Quagmires in the Fed’s War on Inflation
After the financial crisis of 2008, the Federal Reserve used two policies to prop up the economy: zero percent interest rates and pumping newly-created money into the economy through quantitative easing (QE). Because of 40-year-high inflation, the Fed has recently reversed policy and is raising its key interest rate target on overnight loans between banks. The Fed is also doing quantitative tightening (QT, the opposite of QE), and is withdrawing money from the economy.
There are two ways to do QT: “portfolio runoff” and selling assets. The Fed is doing only the former, runoff, which entails allowing its assets to mature and not reinvesting the proceeds. Beginning in September, the Fed will do portfolio runoff at a pace of $95B a month, $60B of which will be U.S. treasuries and $35B will be mortgage-backed securities. That pace works out to $1.14 trillion in a year. Nothing to sneeze at, but to really fight inflation could the Fed go faster and take even more money out of the economy each month?
Rather than relying solely on portfolio runoff of maturing assets, this writer recently suggested that the Fed also sell its assets prior to maturity in order to speed up the deflating of the money supply, and perhaps obviate continued interest rate hikes. Just as with portfolio runoff, the Fed wouldn’t reinvest the proceeds of its sales. Selling assets presents serious implications concerning prices and yields.
Reducing the Fed’s portfolio (balance sheet) through sales is a problem. Back in the Spring of 2020, during the height of the pandemic, the Fed bought assets for a time at the furious pace of a trillion dollars a month. Selling those assets will be more of a problem than was buying them. What if the Fed tried to sell off its assets as quickly as it bought them in 2020?
When it sells its assets, the Fed does so in secondary markets where prices and yields are subject to change. When too much of something is put on any market at one time, prices tend to fall. In bond markets, when prices fall yields rise.
The trick for the Fed in selling its assets is to sell them at high prices. The higher the price, the more money the Fed is sucking out of the money supply, thereby attacking inflation directly. But there’s another consideration: the relationship between the secondary market and the primary market.
In the case of the primary market for U.S. treasuries, they’re sold at par, or face value; what’s paid at maturity. So the way that that primary market could compete with its secondary market during times when the secondary market has better yields than its primary market is to raise its coupon rates, i.e. the interest rates on its treasuries.
Since interest on treasuries is an item in the federal budget, low prices for treasuries in the secondary market is a problem if they result in higher interest rates for new treasuries. The amount of interest on the federal debt that the taxpayer is to pay in ten years is already predicted to go up by a factor of three.
The “trick” for the Fed in selling its assets seems fraught with problems and dependent on other factors, such as what’s happening in the primary markets. Were the Fed to sell its assets, it would need to decide which of them to unload. Would it be wiser to sell its treasuries or its mortgage-backed securities?
To suck enough money out of the system to defeat inflation, the Fed may need to sell its mortgage-backed securities, or MBS.
On May 18, Axios ran “The Fed’s $2.7 trillion mortgage problem” by Neil Irwin that’s worth reading:
The Fed will face a series of political and economic headaches as it attempts to move away from subsidizing home lending by shrinking its portfolio of mortgage-backed securities… The Fed's pandemic actions fueled a housing boom. As it tries to withdraw that support, it could be bad news for housing.
At Substack, economist Arnold Kling immediately critiqued Irwin. Econlib then ran “Is the Fed Likely to Go Bankrupt?” which is a posting of correspondence from Jeffrey Hummel that analyzes Kling’s article on Irwin:
But if Irwin is correct, his prediction is quite ironic: the very high inflation that the Fed itself created undermines its ability to reduce the size of its bloated balance sheet. Still, the Fed could easily reduce its MBS portfolio slowly, as Irwin points out, by letting “its holdings shrink” as they mature, and not rolling over the portfolio with new purchases. Unfortunately, most of its MBS portfolio, an amount of $2.6 trillion, has a remaining maturity of over 10 years.
That last sentence points to an additional consideration besides prices and yields, and that’s maturity dates. With most MBS maturities being a decade in the future, they’re not currently candidates for portfolio runoff. Were the Fed to sell such MBS, it would surely affect the market for them.
The Fed’s dilemma is that it must crash the economy in order to save the economy from the inflation it created. The Fed could continue to prop up its false, Potemkin economy, but the pain would be worse down the road.
The Fed should be more surgical in its tender mercies and localize the pain by selling its MBS, even if it causes housing to go fallow for a while. For two decades the Fed has propped up housing. It’s time to withdraw the support and let the industry fend for itself. After all, it was housing that caused the 2008 financial collapse. Given that, should mortgage-backed securities even exist?
If inflation proves to be especially intractable and sticky, the Fed should consider unloading its MSB en masse, come what may. If it collapses the housing industry, so be it. That would be better than ballooning up the deficit from the sales of its treasuries.
On August 26, Chairman Powell warned of yet more economic pain to come, due to the Fed’s war on inflation. There will be continued hikes of the fed funds rate. And the reason for the rate hikes is that quantitative tightening isn’t as easy as quantitative easing.
The answer to a question posed above is: The Fed can’t sell off its assets as quickly as it bought them in 2020 without risking havoc. The Fed simply can’t suck money out of the economy as easily as it can flood the economy with money. Given that, the Fed should allow all of its maturing assets to undergo portfolio runoff, not put a cap on runoffs of $95B a month.
It’s easy to change a number, such as an interest rate, it takes a couple seconds worth of typing. But to change one’s portfolio, one must find buyers. The Fed did QE for far too long, and it distorted the economy.
It may be that the Fed has little choice but to keep raising interest rates, because selling the assets in its balance sheet can be dangerous and slow. It seems that the Fed’s funny money is easier to create than to destroy.
Jon N. Hall of ULTRACON OPINION is a programmer from Kansas City.