The Fed’s $4 trillion experiment is growing
The Federal Reserve is once again buying vast amounts of bonds to calm stress in financial markets. But this isn’t a return to crisis-era efforts to save the economy. At least not yet.
The Fed announced on Friday it will launch a new program next week that will gobble up $60 billion of Treasury bills per month. The purchases will further boost the size of its already-massive $4 trillion balance sheet.
Given the slowing American economy, the actions are reminiscent of the bond buying programs known as quantitative easing. The Fed resorted to QE, and eventually QE2 and QE3, to keep borrowing costs ultra-cheap once it ran out of room to cut interest rates in 2008.
Yet central bank officials and economists stress today’s moves have an entirely different purpose. Rather than boosting sluggish growth, the Fed is buying bonds to fix significant problems that have emerged in the plumbing of the capital markets.
“This is not QE to induce animal spirits and pull people into risk-taking and borrowing,” said Danielle DiMartino Booth, a former Fed official who is now CEO of Quill Intelligence.
The Fed even put out a Frequently Asked Questions page on Friday that sought to draw a bright line between the moves and what happened during the crisis.
“These operations have no material implications for the stance of monetary policy,” the statement said, adding that there should be “little if any effect” on household and business spending nor the overall level of economic activity.
Instead, the Fed just wants to make sure there is enough cash sloshing around the system — because lately there hasn’t been.
‘Plumbing’ problems emerge
Overnight lending rates spiked suddenly last month. The episode revealed a sudden cash crunch. Now the Fed is responding by pumping in more cash to get the plumbing flowing again.
“This is not about changing the stance of monetary policy. This is about making sure markets are functioning,” Neel Kashkari, president of the Minneapolis Federal Reserve, said on Thursday at the Yahoo Finance All Markets Summit. “This is kind of just a plumbing issue.”
But as many homeowners know, even plumbing problems can turn into bigger ones.
The Fed needs to fix the cash crunch before it erodes confidence or spills over into the real economy, which has already started to show serious cracks because of the US-China trade war and weak global growth.
“You don’t want to have funding shocks add to the worsening outlook. We don’t need this problem on top of our other problems,” said Ralph Axel, senior US rates strategist at Bank of America Merrill Lynch.
The Fed revealed on Friday that officials met by videoconference on October 4 to discuss the recent pressure in overnight lending markets. Final plans for the Treasury bill purchases were approved on Friday.
Normally, the overnight lending markets get very little attention. But that’s not because they aren’t important. These markets are critical. They allow banks, hedge funds and other financial institutions to quickly and cheaply borrow money for short periods of times.
Many were surprised when the rate on overnight repurchase, or repo, agreements surged in mid-September well above the target range for short-term borrowing set by the Fed.
Even Fed chief Jerome Powell acknowledged that these markets experienced “unexpectedly intense volatility.”
The Fed blamed the stress on two one-off factors: The withdrawal of cash by US companies to make quarterly tax payments to the Treasury Department and the settlement of a large amount of Treasury purchases.
Sustained pressure could lead investors to fear the Fed is no longer in control of short-term borrowing rates. That would be a problem because that’s precisely how the Fed influences the economy.
“This volatility can impede the effective implementation of monetary policy, and we are addressing it,” Powell said.
The initial response, led by the New York Fed, featured a series of emergency “overnight repo operations.” These cash injections, which are promptly repaid, were aimed at getting borrowing costs back in line. The moves worked, driving rates back down.
However, the NY Fed’s repo operations drew very strong demand, suggesting it couldn’t just walk away.
The fact that there is still a clamor for cash signals there still isn’t enough cash in the system. These aren’t one-off events driven by tax payments or Treasury auctions.
The Fed started to shrink its balance sheet in October 2017 because the economy was improving. Economists say the Fed underestimated how much cash the financial system needed to keep operating smoothly. The Fed seems to have sucked out too much cash when it reversed QE.
“It was a bridge too far,” said DiMartino Booth.
There was always a risk that would happen. No one, not even the Fed, knows how much cash needs to be kept in the post-crisis system.
“They are winging it, absolutely,” said Bank of America’s Axel.
Powell signaled this week that the Fed will soon increase the size of its balance sheet. It’s a return to what the Fed did prior to 2007, when the central bank’s balance sheet regularly grew prior to the crisis in line with the growth of currency.
But Powell stressed that this “should in no way be confused” with the QE program launched after the financial crisis.
And to emphasize that point, the Fed is purchasing short-term government debt known as Treasury bills, or T-Bills. The Fed said these purchases “should have little if any effect” on long-term interest rates.
That’s a major difference from QE, when the Fed gobbled up longer-duration Treasuries in a bid to keep borrowing costs cheap.
“They are specifically targeting T-Bills to try to help the messaging, which is difficult because of the simultaneous happenings of the slowdown and the Fed cuts,” said Axel.
QE4 to fight the next recession
The Fed has already cut interest rates twice in response to the loss of momentum in the US economy. Those rate cuts, down to a range of 1.75% to 2%, have eroded the Fed’s limited firepower to fight the next recession.
UBS has warned that US GDP growth will tumble to near-zero next year, forcing the Fed to slash interest rates by another percentage point between now and the first half of 2020.
“We’ve got a pretty massive slowdown in our forecasts,” said Rob Martin, US economist at UBS.
Although UBS isn’t calling for GDP growth to go negative, Martin said he’s “not at all” confident the United States will avert a recession.
And Fed officials have already said that they would be comfortable relaunching QE if they have no room to cut rates in the next recession.
“When history is written, this will be looked at as the second step in the Fed’s easing campaign headed into the coming downturn,” said DiMartino Booth. “First we had rate cuts. Now we have relief in the overnight lending market. The third step is quantitative easing.”