While we are transfixed by the flurry of controversial actions emanating from the White House, over at the Federal Reserve (the Fed), Fed governors, presidents, and the former chairman have been quietly discussing how to unwind perhaps the most impactful and important socio-economic policy this country has seen probably since the “Great Society” in the 1960s. I’m referring to the Quantitative Easing (QE) program that started in late 2008 and continues to this day. Currently, the Fed has a balance sheet of approximately $4.5 trillion consisting mostly of Treasury notes and agency mortgage-backed securities (MBS). While they are no longer adding to the portfolio, they are still reinvesting the principal pay downs from the $1.8 trillion MBS portfolio to the tune of $25 to $40 billion a month.
In JD Salinger’s novel, Catcher in the Rye, the infamous Holden Caulfield said, “It's funny. All you have to do is say something nobody understands, and they'll do practically anything you want them to.” If young Holden could have seen into the future, he might very well have been talking about QE. It is pretty safe to say that when the Fed embarked on QE, very few people really understood it, and one could argue that even the Fed didn’t have a full understanding of how the program would really affect the financial system and the broader economy. Moreover, and perhaps more importantly, once the policy was complete, how would they unwind it?
And yet, despite the broad lack of understanding, the Fed’s QE program crossed the boundary of monetary policy and became the dominant social policy of the last decade, with hardly a question from any other center of power in the United States. While I believe it was an unintended consequence, QE determined the winners and losers in the economy and society. Investors won big, while savers lost. Industries such as oil and gas (producers, transporters, and refiners) prevailed as QE drove investors into the bonds that financed the tremendous growth that returned the United States into a global energy powerhouse.
Meanwhile, the life insurance industry and pension fund managers took a beating as QE drove relatively safe, long-term asset yields to levels where they could not possibly grow enough to meet future liabilities. These companies were forced to take on more risk for more yield, which was a tremendous boon to major Wall Street broker-dealers, money managers, and private equity firms. With regard to individuals, those wealthy enough to own relatively large equity and other risk asset portfolios were made wealthier as QE drove risk assets higher. However, those individuals who rely on income from savings, like retirees, were harmed by near-zero interest rates. The wealth gap in the United States widened considerably during the era of QE, and I believe QE is partly to blame.
This week, perhaps because the White House is the focus of economic attention as opposed to the Fed for the first time in quite a few years, the Fed has begun talking about how to unwind QE. Former Fed Chairman Ben Bernanke chimed in on the discussion with a very informative blog post. Some Fed bank presidents are questioning whether it is time to slow down or stop reinvesting the $25 to $40 billion of monthly MBS runoff given the strengthening economy, inflation stirring, and the potential for significant fiscal policy. The answer from the Fed has come in multiple Federal Open Market Committee statements which assert that they won’t stop until their policy rates are significantly higher. The Fed has two major levers to pull in order to tighten monetary policy—they can raise the Fed Funds rate to shrink excess bank reserves at the Fed (excess reserves have risen from about $800 billion to about $2 trillion since QE started) or they can cease reinvesting MBS pay down from their portfolio.
With regard to ceasing reinvestment, imagine the principal pay downs from the bonds the Fed owns being thrown into the shredder. The asset goes away, and the monetary base and excess bank reserves at the Fed decline. This action is a tightening of monetary policy. From reading former Chairman Bernanke’s blog, together with the comments from various Fed members, it seems that once the Fed stops reinvesting, it wants to avoid starting and stopping, as this would create an unacceptable level of volatility in the rates markets (like the 2013 “Taper Tantrum”). The Fed would much rather have a higher Fed Funds rate from which to cut should the economy fall into recession, rather than restart reinvesting the MBS pay downs. In the perfect scenario, the Fed will be able to gradually raise the Fed Funds rate over the next two to three years, and then start allowing their balance sheet to run off. Optimally, they do not want to have to sell assets from their balance sheet, as that would disrupt the rates markets.
However, the question I have is, what if we get a less than perfect scenario? What if the Fed has waited too long to raise rates or reduce the size of their balance sheet? The Fed created about $1.5 trillion in additional excess bank reserves. What happens if growth and inflation ramp up faster than anticipated? The Fed will be forced to reduce those excess reserves at a very fast clip in order to prevent too much leaving the Fed and entering the economy too fast. That could create corrosive inflation. In this case, the Fed would find itself behind the curve and have to raise policy rates to abnormally high levels or sell assets from their balance sheet. This scenario could certainly wreak havoc in the financial markets and the economy.
Right now, the Fed assures us that the unwinding of QE will be a smooth and orderly process. Yet, this event is really without precedent. They’ve never done this before, and their confidence is a little unsettling. This reminds me of another Holden Caulfield observation: “If you do something too good, then, after a while, if you don’t watch it, you start showing off. And then you’re not good anymore.”
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