Will the Fed continue to tighten as the banks fail?

Quantitative tightening is supposed to be boring. It is by design.

It does not demand attention like bank failure, emergency government rescue, wildly fluctuating interest rates, or excessively high inflation.

But it’s the most important Federal Reserve program that you rarely hear about.

At its core, it’s about cutting the more than $8 trillion — yes, trillion — of bonds and mortgage-backed securities held by the Fed, as well as draining money from the system financial. This whole contraction is part of the Fed’s efforts to rein in inflation, which is running at 6% a year.

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

They were both optimistic, if not totally hypocritical, I would say.

Keeping the huge, boring asset reduction program going in a year like this will be a remarkable achievement – ​​like parading a barely tamed elephant through city traffic. At any time, someone could be stepped on.

Some damage has already taken place. It’s fair to say that the Fed’s gargantuan operation has contributed to serious problems for regional banks and Treasury traders – and high mortgage rates that have made it difficult for ordinary people to buy a home.

Moreover, by effectively reducing the money supply, quantitative tightening amplified the impact of the rate hike across the economy. And by removing the Fed as the biggest buyer of Treasuries and mortgage-backed securities, quantitative tightening has weakened those markets.

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

Rising interest rates also devalued bonds on the Fed’s own balance sheet, while increasing spending. It is therefore extremely unlikely that the Fed will send the US Treasury its usual $100 billion in internal profits this year. This could become a political flashpoint as the federal debt ceiling approaches.

If you have money in the stock or bond markets, either directly or through funds, you have also been affected. Quantitative tightening – along with conventional Fed rate hikes – have helped trigger steep price declines over the past year, leading to significant losses in most portfolios.

Fed policymakers will meet again next week. After the bank closings and financial strains of the past few days, speculation has centered on whether the Fed will stop raising the fed funds rate and drop its focus on fighting inflation — and perhaps it will even prepare to start cutting rates – to ensure the stability of the financial system. .

But economists at Nomura Securities say the Fed should also stop quantitative tightening now.

how it started

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

The world economy then fell into a deep recession. The Fed embarked on bailouts that included massive monetary stimulus. Under Ben S. Bernanke, he lowered interest rates to near zero. Then he tried quantitative easing. The idea was to create a “fictitious” real interest rate – a rate below zero, effectively in negative territory – giving more momentum to the economy than conventional interest rate cuts could do to them. alone.

In his 2022 book on contemporary monetary policy, Mr Bernanke described the soft experiment as “large-scale purchases of longer-dated 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 outsized effect on the housing market. But now the Fed is playing a negative role.

Over the past year, mortgage rates have risen more sharply than Treasury rates. But why? The Fed is a quiet elephant in these markets. He owns more than $2.6 trillion in mortgage-backed securities (as well as $5.3 trillion in Treasuries, where he is also a giant), making him the largest owner and, so far, ‘to last year, the biggest buyer. Since it began its quantitative tightening in June, the Fed has been putting downward pressure on prices and pushing yields – and, in particular, mortgage rates – higher.

How’s it going

Despite previous tightening attempts – including a $675 billion balance sheet reduction from October 2017 to March 2019 – the Fed’s gigantic stake in financial assets has grown exponentially over the past 15 years.

The current tightening has not done much. On March 8, the Fed still held $8.34 trillion in assets. That’s less than last April’s $8.965 billion peak, but only 6% lower.

To minimize disruption, the Fed cuts certain securities as they mature, without selling them quickly. If even this breakneck pace continues — a debatable assumption in today’s alarming markets — it will take two years to reach the $6 trillion range. It’s still an unfathomable fortune – about $2 trillion more than before the pandemic.

The Fed purchased these assets with its unique powers to create money. It was deliberately inflationary. US public debt is $31.5 trillion, and the Fed has financed a large portion of it.

Now it reverses. The likely effects – in terms of slower growth, higher unemployment and lower inflation – are hard to calculate, but Solomon Tadesse tried. He leads North American quantitative equity strategies for Société Générale. In an interview, he estimated that a $2 trillion cut would be roughly equivalent to 2.4 percentage points of additional increases in the federal funds rate. “It would have a serious impact,” he said.

Facing the constraints

Will the Fed ever get there?

It capped monthly asset reductions at $95 billion, split between treasury bills at $60 billion and mortgage-backed securities at $35 billion. But it fell short of those targets, especially for mortgage-backed securities.

By raising rates, the Fed made it recklessly expensive for homeowners to refinance their mortgages, and relatively few people took out new mortgages to buy homes. As a result, 98% of mortgage-backed securities on the Fed’s books won’t mature for at least a decade, by my calculations. Unless rates go down, mortgages will not be paid off.

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

Of course, the Fed could abandon rate hikes and quantitative tightening. It would mean the end of the Fed’s inflation fight, and it was unthinkable not long ago. But it could happen if banking problems worsen and a recession is evident.

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

In short, the Fed has moved to an “adequate reserves” regime, which means it is making plenty of “reserves” – money – available to banks and money market funds at rates of attractive interest. This only works with sufficient assets on its balance sheet.

It reduces assets and drains reserves to get fit for battle. He says he will stop long before the safety of banks and money market funds is compromised. And by “normalizing” monetary policy by dumping assets and raising rates, it is replenishing its arsenal for the next economic shock.

If we’re lucky, that won’t happen 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 money market funds that hold treasury bills. Don’t take excessive risks.

In the event of a severe crisis, the central bank would undoubtedly again flood the economy with unlimited flows of money. The only question is when he should start.