QT? The Fed Needs to Clarify Why and How It Intends to Reduce Its Balance Sheet
The Federal Reserve has made clear over the past few years that it feels it must gradually reduce its balance sheet (i.e., mostly its holdings of U.S. Treasury bonds) which ballooned between 2010 and 2013 due to $3 trillion of QE (quantitative easing). That QE (i.e., the Fed purchasing Treasury bonds with newly printed money) was essential to help finance the Treasury’s enormous bank bailout, which in turn was necessary to prevent a collapse of the banking system following the sub-prime crisis. The balance sheet reduction has been nicknamed “QT” (quantitative tightening) by the financial press and market participants, but without a proper understanding of what the Fed’s intentions really are, and whether QT is the only way for the Fed to reduce its balance sheet.
QT would be a simple reversal of QE, i.e., a withdrawal of liquidity from the money supply, as opposed to an injection of liquidity into the money supply. QE consisted of the Fed buying Treasury bonds with freshly printed money, which resulted in the injection of cash into the money supply and bank reserves. QT would be the opposite, i.e., it would consist of the Fed selling some of its Treasury bonds and by so doing it would draw cash out of the money supply and bank reserves. In other words, QE expands the money supply, while QT would contract the money supply. Contracting the money supply and bank reserves would not be enlightened monetary policy if concurrent with a weakening economy: that is why the stock market plunged in December 2018 when Fed Chairman Jerome Powell seemed to indicate that a gradual monthly reduction of the Fed’s balance sheet was on automatic pilot, regardless of the state of the economy. The stock market recovered in January 2019 after Powell clearly indicated that monthly balance sheet reduction was no longer on automatic pilot but was “data dependent”, i.e., would be determined by the state of the economy on an ongoing basis.
What the financial press and market participants fail to understand is that “QT” is not the only mechanism for reducing the Fed’s balance sheet. The Fed can gradually reduce its balance sheet by simply letting its Treasury bond holdings mature, instead of actively selling its bond holdings before they mature. The difference is enormous. Selling Treasury bonds (QT) reduces liquidity (the money supply and bank reserves), while holding on to Treasury bonds until they mature does not, assuming the Fed returns the payments of principal to the Treasury instead of keeping them and effectively canceling those dollars. By returning the principal payments to the Treasury, the money supply remains unchanged. That should be the Fed’s choice since reducing the money supply (monetary tightening) when there is no inflation makes no sense. Today, we have historically low inflation with no sign the economy is about to overheat, while the global economy is slowing down, so a tightening of monetary policy would be inappropriate, even risky. In any case, the Fed should make clear which path it has chosen.
Two important questions which the Fed should answer are the following: 1) Why should the Fed want to reduce its balance sheet actively through QT (a tightening of monetary policy) when inflation remains low, the economy gives no signs of overheating, and the global economy is slowing? There is absolutely no rational reason to tighten monetary policy today. If the Fed feels it must reduce its balance sheet for “cosmetic” or symbolic reasons, then it should do so passively, returning principal repayments on maturing bonds to the Treasury, so that the money supply and bank reserves are not reduced. 2) Why should the Fed feel it is important to reduce its balance sheet in the first place? In fact, there is nothing problematic with a large balance sheet. It’s not as if the Fed’s Treasury holdings, no matter how large, are unstable bombs, which could explode at any time. Those Treasury bonds are permanently dormant, their effect already spent, as the printed money used to purchase them is already in the money supply. The situation is stable. If at any point in time excess aggregate demand starts developing and inflation starts rising, the Fed can always sell some of its bond holdings, thereby tightening monetary policy in order to reduce demand. Those bond holdings effectively constitute a tool held in reserve for when the Fed wants to tighten monetary policy.
The Federal Reserve should be reminded that many of the conventional economic theories it has espoused for decades have been flatly contradicted by statistics, meaning that those theories are fallacies and should no longer inform monetary policy. Examples of fallacious conventional economic wisdoms held by the Fed: 1) rapid economic growth necessarily causes inflation; 2) a low unemployment rate necessarily causes inflation; 3) rapid money supply growth necessarily causes inflation; 4) budget deficits necessarily cause inflation and high interest rates; 5) budget deficits necessarily cause trade deficits; 6) trade deficits are the mirror image of budget deficits; 7) a weak dollar necessarily causes inflation; 8) a strong dollar due to a tight monetary policy is desirable; 9) a large Fed balance sheet necessarily causes inflation; 10) the U.S. depends on foreign capital to finance its budget deficits.
The Fed and the economics profession should finally realize that budget deficits are not undesirable or dangerous per se, especially when QE is available. Often, budget deficits financed through QE are absolutely essential for a country’s economic health: to stimulate growth in times of slack, and to prevent recessions and high unemployment. Importantly, thanks to QE, federal debt need not be a reason to raise taxes or cut spending, nor be a weight on the economy, nor be passed on to future generations (since Treasury bonds held to maturity by the Fed are effectively only “virtual debt”, as they evaporate in thin air at no cost either in terms of principal or interest when the Fed chooses to return principal and interest payments to the Treasury). It must be understood that the obsession with budget deficits and federal debt is completely misguided and has negatively affected economic policy, preventing urgently needed investments in education, scientific research, and infrastructure.
Obsession with budget deficits led to an economic austerity policy which caused our Great Depression in the 1930’s, and it has led to the economic disaster of the Eurozone over the past eight years. The Eurozone urgently needs to abandon its misguided austerity policy which is ruining the life of many of its citizens and leading to demagogic populist governments. It needs a large tax rebate (on the order of 5,000 euro’s for each taxpayer) financed through QE by the European Central Bank, in order to have a quick economic recovery and to greatly reduce unemployment, as well as to restore faith in capitalism and free markets. Contrary to increasingly widespread popular belief, the Eurozone crisis has not been of capitalism, but rather of terribly misguided economic policy.
Importantly, as we have seen over the years since enormous QE ($3 trillion) was implemented between 2010 and 2013, QE is not inflationary per se. It should be liberally used under the proper circumstances (i.e., when there is economic slack) and properly calibrated so as not to generate excess aggregate demand and consequent “demand-pull” inflation. Having QE-financed tax rebates as the standard economic stimulus policy (instead of ultra-low interest rates, which have negative side-effects) would ensure that recessions are always nipped in the bud and that high unemployment is always avoided.
© Edward Sonnino 2019
February 1, 2019
