- This is the second part of a two-part post that looks at the steps the Federal Reserve is taking to unwind the “Quantitative Easing” program it initiated in response to the 2008-2009 financial crisis.
- Part I reviewed the unprecedented steps the Fed took beginning in 2008 to stimulate the U.S. economy by injecting massive amounts of liquidity into the financial system.
- In Part II we’ll be discussing the Fed’s plan to slowly drain liquidity from the financial system in an effort to avoid over-stimulating the economy, and the concerns being expressed by some economists and market observers regarding that plan.
Last week I reviewed the Federal Reserve Bank’s two prong approach to prop up the U.S. economy in response to the Great Recession of 2008-2009. In summary, the Fed sought to stimulate the economy by increasing the amount of money in circulation in the U.S. economy (referred to as “liquidity”). It did so by (i) lowering short-term interest rates (making it cheaper to borrow money, which stimulated economic activity and boosted asset prices), and (ii) dramatically growing its balance sheet through massive purchases of government backed mortgages and agency debt (which lowered the supply, and thereby bolstered prices, for U.S. government-backed debt).
The Fed was anything but timid in its efforts. Shortly before the onset of the Great Recession, the federal funds rate (the rate banks and credit unions charge one another on overnight loans) was 5.25% and the Fed’s balance sheet stood at approximately $870 billion. By the time the Fed pulled the plug on its quantitative easing program, its balance sheet had ballooned to about $4.5 trillion and the fed funds rate was ranging from 0 – 0.25%.
In its “Policy Normalization Principles and Plans” report issued in September of 2014, the Federal Open Market Committee (FOMC) described its plans to normalize its monetary policy. The normalization plan has two components; namely, (i) a gradual and systematic reduction in the Fed’s balance sheet; and (ii) and a slow increase in the federal funds rate and other short-term interest rates. The goal of the Fed’s current “quantitative tightening” plan is to limit the amount of money circulating in the U.S. economy to a level that will not cause the U.S. economy to overheat.
The Federal Reserve’s Central Bank has been decreasing its balance sheet since October, 2017. It’s done so by allowing $50 billion in proceeds collected from maturing bonds to run off each month, while reinvesting the rest. Today, the balance sheet stands at approximately $4 trillion.
The Fed also began gradually raising the federal funds rate in December of 2015. As of this writing, the rate stands at a range of 2.25% to 2.5%. The Fed has also signaled its intention to raise the rate by 25 basis points two more times in 2019.
Some economists fear that the Fed is over-estimating the current strength of the U.S. economy and therefore is draining liquidity from the financial system too soon. Some market commentators have also suggested that the Federal Reserve’s recent actions will hurt the stock market by making it harder for businesses and investors alike to borrow money, which in turn hurts corporate earnings and reduces the cash available to invest in stocks.
Criticism of the Federal Reserve is nothing new. Our Founding Fathers argued bitterly over whether a central bank was even necessary. Alexander Hamilton (America’s first secretary of the Treasury) argued a central bank was needed to manage a single currency for all of the states of the union. By contrast, Thomas Jefferson saw a central bank as an unnecessary consolidation of power benefitting bankers and businessmen at the expense of the average citizen. President Andrew Jackson referred to it as “a den of vipers and thieves”.
Before you go swimming with today’s critics of the Fed’s quantitative tightening program it’s important to remember:
- The Federal Reserve’s quantitative easing program was intended to be temporary from the outset.
- When the Fed began its quantitative easing program, many of the Fed’s current critics predicted that program would lead to skyrocketing interest rates and soaring inflation. Neither happened.
- The “real” fed funds rate (that is, the interest rate after adjusting for inflation) is still close to zero.
- While the Fed has not said so explicitly, the consensus opinion is that the Fed does not plan to lower its balance sheet to pre-Great Recession levels.
- Lending standards have been loosened and the interest rates being charged to the riskiest of borrowers have fallen to historic lows, as lenders and investors scramble for yield. Needless to say, this is a dance that can’t continue forever, and it won’t be pretty if the music stops suddenly.
Finally, it’s important not to lose sight of just how severe the 2008-2009 financial crisis was. It’s not an exaggeration to say that the global financial system was facing its biggest threat since the Great Depression. If the comparably modest financial volatility we are experiencing today proves to be the trade-off for preventing another Great Depression, it seems to be a very good trade indeed.
In short, there’s no denying the Fed has made its share of mistakes, and perhaps the quantitative tightening program will be another. However, all of the Fed’s critics can agree that the Fed needs to remain independent of political pressure. As Frank Sinatra might have sang, they need to do it their way. Perhaps the Fed isn’t draining the pool too quickly; but rather simply keeping the pool from over-flowing.