Will the Fed continue to tighten as banks fail?

Quantitative adjustment is supposed to be boring. That is by design.

Doesn’t demand attention like a bank failureemergency government rescuewildly fluctuating Interest rates or awkwardly high inflation.

but it is the most important Federal Reserve program you rarely hear about.

In essence, it involves reducing the more than $8 trillion, yes, trillion, in bonds and mortgage-backed securities held by the Federal Reserve, as well as draining money from the financial system. All of this tightening is part of the Fed’s efforts to stifle inflationRunning on 6 percent one year.

Secretary of the Treasury, Janet L. Yellen He once said that the thinning process should be as boring as “watching paint dry.” Jerome H. Powell, his successor as Fed chairman said it was so straightforward it should be on “autopilot” and not worth close scrutiny.

They were both being optimistic, if not outright disingenuous I would say.

Keeping the massive asset reduction program boring in a year like this will be a remarkable achievement, like parading a barely tame elephant through city traffic. At any moment, someone could be trampled.

Some damage has already been done. It’s fair to say that the Fed’s mammoth operation has contributed to the serious problems they face regional banks and treasure merchants — already high mortgage rates that have made it difficult for ordinary people to afford a house.

Furthermore, by effectively reducing the money supply, quantitative tightening has amplified the impact of the rate increase on the entire economy. And by removing the Fed as the biggest buyer of Treasuries and mortgage-backed securities, quantitative tightening has weakened these markets.

Because interest rates and bond prices move in opposite directions, quantitative tightening has reduced the value of bonds on banks’ balance sheets. Such losses were partly responsible for the collapse of Silicon Valley Bankthe biggest bank failure since 2008.

Rising interest rates have also caused the value of bonds on the Fed’s own balance sheet to lose value, while increasing its spending. This makes it extremely unlikely that the Fed this year will send the US Treasury its usual $100 billion in annual internal earnings. That could become a political flash point as the federal debt ceiling approaches.

if you have money in the stock or bond markets, directly or through funds, you too have been hurt. Quantitative tightening, coupled with conventional Fed rate hikes, helped trigger large price declines over the past year, causing major losses in most portfolios.

Fed policymakers will meet again next week. After the bank closures and financial stress of the past few days, speculation has turned to whether the Fed will stop raising the fed funds rate and abandon its focus on curbing inflation, and perhaps even prepare to start to cut rates, to ensure that the financial system is stable. .

But the economists of Nomura Values they say the Fed should also stop quantitative tightening now.

How it started

Quantitative tightening is the flip side of QE, an experiment that began in earnest during the financial crisis of 2007 and 2008.

The global economy then fell into a deep recession. The Fed engaged in bailout operations that included a massive monetary stimulus. Under Ben S. Bernanke, he cut interest rates to near zero. Then, he tried quantitative easing. The idea was to create a “shadow” real interest rate, one that was below zero, effectively in negative territory, providing more of a boost to the economy than conventional interest rate cuts alone could.

In his 2022 book on contemporary monetary policyMr. Bernanke mildly described the experiment as “large-scale purchases of longer-term securities,” specifically aimed at restoring the moribund housing market. The Fed did this by buying mortgage-backed securities in an effort to lower mortgage rates.

It still has an outsized effect on the housing market. But now, the Fed is playing a negative role.

During the past year, mortgage rates moved more sharply up than Treasury rates. But why? The Fed is a silent elephant in these markets. It owns more than $2.6 trillion in mortgage-backed securities (as well as $5.3 trillion in Treasuries, where it is also a giant), making it the biggest owner and, as of last year, the biggest buyer. Since quantitative tightening began in June, the Fed has been putting downward pressure on prices and pushing yields, and especially mortgage rates, higher.

How’s it going

Despite previous attempts at tightening, including a $675 billion balance sheet reduction from October 2017 to March 2019, the Fed’s mammoth share of financial assets has grown exponentially over the past 15 years.

The current tightening has not made much of a dent. On March 8, the Federal Reserve still had $8.34 trillion in assets. That’s down from last April’s peak of $8.965 trillion, but down only 6 percent.

To minimize disruption, the Fed is cutting some securities when they mature, not selling them quickly. If even this heavy pace continues, a questionable assumption in today’s sorry markets, it will take two years to reach the $6 trillion range. That is still an unfathomable fortune: about $2 trillion more than before the pandemic.

The Fed bought these assets with its unique powers to create money. This was deliberately inflationary. US government debt is $31.5 billion, and the Fed financed a large part.

Now, it is being reversed. The likely effects, in terms of slowing growth, rising unemployment, and lowering inflation, are hard to gauge, but Solomon Tadesse has tried. He leads North America quantitative equity strategies for Société Générale. In an interview, he estimated that a $2 trillion cut would be equivalent to about 2.4 percentage points of additional increases in the federal funds rate. “It would have a serious impact,” he said.

Facing Constraints

Will the Fed ever get there?

It has limited monthly asset drawdowns to $95 billion, 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 Federal Reserve has made it recklessly expensive for homeowners to refinance mortgages, and relatively few people have taken out new mortgages to buy homes. As a result, by my calculations, 98 percent of the mortgage-backed securities on the Federal Reserve’s books will not mature for at least a decade. Unless rates come down, mortgages won’t recover.

If the Fed continues to tighten, it will have to remain a behind-the-scenes giant in the mortgage market for many years, or sell large amounts of securities at a loss. Such sales would risk a new market meltdown that could send mortgage rates soaring further, adding to the damage to the housing, construction and real estate industries.

Of course, the Fed could abandon rate hikes and quantitative tightening. That would mean the end of the Fed’s fight against inflation, and it was inconceivable not long ago. But it could happen if banking problems escalate and a recession becomes apparent.

For the Fed, going back to pre-2008 policymaking is not an option. The quantitative easing and tightening tandem is an essential part of the Fed’s toolkit. economics textbooks and teaching plans they are being rewritten to incorporate the change.

In short, the Fed has moved to a “ample reserves” regime, which means that it makes a lot of “reserves” (money) available to banks and money market funds at attractive interest rates. That works only with extensive assets on your balance sheet.

He’s cutting assets and depleting reserves to get into fighting shape. He says it will stop long before the safety of banks and money market funds is affected. And by “normalizing” monetary policy by removing assets and raising rates, you are restocking your arsenal for the next economic shock.

If we’re lucky, that won’t be happening anytime soon. The current turmoil will subside without much more Fed involvement, and the Fed can continue its slow and steady quantitative tightening.

But I would hedge my bets. Invest for the long term, yes, but keep the money you need to pay the bills in FDIC-insured accounts or in money market funds that hold Treasury bonds. Don’t take excessive risks.

In a severe crisis, the central bank would undoubtedly flood the economy once more with unlimited flows of money. The only question is when it will have to start.