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The dangers of the Fed’s huge bond holdings

The Federal Reserve is involved in a colossal transformation of the financial industry. But hardly anyone notices it.

What it does is like taking a walk Herd of elephants through midtown Manhattan without drawing much attention. This used to happen in New York in the early hours of the morning – when the circus came to town and elephants ran across the city’s bridges and through its tunnels to Madison Square Garden.

I’m not talking about the Fed’s decisions on short-term interest rates, which are making headlines at the central bank meeting like Wednesday. The Fed kept those interest rates stable — and fairly high — at around 5.33 percent, in a frustrating battle to contain inflation.

I’m talking about a remarkably ambitious and little-understood Fed project known as quantitative tightening, or QT. This refers to the Fed’s reduction of Treasury bonds and mortgage-backed securities in its mammoth balance sheet.

The central bank said On Wednesday, the central bank announced that starting in June it would begin slowing the pace of this asset erosion from a maximum of $95 billion per month to $60 billion per month. This is not the sale of securities, but simply the tacit disposal of some when they mature without reinvesting the proceeds.

These can look like large numbers. However, they are ridiculous in comparison.

Remember that the Central bank assets peaked two years ago at almost $9 trillion. This sum represents about one-third of all goods and services – gross domestic product – produced in the United States in a year. Now, after careful effort, the Fed has reduced that total to around $7.4 trillion.

Yes, it took about $1.6 trillion out of its coffers. But even after two years of quantitative tightening, the amount of bonds and securities the Fed is still holding is enormous.

While this is startling, a basic understanding of quantitative tightening is important for several reasons:

  • Policies are now impacting financial markets and making living conditions more difficult for millions of people Upward pressure in the government bond and mortgage markets and a variety of related interest rates, effectively complementing the Fed’s monetary tightening by raising the key short-term interest rate.

  • Quantitative tightening is a dangerous operation. Previous attempts – esp in 2019 — disrupted financial markets. This could happen again if the Fed gets too hasty.

  • If the Fed moves as slowly as current plans suggest, it will own trillions of dollars in securities in the coming years. An experiment that began in the 2008 financial crisis is becoming permanent, giving the Fed — and whoever controls it — broad expanded powers.

  • The slow pace of quantitative tightening is partly responsible for the Fed’s inability to contribute to the federal budget.

That’s because the Fed has also raised interest rates, which move in the opposite direction of bond prices. Through its own policies, the Fed has reduced the value of its asset holdings. And it has now inflicted more than $133.3 billion in losses on itself.

not how Silicon Valley Bankwhich defaulted last year, the Fed can weather paper losses — but it can’t help the U.S. government reduce huge deficits.

QT is the reversal of an unorthodox monetary policy approach known as quantitative easing, adopted by the Fed at the time Ben S. Bernanke was chair. After the collapse of Lehman Brothers in September 2008, the economy and markets collapsed. In an urgent attempt to provide a stimulus to the economy, the Fed cut interest rates to near zero, but it wasn’t enough.

These were desperate times, and the Fed improvised. Expanding on a program the Bank of Japan launched in 2001, the Fed began large-scale purchases of government bonds and mortgage-backed securities.

The idea, as Mr. Bernanke said in his book: “Monetary policy in the 21st centuryThe aim was to “influence private sector decisions that are not normally directly dependent on government bond yields.” The Fed, he added, “expected that lower yields in the Treasury market would lead to lower yields elsewhere – for example, on residential and commercial mortgages and corporate bonds.”

Additionally, Fed policymakers expected that “lower long-term interest rates in the private sector would boost business investment and consumer spending on new cars and homes,” Bernanke said. “Lower long-term interest rates would also push up the prices of other financial assets such as stocks and weaken the dollar, easing overall financial conditions.”

All of these things happened.

But what started as a temporary stopgap turned into a permanent part of the Fed’s toolbox that some economists say the Fed has overused.

“The analogy is terrible, but what the Fed has done is create an addiction,” Raghuram Rajan, a finance professor at the University of Chicago, said in an interview.

Mr. Rajan, a former Reserve Bank of India governor and chief economist at the International Monetary Fund, said U.S. banks had become “addicted to the easy liquidity” associated with the Fed’s expansionary policies and had been weaned off it The flood of money had proven extremely difficult.

It is instructive to look back at the Fed’s early official comments. In February 2010, in a statement before the House Financial Services Committee, Mr. Bernanke said: “The Federal Reserve expects to eventually return to an operating framework with much lower reserve balances than currently.” His statement was described as the “Federal Reserve’s exit strategy.”

But the Fed never abandoned its strategy of quantitative easing. In fact, Fed records show that the central bank’s balance sheet contained less than $2.3 trillion in assets when Mr. Bernanke testified about a possible end to quantitative easing in 2010. Fourteen years later, the Fed holds more than three times that amount, even after its most ambitious round of tightening to date.

Crises arose, the economy stalled, and the Fed got involved several rounds the quantitative easing under Mr. Bernanke and his successors, Janet L Yellen And Jerome H Powellthe current Fed chairman.

All attempted quantitative tightening – which in early Fed planning appeared to mean a reversal of the Fed’s active interventions in the bond and mortgage markets, a radical reduction in its holdings and a return to pre-crisis activity. For example, in his 2010 testimony, Bernanke said the Fed could eventually sell the assets it purchased.

But all these years later, this has not happened. When it is not in emergency mode and trying to return to something resembling “normalcy,” it has allowed maturing bonds and other securities to slowly “expire” or “unroll” instead of reinvesting the proceeds, which is holding the stock would be the size of his wealth stock.

It moves at an unbearable pace. A report In April, a group within the New York Federal Reserve Bank predicted that even if quantitative tightening continued, assets across the Fed’s balance sheet would fall – and then rise again – by as much as $6 trillion over the next few years.

In the past, when the Fed even hinted that it might reduce its assets quickly, financial markets collapsed. In a news conference on Wednesday, Mr. Powell alluded to this 2019 quantitative tightening efforts led to chaos in the money markets – and a U-turn by the central bank. The Fed is now carefully slowing down the already impressive pace of balance sheet reduction “so that there is no financial turbulence like last time,” he said.

Simply put, the Fed’s balance sheet consists of assets on one side and liabilities on the other – and these must balance. When it buys assets, it creates bank reserves out of thin air, and it pays banks to keep those reserves on deposit with the Fed. The reserves are available for both emergencies and routine operations. In times of quantitative shortages like this, both assets and reserves shrink – and this has regularly led to major disruptions.

So far, the Fed has managed the process skillfully in this round. Hardly anyone realized that this would drain more than a trillion dollars from the financial system. But by concentrating so much financial power in its own hands, the Fed may be ensuring that the possibility of bigger crises and worse crises will always loom.

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