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Is the Federal Reserve Making It Up as They Go Along?

Is the changing Fed story something that should concern you, or is it just growing pains adapting to the massive balance sheet inherited from the unconventional policy QE?

In September 2017, then-Federal Reserve Chairperson Janet Yellen announced that the Fed would slowly begin reducing its $4.5 trillion balance sheet.[i]

If you remember, the Fed’s balance sheet ballooned from around $800 billion pre-financial crisis to $4.5 trillion under the unconventional monetary policy nicknamed quantitative easing or QE.

Enter Jerome Powell

Barely two months after that announcement, in November of 2017, President-elect Trump broke with precedent by failing to appoint Chairperson Yellen to a second term. Instead, he announced that Fed Governor Jerome Powell would become the head of the Fed when Yellen’s term ended in February of 2018.[ii]

Balance Sheet Reduction on Autopilot

In December 2018, Chairman Powell stated in a press conference that the reduction of the Fed’s Balance, which was then $50 billion a month, would continue on a preset course.[iii] 

Three days before that press conference, famed hedge fund manager Stanley Druckenmiller and former Fed Governor Kevin Warsh wrote an op-ed  which said that reducing the balance sheet was jeopardizing the economy. [iv]

Chairman Powell Buckles

In January 2019 press release, the Fed announced that it would be implementing a monetary policy using a high level of reserves instead of a pre-financial crisis policy with few excess reserves, either adding or withdrawing them based on whether the Fed wanted to raise or lower interest rates.[v]

This policy change would require more significant reserves in the banking system and was a precursor for the Fed’s ending balance sheet reduction.

In February of 2019, two months after telling the world that the Fed balance sheet reduction plan was on autopilot, Chairman Powell announced that the Fed would soon unveil a plan to end it.[vi]

That announcement followed a fourth-quarter drop in the stock market of almost 14%. It appeared to be an admission that the Feds’ belief that reducing the balance sheet would have little impact on the markets, and the economy was wrong. Apparently, they did not understand that by cutting it, they would be reducing the amount of money in the economy.

The Market for Reserves Has a Big Hiccup

In the week of September 16, 2019, the plumbing that provides overnight loans became tight, jumping from 2% to 8%.

Nobody seems to know why. Some thought it had to do with a shortage of reserves, due to companies paying their federal taxes, together with the government selling bonds to fund the deficit.

Others thought that the big banks were unwilling to lend reserves because new rules require them to keep safe assets such as reserves on their books.

Neither explanation makes much sense. When companies pay their taxes or purchase bonds, this does reduce reserves; however, the government uses those proceeds to pay contractors, staff, the military, and social security recipients, etc. This moves reserves back into the banking system, and it ends up being a wash.

The regulatory argument is also specious as big banks get back as collateral an equally safe investment (treasuries) when they lend their excess reserves.

The Fed Comes to the Rescue

On September 17, 2019, The Fed began market operations to add reserves into the banking system.[vii] Even though there are still $1.3 trillion of excess reserves, they continued adding reserves in the subsequent days, seemingly in contrast to Fed Chair Powell’s January 2019 announcement that the Fed would manage interest rate policy by keeping large amounts of reserves and not by daily market operations.

On October 11, 2019, the Fed announced that they were starting a plan to increase their balance sheet to increase bank reserves. However, the Fed is adamant that this new program is not QE. They say it is about short-term rather than long-term bonds.

These are the opinions of Tim Hayes and not necessarily those of Cambridge Investment Research. They are for informational purposes only,and should not be construed or acted upon as individualized investment advice.

[i] Long, Heather, “ In Sign of U.S. economy’s strength, Fed start to reducing $4.5 trillion balance sheet” Washington Post, Sept 20, 2017, https://www.washingtonpost.com/news/wonk/wp/2017/09/20/in-sign-of-u-s-economys-strength-fed-to-start-reducing-4-5-trillion-balance-sheet/

[ii] Swanson, Ana and Binyamin Appelbaum, “Trump Announces Jerome Powell as New Fed Chairman” New York Times, Nov 2, 2017, https://www.nytimes.com/2017/11/02/business/economy/jerome-powell-federal-reserve-trump.html

[iii] Brettell, Karen, “TREASURIES – Yields fall as Fed’s Powell says balance sheet reduction on auto pilot”, Reuters, Dec 19, 2018, https://www.reuters.com/article/usa-bonds/treasuries-yields-fall-as-feds-powell-says-balance-sheet-reduction-on-auto-pilot-idUSL1N1YO1RJ

[iv] Druckenmiller, Stanley and Kevin Warsh, “Fed Tightening? Not Now The central bank should pause its double-barreled blitz of higher interest rates and tighter liquidity”, Wall Street Journal, Dec 16, 2018, https://www.wsj.com/articles/quantitative-tightening-not-now-11544991760

[v] Statement Regarding Monetary Policy Implementation and Balance Sheet Normalization, Federal Reserve, January 30, 2019, https://www.federalreserve.gov/newsevents/pressreleases/monetary20190130c.htm

[vi] Fleming, Sam, Fed aims to unveil plan to end balance sheet rundown fairly soon, Financial Times, Feb 27, 2019, https://www.ft.com/content/83c1fdc2-3aa7-11e9-b856-5404d3811663

[vii] Smialek, Jeanna and Matt Phillips, Fed Jumps Into Market to Push Down Rates, a First Since the Financial Crisis, The New York Times, Sept 17, 2019, https://www.nytimes.com/2019/09/17/business/economy/fed-interest-rates.html