It is simply a matter of time before the Federal Reserve finds itself having to choose between inflation and federal insolvency.
The Federal Reserve made a colossal gamble with its so-called “Quantitative Easing” or “QE,” which is simply a euphemism for its $4.4 trillion binge of buying long-term bonds and mortgages. Its big bid for long bonds, along with parallel programs undertaken by other members of the international fraternity of central banks, has artificially suppressed long-term interest rates, and has deliberately fostered asset-price inflations in bonds, stocks, and houses.
Will this gamble pan out?
The Fed now intends to reduce its buying and slowly shrink its portfolio by letting bond maturities and mortgage prepayments exceed new purchases. As its big bid is reduced, will the asset-price inflations it fostered end well in some kind of soft landing, or will they end badly in an asset-price deflation? Will the Fed be able to take its stake off the table and go away a winner—or will it ultimately lose?
Nobody knows, including the Fed itself. The officials who run the institution are guessing, like everybody else—and hoping.
In particular, they are hoping that by making the unwinding of the gamble very slow, with emphatic announcements well in advance, they will mitigate the potential negative price reactions in bond, stock, and housing markets. Well, maybe this strategy will work—or maybe not. The behavior of complex financial systems is fundamentally uncertain. As Nobel laurate economist Robert Shiller said in a recent interview with Barron’s, “We don’t know what will happen in this unwinding.”
Shiller is right. But who are the “we” who don’t know? In addition to himself, “we” includes Nobel laureates, all other economists, financial market actors, regulators, the Federal Reserve, all the other central banks, and you, honored reader, and me.
With its buying in the trillions, the Fed made asset prices go up and long-term interest rates go down, as intended. Simply reversing its manipulation by selling in the trillions, turning its big bid in the market into a big offer, would surely make asset prices go down and interest rates go up, perhaps by a lot. This outcome the Fed wants at all costs to avoid. So it is not selling any of its bonds or mortgages. The plan is to stop buying as much, a little at a time, while continuing the steady stream of rhetorical assurances. We don’t know, and Fed officials don’t know, if this will work as hoped.
The Fed did not strive to inflate asset prices as an end in itself, of course. The theory was that this would result in a “wealth effect,” which would in turn accelerate economic growth. Did it? Would economic growth have been worse or better without QE? Were the risks entailed in the inflation of asset prices worth whatever additional growth it may or may not have induced? In fact, U.S. real GDP growth over the many years of QE has been generally unimpressive.
“Evaluating the effects of monetary policy is difficult,” as Stephen D. Williamson, an economist with the Federal Reserve Bank of St. Louis, writes in a new article in The Regional Economist, and “with unconventional monetary policy, the difficulty is magnified.” Williamson adds that “With respect to QE, there are good reasons to be skeptical that it works as advertised, and some economists have made a good case the QE is actually detrimental.” He points out that Canada without QE had better growth than the United States with it. As usual in macroeconomics, you can’t prove it one way or the other.
The Fed’s effect on asset prices seems clear, however. As one senior investment manager recently said about the price of the U.S. Treasury 10-year note, “What it tells you is the amount of distortion that quantitative easing is creating.” How much of that distortion is going to reverse itself?
With QE, the Fed has been practicing “asset transformation,” according to Williamson. That is economics-speak for borrowing short and lending long. The Fed is funding its long-term bonds and very long-term mortgage securities with short-term, floating-rate deposits. This is one of the most classic of all financial speculative gambles. In other words, the Fed has created a balance sheet for itself that looks just like a 1980s savings and loan, and has become, in effect, the biggest savings and loan in history.
Williamson reasonably asks if the Fed has any competitive advantage at holding such a speculative position, and doubts that it does. However, I believe the Fed does have two unique advantages in this respect: control of its own accounting, and lack of penalties for insolvency. The Fed uniquely sets its own accounting standards for itself, and Fed officials have decided never to mark its securities portfolio to market. More remarkably, even if it should realize losses on the actual sale of securities, officials have decided not to let such losses reduce its reported capital, but to carry the required debits to a hokey intangible asset account. No one else would be allowed to get away with that.
Suppose hypothetically that realized losses on the Fed’s giant portfolio come to exceed its small capital (less than 1 percent of the portfolio). Even then it is not clear whether that would affect the Fed. Many economists argue that insolvency doesn’t matter if you can print the money to pay your obligations. Nonetheless, it would be embarrassing to the Fed to be technically insolvent, and its QE-unwind program is designed to avoid any realized losses while not disclosing any mark-to-market losses.
Although the GDP growth effects of the QE gamble are uncertain, it certainly has succeeded in two other ways besides inducing asset-price inflation: in robbing savers, and in allocating credit. By forcing real interest rates on conservative savings to be negative, the Fed has transferred billions of dollars of wealth from savers to borrowers—especially to the government, the biggest borrower of all, and to leveraged speculators. It has meanwhile assured the aggrieved savers that they are really better off being sacrificed for the greater good.
QE also means the Fed allocated trillions in credit to its favored sectors: housing and the government. In housing, this resulted in national average house prices’ inflating back up to their bubble levels, obviously making them less affordable. For the government, the Fed made financing its deficits cheaper and easier, and demonstrated once again that the real first mandate of any central bank is financing, as needed, the government of which it is a part.
As the Fed moves to unwind its big QE gamble, what will happen? It, and we, will find out by experience.