In the wake of two bank failures, the Federal Reserve and the US Treasury announced a bank bailout program.
Last week, Silicon Valley Bank was shuttered by federal authorities after the bank suffered significant losses selling bonds in order to raise capital. When that news hit, depositors rushed to pull funds from the bank, making it functionally insolvent. Then over the weekend, federal authorities shut down Signature Bank.
Most people have focused on Federal Reserve interest rate cuts as it battles price inflation. But there is another element in the inflation fight most people ignore – balance sheet reduction.
It isn’t going well.
Interest rate hikes get most of the attention as the Federal Reserve fights inflation, but balance sheet reduction is arguably more important. And it’s not going well.
Since the Fed stopped buying Treasuries and started letting bonds fall off its books as they mature, the bond market has experienced increasing volatility and liquidity problems. In fact, there is already talk about the possibility of the central bank abandoning quantitative tightening.
Ben Bernanke was one of the architects of the inflation you’re suffering from today. He won a Nobel Prize for his efforts.
Bernanke rolled out quantitative easing to rescue the economy in the wake of the 2008 financial crisis. At the time, he swore it was a temporary emergency measure and that the Fed would eventually sell all of the bonds it was accumulating on its balance sheet. He insisted that it was not a debt monetization scheme.
The Federal Reserve has talked a lot about fighting inflation. But what has it actually done?
In practice, not a lot. It has nudged interest rates up 75 basis points. And while the Fed has ended the massive quantitative easing program that it ran during the pandemic, it pushed balance sheet reduction back from May until June. In fact, the balance sheet has crept upward throughout the entire month of May.
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.
It appears quantitative easing has pretty much come to an end. At least for now.
Although the Fed was still expanding the balance sheet through mid-month, it only added a net $9B to the balance sheet during March. This was accomplished with moderate purchases of short- and long-term debt, while 5–10-year notes had a $20B runoff. MBS (light green) was surprisingly quiet with a net $2B runoff, but this disguises the typical volatility seen in MBS weekly purchases.
Is the US about to go the way of Japan?
The Japanese yen tanked after the Bank of Japan vowed to buy an unlimited number of Japanese government bonds in order to hold the 10-year yield under its 0.25% target.
Earlier this month, the Federal Reserve launched its first salvo against inflation, raising interest rates by a quarter-percent. It was a pretty weak shot given 7.9% CPI, but Jerome Powell and other Fed presidents ratcheted up the tough rhetoric last week. Powell raised the possibility of 50 basis-point rate hikes at future meetings and San Francisco Fed President Mary Daly, “With the labor market so strong, inflation, inflation, inflation is top of everyone’s mind.”
We talk a lot about how the Fed keeps its big fat thumb on the Treasury market. But it also has its big fat thumb on the housing market. And if the Fed really does follow through with its taper and its plans to shrink its balance sheet, it will have a big effect on the housing market.
If you’ve ever held something under tension down with your thumb and suddenly release it, you know what happens.