Commentary on Political Economy

Friday 10 May 2024

MINSKY MOMENTS

 

Opinion | Quantitative Tightening Becomes a Trap for the Federal Reserve

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Federal Reserve Bank Chairman Jerome Powell speaks at a news conference in Washington, May 1. Photo: Chip Somodevilla/Getty Images

As policy-wonk buzzwords go, few are more important these days than “ample.” What that word means, or rather what the Federal Reserve thinks it means, has become a $7.4 trillion question hanging over the U.S. economy.

The issue is the Fed’s balance sheet, which currently stands at about that level. The Federal Open Market Committee decided last week to slow the pace at which the balance sheet will shrink. Since June 2022, the central bank has been allowing up to $60 billion a month in Treasurys to roll off and up to $35 billion in mortgage-backed securities. That rate will now slow to $25 billion per month for Treasurys.

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This sounds counterintuitive. The Fed is fighting stubborn inflation. Quantitative easing (the purchases of bonds through which the central bank expanded its balance sheet after 2008) marked a prominent effort to stimulate the economy and inflation. Quantitative tightening to unwind those purchases seemed to be part of the Fed’s plan to combat inflation starting in 2022. Why slow down now?

Because taming inflation isn’t the central bank’s only task (and the Fed isn’t sure QE matters to inflation anyway). The central bank also has changed the way the American financial system operates in significant ways since 2008 and this is limiting the Fed’s ability to shrink its balance sheet.

The problem is the central bank’s liabilities, which necessarily have increased in tandem with its assets. One liability in particular ballooned under QE: bank reserves. These are the deposits commercial banks hold at the Fed to guarantee their liquidity, and they’re huge: $3.3 trillion as of the most recent count, and that already is down from $4.3 trillion at the peak, in late 2021.

It wasn’t always this way. Before the 2008 panic, reserve balances were minuscule relative to the size of the economy—in the low tens of billions. Banks instead borrowed from and lent to each other overnight to manage liquidity.

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Regulatory changes since 2008 have pushed banks to hold more reserves, and the Fed further encouraged this stockpiling when it started paying banks interest on reserve balances. Banks now rely primarily on reserve accounts rather than overnight borrowing to satisfy liquidity requirements, and that overnight market has shriveled.

The Fed describes this new system as an ample-reserves regime—there’s that word—but no one can say what “ample” means. The quantity of reserves banks want to hold arises from a complex alchemy of regulation, market forces and managerial preferences. No wonder the central bank’s estimates of likely reserve demand have shifted dramatically over the years, from as little as $100 billion in the mid-2010s to $1 trillion in late 2018 and around $2.3 trillion now.

This is especially concerning because the Fed has other large liabilities that affect its ability to meet banks’ uncertain reserve demand. Particularly relevant here is the Treasury general account, the federal government’s checking account at the Fed. The TGA has grown considerably since 2008 (before then, Treasury parked most of its cash at private-sector banks) and it’s very volatile. Seasonal tax payments, for instance, rapidly withdraw money from the banking system and cause a decline in bank reserves while pumping up the TGA.

The pinch comes if a change in the TGA or elsewhere on the Fed’s balance sheet causes bank reserves to fall below some minimum level everyone knows exists but no one can identify. This already has happened once. The central bank started its first quantitative tightening in 2017, when bank reserves hovered around $2.3 trillion, give or take. By September 2019, reserves had fallen to around $1.5 trillion, still well above what the Fed at the time thought was ideal. Then a surge in tax payments caused the TGA to swell at the expense of bank reserves—and it turned out banks thought their reserves were too low. Sudden demand for liquidity caused overnight lending rates to skyrocket out of the central bank’s control.

Chairman Jerome Powell is slowing quantitative tightening now because the Fed is anxious to avoid a repeat of that fiasco. Is his caution premature? Perhaps, considering reserves still stand at roughly double their pre-pandemic (and post-September 2019) level. But you can understand the worry.

His bigger dilemma is this: The conceit of many Fed innovations since 2008 has been that novel policies—for which no one voted and that the central bank itself often doesn’t fully understand—could be easily reversed when the time came. Well, the time has come amid the worst inflation spike in 40 years and a new debate about Fed accountability. But the central bank finds itself hemmed in by those “temporary” policies. In this way, the balance sheet is becoming a political problem as much as an economic one.

Journal Editorial Report: The week's best and worst from Kim Strassel, Allysia Finley, Mary O'Grady and Dan Henninger. Image: Chris Pizzello/Associated Press

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Appeared in the May 10, 2024, print edition as 'Quantitative Tightening Becomes a Trap for the Federal Reserve'.

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