In the complex interplay between consumer price inflation and interest rates lies the significant role of central planners intervening in the market. Choices made today can lead to unexpected consequences tomorrow. The Federal Reserve’s past missteps in monetary policy contribute to the challenges we face now.
During the surge of quantitative easing (QE) amid the turmoil of repo issues and the COVID-19 pandemic, the Federal Reserve dramatically increased its balance sheet, soaring from $3.7 trillion in September 2019 to an astounding $8.9 trillion by May 2022.
The Fed essentially created money from nothing, using it to purchase U.S. Treasuries and mortgage-backed securities. Despite employing numerous economists with advanced degrees, the Fed decided to buy these assets when yields were at the lowest levels seen in 5,000 years.
The fallout from this asset purchasing spree is detailed weekly in the Fed’s H.4.1 report. As of May 30, the remittances owed to the U.S. Treasury reached a staggering deficit of $171.9 billion, a 163 percent increase compared to the same week last year.
To clarify, negative remittances represent a form of operational loss.
A fundamental principle taught in Finance 101 is this: when interest rates rise, bond prices fall. This essential concept underpins the functioning of capital markets. However, the Fed seems to have disregarded this notion and now holds a portfolio of Treasuries that are underwater.
Previously, the Fed’s operating profits were transferred to the Treasury as remittances. Now, they are negatively impacting taxpayers as losses instead.
If you work, earn a salary, and pay taxes, consider the reality that you are indirectly covering the Fed’s operational losses. Does this thought comfort you as you begin your workweek on Monday morning?
Tune In Tokyo
Central bankers occasionally convene to reflect on their previous decisions. What went right? What went wrong? How can they better ensure monetary interventions foster global prosperity?
These inquiries are part of the ongoing process of improvement for monetary policymakers.
This past week, on May 27 and 28, the Institute for Monetary and Economic Studies hosted its annual Bank of Japan BOJ-IMES Conference in Tokyo. The conference focused on the theme, “Price Dynamics and Monetary Policy Challenges: Lessons Learned Going Forward.”
Understanding lessons learned is vital for improving corporate entities. They are intended to prevent the repetition of mistakes. In practice, however, these lessons often dilute responsibility, shifting blame from individuals to organizations.
This method functions until the accumulation of errors and lack of accountability reaches a tipping point.
During the BOJ-IMES Conference, European Central Bank executive board member Isabel Schnabel participated by sharing her insights on quantitative easing. From her viewpoint, policymakers “need to carefully assess whether the benefits of asset purchases outweigh the costs.”
Similar to the Fed, the ECB is experiencing financial losses from the bonds it purchased during the pandemic prior to future rate increases. The ECB reported a €1.3 billion loss in 2023, marking the first full-year deficit since 2004.
Lessons Unlearned
The ECB’s financial downturn has consequences, such as the elimination of the dividends it typically pays to national central banks.
Between 2018 and 2022, these dividends amounted to €5.8 billion, which national central banks would usually pass on to governments in the Eurozone. Schnabel indicated that while the losses in 2023 may not appear dire compared to earlier profits, they could still impact the credibility and reputation of central banks.
Perhaps Schnabel’s lesson for central bankers is to refrain from employing QE during periods of low interest rates. Yet, shouldn’t this be an intuitive understanding?
It seems that this lesson is more accurately described as one unlearned. When nominal interest rates are high but real interest rates remain low due to inflation, should central banks continue acquiring assets?
The most significant takeaway is clear: quantitative easing has proven to be a considerable failure.
Unfortunately, this realization seems to escape Federal Reserve Governor Michelle Bowman and her colleagues. Currently, she is focused on unwinding past QE efforts—termed quantitative tightening (QT)—to better utilize QE in future financial crises. At the Tokyo conference, Bowman stated:
“While it is important to slow the pace of balance sheet runoff as reserves approach ample levels, in my view we are not yet at that point. It is essential to keep reducing the size of the balance sheet to achieve ample reserves as soon as possible while the economy remains strong. This will allow the Federal Reserve to more effectively respond to future economic and financial shocks.”
The Fed’s Harrowing Search for Ample Reserves
Bowman’s comments contrast with the Fed’s latest implementation note, which states that beginning June 1, the Fed will scale back its monthly reduction of U.S. Treasuries from $60 billion to $25 billion, while maintaining the $35 billion limit for mortgage-backed securities.
The FOMC meeting minutes indicate that some members preferred to maintain the current pace of balance sheet reduction, implying that Bowman may align with this viewpoint.
At the core of the issue lies the concept of “ample” reserves. No one within the Fed—or anywhere else—can accurately determine what level constitutes “ample”. Nevertheless, the Fed continues its quest for this elusive target.
The experience gleaned from previous rounds of QT suggests that reducing the balance sheet below this unidentified threshold may trigger detrimental consequences, reminiscent of the repo crisis.
Recall that from the evening of September 16 to the dawn of September 17, 2019, the overnight repo rate surged to 10 percent, signaling a breakdown in short-term liquidity markets. In response, the Fed needed to inject hundreds of billions in credit nightly to sustain fluidity in credit markets.
This state of affairs quickly escalated amidst the coronavirus panic, resulting in the Fed grossly expanding its balance sheet by $5 trillion. By May 2022, the Fed’s balance sheet reached over $8.9 trillion, coinciding with a 40-year high in consumer price inflation.
As of now, the Fed’s balance sheet stands at approximately $7.4 trillion, reflecting a reduction of about $1.5 trillion. As a result, the Fed is growing increasingly anxious.
This time, it intends to proceed cautiously in its search for ample reserves.
Ultimately, the Fed may only realize it has crossed the threshold of ample reserves after it has already exceeded that level. By then, it might catalyze the next major financial crisis.
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Sincerely,
MN Gordon
for Economic Prism
Return from The Fed’s Harrowing Search for Ample Reserves to Economic Prism
