The Dollar Dearth and the U.S. Economy
With signs of economic weakness popping up everywhere, the Federal Reserve has come under increasing pressure to slow down the pace of interest rate hikes. The Fed has hiked rates six times since President Trump took office and is on track to up the pinch point again in December. The Fed’s interest rate policy has long been material for financial new headlines, but it is only part of the current cycle of monetary tightening. Another part is the admittedly wonkish issue of reducing the Fed’s balance sheet. Policymakers should give it more prominence because it is siphoning billions of dollars out of the economy. Some analysts go so far as to say that, coupled with interest-rate hikes, it could tip the U.S. into recession.
Today the Federal Reserve owns some $4.1 trillion in financial assets, most of which are intermediate-term U.S. Treasury bonds of five to seven years maturity, but it also shows $1.6 trillion in mortgage-backed securities on its books. The Fed acquired this stash during the global financial crisis and its aftermath. In the period 2008-14, the Federal Reserve periodically made large-scale security purchases from its primary dealers. We can thank the Fed for that move, since by many accounts it averted another Great Depression.
Collectively, this process was known as “quantitative easing.” It gave the Fed a way of injecting liquidity directly into the economy without waiting for the slower and more indirect effect of near-zero interest rates. Accordingly, the primary dealers sold securities to the Fed, and in exchange, their accounts at the Federal Reserve were credited money. These transactions were an exercise in money creation. Trillions of dollars thus came into existence and entered the economy.
In principle the Fed could sell off its assets, but selling a bond portfolio in the trillions of dollars could disrupt the markets. So in late 2017 the Fed announced it would just let the bonds run to their maturity dates and would not use any proceeds to buy new bonds. When any bond matures, the owner receives its face value in cash from the issuer. The Fed is presently receiving about $50 billion a month from the U.S. Treasury for bonds reaching maturity.
Whenever any of its bonds reaches maturity, the Fed simply removes it from its balance sheet, and the money paid at maturation by the Treasury Department is extinguished. The Fed makes those dollars go out of existence. So far billions of dollars have been taken out of the economy, at a pace of $600 billion a year.
The process of reducing the balance sheet is the mirror image of the Fed’s acquisition of assets in 2008-14. Today the Fed wants to get its balance sheet down to fighting weight so that it could move into action should a future contingency arise calling for another round of quantitative easing. The Fed describes this process as “balance sheet normalization,” but outside observers more commonly refer to it as “quantitative tightening,” or QT, because it results in draining liquidity from the economy.
Some observers say that QT is compounding the contractionary effect of the Fed’s interest rate hikes. Ben Steil and Benjamin Della Rocca of the Council on Foreign Relations estimate that by the end of 2019 QT will have the effect of adding 2.2 percent to interest rates. The implication is that if the Fed achieves its goal of pegging short-term rates at about 3 percent, the economic environment would sense those rates as though they were actually 5.2 percent. This projection is grounds for concern about a recession.
The Federal Reserve does not consider its drawdown of assets as a tool of monetary policy. That may be so, and it should be said that the Fed is acting prudently in seeking to address the legacy resultants of its market interventions during the period of quantitative easing. Nonetheless, the Fed mischaracterizes balance sheet normalization. If during 2008-14 the Fed acquired trillions of dollars worth of assets explicitly for the purpose of injecting liquidity into the economy, in what way does the offloading of the same assets not affect that liquidity, but only in the opposite direction? To an outside observer, balance sheet normalization looks suspiciously like a monetary tool in everything but name.
Instead of thinking of QT as something that goes on behind the scenes, like a computer program running in the background while the interest rate story plays out on the active screen, bring it forward for a moment and take another look around. When we take QT as an element of monetary policy, we begin to see current economic conditions in a different light. With QT up front we are better able to explain the recent deflationary trends in commodity prices, and we can get a different perspective of why the housing industry is soft and why equity prices have tanked. If we take QT and interest rates together as reinforcing moves, we get a fuller appreciation of the monetary forces at work that point to slower economic growth ahead and possible recessionary conditions.
Today the U.S. economy is suffering from a dollar dearth. In putting its own balance sheet on a weight-loss regime, the Fed has also put the economy on a dollar-restricted diet. The Fed’s drawdown of its assets is siphoning billions of dollars out of the economy. This does not mean the money supply is shrinking, but it does mean that balance sheet normalization dampens its growth. This would be seen more clearly if QT were brought forward and its implications explored more explicitly.
Here’s the dilemma: if the Fed continues to raise interest rates and to reduce its balance sheet, it will tip the U.S. into recession. But if it pauses on interest rates, it would also have to pause on reducing its balance sheet, for to do the one without the other would be incoherent. A slower pace on the asset drawdown means the Fed would roll over all or part of the funds it receives when bonds mature into buying new bonds. The Fed would be back in the asset-buying business again, not necessarily as a rerun of the 2008-14 quantitative easing, but such a move could give rise to an inflationary mess.
Nonetheless, if economic conditions continue to weaken, and if Wall Street feels more pain, the Fed may have to opt for some kind of a double pause on interest rates and on balance sheet normalization. A carefully calibrated policy to reinflate may be unavoidable.
One way to do this would be to use a commodity-based index to gauge the amount of dollars demanded by the economy, and to adjust interest rates and the asset drawdown accordingly. Using gold as a proxy, the Fed should try to raise its price to a range within several of its long-term averages. Right now, the price of gold is below those averages. It is saying the markets need more dollars. The Federal Reserve should be injecting, not draining, liquidity from the economy.
James Soriano is a retired Foreign Service Officer.