As the financial crisis started to become apparent to the policy makers on the Federal Open Market Committee (FOMC) at the Federal Reserve System (Fed) in late 2007, they started implementing fairly dramatic and extraordinary policy options.
The trouble is they were too drastic and they lasted far too long. Now, more than a decade later, the economy is in very good shape and based on its actions the Fed’s number one priority appears to be to achieve “monetary policy normalization.”
To the Fed, this means getting the federal funds (fed funds) rate up to a 3.5 percent to 4.0 percent range and the Fed’s balance sheet assets down to a level closer to where they were prior to the financial crisis.
The Fed seems to be in a desperate race toward normalization before a downturn in the economy arrives so that it has some tools to help fight the next recession. The Fed’s conundrum is whether it can achieve normalization without causing the economic downturn for which it is trying to prepare. In other words, the Fed is between a rock and a hard place.
How the Fed got there
As the bursting of the housing bubble in 2007 and its spillover effects on the U. S. economy and financial system became obvious, the Fed’s FMOC implemented a number of policy responses. The two most prominent actions were: (1) reducing interest rates and (2) purchasing securities on the open market.
Starting in September 2007 and ending in December 2008, the fed funds target rate was reduced from about 5.25 percent to a range between 0 percent and 0.25 percent. This near zero interest rate remained in effect until December 2015, a full seven years.
Prior to the start of the Great Recession, the Fed’s balance sheet had assets of about $900 billion consisting mostly of U. S. Treasury securities and it had liabilities and capital of about $900 billion consisting mostly of currency in circulation, reserve balances, and the Fed’s capital account.
Between 2009 and 2014, the Fed undertook three rounds of so-called “quantitative easing” (QE), buying Treasury securities, agency debt and agency mortgage-backed securities (MBS). These securities now comprise the majority of the assets on the Fed’s balance sheet.
By 2014, the Fed’s balance sheet ballooned to a peak of $4.5 trillion, including nearly $1.8 trillion of MBS, which are debt instruments primarily issued by three government, housing- finance related agencies: the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), and the Government National Mortgage Association (Ginnie Mae).
The Fed purchased these debt securities (bonds) from financial institutions, primarily commercial banks. To a great extent, they were bought to support their prices at a time when their values were unknown and the commercial banks and other financial institutions were anxious to get them off their books. In effect, the Fed created its own TARP (Troubled Asset Relief Program) primarily to help bailout commercial banks at taxpayers’ expense.
When the Fed buys securities from a commercial bank, it debits an asset account such as Treasury securities or mortgage-backed securities on the asset side of its balance sheet and credits the selling bank’s reserve balance account on the liability side of the Fed’s balance sheet. These additions to the Fed’s balance sheet liability account, reserve balances are simply created out of thin air; it is new money (credit) created by the Fed to purchase the securities. Today, the account, reserve balances represents about 45 percent of the Fed’s liabilities consisting of required reserves and mostly excess reserves. Other major liability accounts are: currency in circulation (Federal Reserve notes), U. S. Treasury accounts, foreign official accounts, non-bank deposits, and the Fed’s capital account. In 2008, the Fed began paying interest on bank excess reserves (IOER) which now consist of more than 90 percent of all reserve balances.
One of the effects of IOER is that the banks sat on the funds (interest paying reserve deposit accounts at the Fed) instead of making new loans, creating deposits, and thereby stimulating economic growth. The Fed, with IOER, in effect, paid the banks for not lending and QE did not result in much economic growth or accelerated inflation as many people had anticipated.
After the Great Recession ended, inflation remained low, unemployment remained high, and gross domestic product (GDP) grew at a very slow rate.
Because of price distortions caused by the Fed’s policies, many markets in the economy experienced significant disruptions. For example, in 2011, the price of an ounce of gold spiked to nearly $1,900 from less than $900 an ounce in 2008. In 2012, investors piled into U. S. Treasuries, pushing down the yield on the 10-year note to a 200-year low. In 2013, the Dow Jones Industrial Average ran up 24 percent while the demand for bonds reversed course and interest rates jumped 75 percent. During 2014 and 2015, the value of the U. S. dollar rose 25 percent. In essence, the Fed lowered interest rates to zero for seven years and printed $3.5 trillion of new money with the objective of stimulating the economy, only to cause major disruptions to markets and produce the weakest economic recovery in history.
In the fall of 2014, the Fed began reversing the policy actions it started in 2007. During the month of October 2014, the Fed ended its program of quantitative easing; it stopped its massive program of open market securities purchases.
Its asset portfolio then remained essentially unchanged for the next three years. Near the end of 2017, the Fed started reducing its portfolio $10 billion per month by allowing maturing securities to runoff without replacing them. Last year it reduced its bond portfolio by $20 billion per month in the first quarter of the year, $30 billion per month in the second quarter, $40 billion each month in the third quarter, and $50 billion monthly in the forth quarter. At the rate of $50 billion a month, the Fed’s balance sheet is shrinking at a rate of $600 billion per year.
Starting in December 2015, the Fed began implementing a plan to raise interest rates 0.25 percent every March, June, September, and December. On Dec. 19 of last year, the Fed raised the fed funds rate for the ninth time to a target range of 2.25 percent to 2.50 percent.
That afternoon Fed Chairman, Jay Powell held a press conference. While the December interest rate hike was widely anticipated and built into most market prices, Powell’s remarks had a major disruptive effect on financial markets. First, he stated that it is likely that there will be two more rate hikes next year and then responding to a question regarding balance sheet normalization, Powell said that the Fed’s balance sheet runoff is on autopilot and would continue at the $50 billion per month rate.
Those remarks seemed to have a negative impact on both the equity and credit markets. That afternoon, the S&P 500 index dropped by 1.51 percent after being up more than 1 percent earlier in the day. The 10-year Treasury note yield fell to 2.7673 percent and the 2-year fell to 2.6417 percent.
A little over two weeks later, during a panel discussion at the American Economic Association’s annual meeting in Atlanta on Jan. 4 of this year, the Fed chairman seemed to reverse course and had a new message for the markets. Saying the U. S. economy has “good momentum,” he added, “With the subdued inflation reading we’ve seen coming in, we will be patient as we watch to see how the economy evolves.” He said the Fed is also aware of market concerns over the reduction of its balance sheet. Despite proclaiming the Fed’s new market sensitivity, surprisingly, he said he does not think the portfolio runoff is an important part of the story of the recent market decline.
What the Fed should do
It is time for the Fed to heed an old Wall Street saying, “There’s a time to buy; there’s a time to sell; and there’s a time to go fishing.” In other words, the Fed should do nothing unless there is some significant change to the country’s economic status.
In early January, the president of the Dallas Fed, Robert Kaplan said that because of slowing global growth, weakness in rate-sensitive industries, and tightening financial conditions that have included a sharp stock market drop, the Fed should stop raising rates until it gets a clearer picture of where the economy is headed.
Other reasons for keeping rates at current levels include the fact that by most measures, there are excessive debt loads carried by the public, business, and household sectors, in other words, just about the entire economy is over-leveraged.
These high debt levels in addition to the fact that real interest rates were zero for such an extended period of time, means that the economy has a higher than normal sensitivity and vulnerability to increases in the rate of interest.
Interest rate increases also exacerbate the burden of servicing these high debt levels. People at home and in various institutions have grown accustomed to zero real interest rates and it will take some time for them to adjust their attitudes, thinking and behavior. All of these are conditions to which the FMOC seems to have been oblivious.
The Fed also should quit quantitative tightening (QT); stop shrinking the size of its balance sheet. There are few good reasons for continuing the market disrupting actions of further QT. Keeping the Fed’s balance sheet assets around $4 trillion would not constrain the Fed from additional asset purchases if the FOMC though they were needed. In a Brookings Institution article published on Jan. 26, 2017, entitled, “Shrinking the Fed’s balance sheet,” former Fed Chairman, Ben Bernake stated, “that there are reasonable arguments for keeping the Fed’s balance sheet large indefinitely, including improving the transmission of monetary policy to money markets, increasing the supply of safe short-term assets available to market participants, and improving the central bank’s ability to provide liquidity during a crisis.” With large amounts of reserves, the banking system is in a lot safer position than if bank reserve balances were equal only to those bank reserve deposits which are required.
I have read where many economists have expressed the opinion that the Fed has nearly total control over the size of its balance sheet; this is not the case. Most analysts concentrate all of their attention on the asset side of the Fed’s balance sheet while ignoring its liability side. Currently, there are about $700 billion in Fed liabilities associated with non-banks; these include deposits held by the U. S. Treasury, foreign central banks, international agencies, and non-bank financial institutions in the U. S. The Fed provides banking services on demand to these institutions. In addition, there is the Fed’s capital account and approximately $1.7 trillion of currency in circulation.
Currency in circulation, which consists mostly of $100 denominated Federal Reserve notes is not a bad kind of liability to have since these debt instruments which serve as legal tender require no interest payments. In the year 2000 this liability account stood at about $600 billion. At the time of the financial crisis it was around $800 billion. Today, this liability account is approximately $1.7 trillion.
Given its growth, in another five to seven years, currency in circulation could be approaching $2.5 trillion. The consistent growth of the majority of the Fed’s liabilities is largely outside the control of the Fed and it will need to offset these additional liabilities by increasing the Fed’s securities portfolio. Over time, the Fed’s ability to shrink its balance sheet may be surprisingly short-lived.
As I wrote earlier, in recent years the Fed’s number one priority appears to be to achieve monetary policy normalization. It is somewhat understandable that the Fed wishes to be prepared for the next recession or financial crisis. However, its statutory objectives do not include normalization; they are maximum employment and price stability. Recent economic data demonstrate that the U. S. economy is doing quite well on both of these measures. So, for a while at least, the Fed should try to find a confortable spot somewhere between a rock and a hard place and start casting a fishing line.
Dennis W. Richardson is a retired investment banker who has held high-level positions in academia, government, banking, and industry. He is the author of “Electric Money” a book published by MIT Press and holds a Ph.D. in finance from the University of Texas at Austin.