Today’s title comes from the code name used for the first test to detonate a nuclear weapon in 1945. Legend has it that Dr. Edward Teller worried that a nuclear fission explosion could ignite the Earth’s atmosphere and destroy the planet. Upon further study, most worries were put to rest. However, it is famously noted that Dr. Enrico Fermi joked right before the test at Los Alamos, “Now, let’s make a bet whether the atmosphere will be set on fire by this test!” Rumor has it that a few of the world’s greatest scientific minds were still a bit nervous that it might happen.
I always reflected upon Trinity and that story when the Federal Reserve (Fed) embarked on its asset purchasing bonanza in 2008 to 2014, ballooning its balance sheet (and excess bank reserves at the Fed) to $4.5 trillion. The purchasing of assets was the relatively easy part. How they would eventually unwind the program, and how we could assess the costs and effects on the economy, the financial system, and society were always my “Dr. Teller Moment.”
Now the Fed is beginning to actively discuss the unwinding of the program. I am starting to come around to the idea that there is a narrow path they can follow that will unwind the balance sheet and not destroy the economy and the financial markets. Perhaps they can gradually unwind the balance sheet over time and not do too much damage. That would be great! However, no sooner had I breathed a hopeful sigh of relief, than I see this quote from Federal Reserve Bank of Boston President yesterday:
It is inevitable we’re going to be talking about the balance sheet expanding in future recessions, in fact in most recessions unless they are very, very mild.”
The policy of the Fed purchasing massive amounts of financial assets was always sold to the public as extraordinary policy—something to be used in extreme circumstances. Now, it seems they are looking at the program and their balance sheet as just another tool. This reminds me of 1950s and 1960s military generals, who viewed nuclear weapons as just another weapon. Luckily, there were not many of these generals, and fortunately, we had Presidents Truman, Eisenhower, and Kennedy to shut them down!
It seems that the Fed believes that this societal changing tool, Quantitative Easing (QE), is something they can use at their discretion, whenever they feel like it. Many current and former Fed leaders have stated that upon tapering, they are targeting a balance sheet that is significantly higher than what it was before 2008. The size of the balance sheet that we have seen tossed around has been in the neighborhood of $2 trillion (it was about $900 million before 2008). An argument put forth by former Fed Chairman Bernanke was that maintaining a relatively large balance sheet, and hence a relatively high level of excess bank reserves, has become a vital tool in influencing short-term rates. In a September 2016 speech, Mr. Bernanke said”
“With the enormous quantity of reserves now available, however, small changes in the supply of reserves no longer suffice to control the fund’s rate. Today, the Fed influences it and other short-term rates primarily by varying the interest rate it pays banks on their reserves (known as IOER, or interest on excess reserves). This approach relies on the presumption that banks are unlikely to want to borrow or lend in private markets at an interest rate much different from what they can earn on the reserves they hold at the Fed. To further improve its control of interest rates, the Fed now also allows other private-sector institutional lenders, such as money market funds, to earn a fixed rate of interest on cash held for short periods with the Fed, through a program known as the overnight reverse repurchase (RRP) program.”
This scares me. I, along with most people, believed that QE was a policy to be used only in the direst of circumstances, like a severe recession or a depression brought on by a terrible credit event, like the one in 2008. A simple economic cycle recession? No way. Now, judging by the Fed’s statements, this is not the case. What makes this frightening is that the use of nuclear weapons must be authorized by the President. The use of QE and the maintenance of a giant balance sheet only needs the authorization of the Fed itself!
I believe they need to walk back this type of thinking. Quantitative easing has proven that it is much more than just monetary policy. Our current experience has shown that for every winner, there is a loser, and the magnitude of these wins and losses is tremendous.
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