessive risks.
In a severe crisis, the central bank would undoubtedly flood the economy once again with boundless streams of money. The only question is when it will have to start.
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