Why Won’t the Fed Be Able to Shrink Its Balance Sheet?
Earlier this week, Federal Reserve governor and vice-chair nominee Lael Brainard indicated the central bank will shrink its balance sheet at a “considerably” more rapid pace than it did during the previous cycle. I, Peter Schiff and a few others outside the mainstream have said the Fed won’t be able to do this.
Why not?
The Fed first expanded its balance sheet in the wake of the 2008 financial crisis. Through three rounds of quantitative easing (QE), the Fed expanded its balance sheet from under $1 trillion to $4.5 trillion. When the central bank started QE, then-Fed Chair Ben Bernanke swore the central bank wasn’t monetizing federal government debt. He said the balance sheet expansion was an emergency measure and that the Fed would eventually sell the bonds it was buying.
The Fed didn’t get around to balance sheet reduction until 2018, and it did so at a relatively slow pace. By the time it ended tightening in August 2019, the balance sheet was just below $3.8 trillion. In all, the Fed shed about $700 billion from its balance sheet in a little more than 18 months.
Why did the Fed abandon tightening in 2019?
Because in the fall of 2018, the stock market tanked and the economy went wobbly. The markets and the economy couldn’t handle even the modest monetary tightening the Fed managed to implement.
It’s important to remember that the Fed resumed QE months before the pandemic — although it didn’t call it QE. By the time the Fed launched QE 4 in 2020, the balance sheet had already expanded back to just over $4 trillion.
Over the last two years, the Fed has added another $5 trillion to the balance sheet expanding it to nearly $9 trillion.
Brainard indicated that the upcoming balance sheet runoff will be “considerably” faster than last time. She did not say what that actually means, but the Fed minutes from the March meeting shed a little bit of light on the nuts and bolts of the plan.
According to the minutes, the plan is to reduce the balance sheet by about $3 trillion over a three-year period. This would leave the balance sheet at $6 trillion – up by $2 trillion from its pre-pandemic level and more than $5 trillion above the pre-2008 financial crisis level. So much for Bernanke’s promise.
Looking at the big picture, the Fed’s plan is relatively modest. If it sticks to this plan, it will shrink the balance sheet by about $1 trillion per year.
But I don’t even think it can accomplish this.
If the central bank couldn’t run off $700 billion in 2018 without popping the bubbles and shaking up the economy, what makes anybody think it can decrease its balance sheet holdings by $3 trillion this time around with even bigger bubbles and more debt in the economy?
THE MECHANISM
I’m not basing my skepticism purely on speculation. The process of balance sheet reduction makes it extremely unlikely that the Fed can accomplish its goal.
First, you have to understand how and why the Fed expanded its balance sheet to begin with.
Through quantitative easing, the Fed buys US Treasury bonds and mortgage-backed securities with money created out of thin air on the open market. For our purposes, we’ll focus on US Treasuries.
QE accomplishes two important things for the US government. First, it injects currency and liquidity to juice the economy. (By that I mean inflate bubbles.) Second, it reduces the supply of bonds on the market and holds bond prices artificially high. Bond yields are inversely correlated with bond prices. When the price of a bond rises, the yield falls. Propping bond prices up through its artificial demand keeps interest rates low.
So, QE benefits the federal government in two ways. It allows the US Treasury to sell more bonds to finance its deficits because the Fed is absorbing some of the supply and keeping demand higher than it otherwise would be. And it keeps the government’s borrowing costs low by artificially suppressing interest rates.
Balance sheet reduction, or quantitative tightening (QT), reverses this process.
The Fed can shrink its balance sheet in two ways.
- Typically, the Fed rolls over the bonds on its balance sheet as they mature. In other words, it takes the money the government pays for the mature bond and buys a new one to replace it. The Fed can shrink its balance sheet simply by letting the old bonds roll off the books without replacing them. This is a relatively slow way to shrink the balance sheet.
- The Fed can decrease its bond holding more quickly by selling them on the open market.
Either way, it creates a big problem for the federal government. If the Fed sheds $1 trillion in bonds from its balance sheet over the next year, the US Treasury will have to find buyers for $1 trillion in additional bonds, on top of the $1 trillion or so in new bonds it will have to sell to finance the annual deficit. And it will also have to sell new bonds to replace maturing bonds that are currently out there in the market. That’s how the government Ponzi scheme works. It pays off old debt with money borrowed from new lenders.
We’re talking about $3 to $4 trillion in bonds that will need buyers over the next year.
This raises a very important question: who is going to buy all of these bonds?
The Fed ranks as the second-largest holder of US debt behind US individuals and institutions. If the Fed is out of the market, and shedding some of its holdings, who is going to fill that gap? Where will the Fed find buyers for an additional $1 trillion in Treasuries every year for the next three years, on top of all the new bonds it needs to sell to finance its massive deficits? The Fed was in the QE game to prop up the bond market. What happens when it pulls out those props?
Supply and demand dictate that as the Fed dumps bonds onto the market, supply will rise and the price will fall. That means yields will rise.
This creates another big problem for the US government.
Rising interest rates mean Uncle Sam’s borrowing costs rise. It’s the same problem you would have if the bank started rising your mortgage rate, or your credit card company raised your interest rate. The US government will have to pay more to finance its debt. That means it will have to borrow more. And that means even more bonds on the market.
This will ripple through the entire financial system and the broader economy. We saw the impacts of tightening in 2018. There is no reason to think it will be any different this time around.
The Fed can talk about balance sheet reduction all it wants. But talking and doing are two different things.
