October 21, 2019 BARRON’S 27
THE ECONOMY n By Matthew C. Klein
Fed’sBondBuyingDoesn’tEqualQE4
For investors, the moves should be seen as technical, not a bid to inflate asset prices
SOME MARKET OBSERVERS
are calling the Federal
Reserve’srecentcommit-
ment to buy billions of
dollars of U.S. Treasury
bills QE4—the start of a
fourthroundofso-called
quantitativeeasingmeanttoboostaflag-
ging economy. This is misleading. It is
more useful for investors to think of the
newroundofassetpurchasesasareturn
totheolddayswherethemarketdictates
the size of the Fed’s balance sheet.
The basic job of the centralbankis to
make sure there is enough money in the
economy to grease the wheels of com-
merce,butnotsomuchastogeneratefi-
nancial bubbles or excessive consumer
priceinflation.Thisisdifficult,andabout
amonthago,theFednearlyfailedatthat.
OnSept.17,theFed’spreferredmeasure
ofshort-terminterestratesspikedabove
5%,withsomeborrowerspayingasmuch
as 9% to pawn U.S. Treasury debt for
overnight cash. At the time, the Fed had
been trying to keep short rates at 2% to
2.25%.
The underlying problem was a sys-
temic shortage of money. Fed officialsbe-
lieved that the banking system was flush
with more reserves than it needed. In re-
ality, the system was operating on a knife
edge where small changes in the quantity
of reserves generated large changes in
price.
Thegoodnewsisthatthisisaproblem
the Fed can easily solve. Over the past
month,thecentralbankhasexpandedits
balance sheet by $200 billion through
lending to securities dealers in exchange
for collateral guaranteed by the govern-
ment.Thispastweek,theFedalsostarted
buying U.S. Treasury bills, with the goal
ofaddingabout$60billioneachmonth“at
leastintothesecondquarterofnextyear.”
Together, these moves could almost
completelyreversetheimpactoftheFed’s
balance-sheetshrinkagethatbeganatthe
endof2017,butitdoesn’tmeanthatQE4
ishere.Forinvestors,thismeansthecen-
tral bank is simply going to buy as many
bondsasitneedstohititsshort-termtar-
getrate,whichcurrentlysitsatarangeof
1.75% to 2%.
How did we get to this point?
Before everything changed during the
financial crisis at the end of 2008, only
about $20 billion of reserves were held
on deposit at the Fed, and banks bor-
rowed and lent those reserves to one an-
other overnight to satisfy regulatory re-
quirements. Traders at the New York
Fed’s market desk calibrated the supply
of reserves to adjust the price of those
interbank loans (the federal-funds rate)
by buying and selling Treasury securi-
ties.
Then,fromtheheightsofthefinancial
crisisinSeptember2008throughthemid-
dleof2014,theFedcreatednearly$3tril-
lion in bank reserves to finance its pur-
chases of long-term Treasury debt and
mortgagebonds,whichweresupposedto
boost lending and investment.
The explosion of reserves means tradi-
tional reserve requirements stopped bind-
ing banks years ago. Even so, two new
rules imposed in response to the financial
crisis have ended up raising the effective
level of “required” reserves. Banks now
need to hold enough “high-quality liquid
assets” to repay depositors and other
short-term creditors during a panic. Re-
serves aren’t the only asset that satisfies
the requirement, but they are the most
attractive one to hold, given the level of
interest rates and the ability to use re-
serves to settle payments throughout the
day. At the same time, the “supplemen-
tary leverage ratio” limits how much
banks can borrow, which also limits their
willingness to make loans with low ex-
pected returns, such as overnight repur-
chase agreements collateralized by U.S.
Treasury notes.
Combined, these rules have dramati-
cally increased banks’ need to hold re-
serves while simultaneously making it
harder to shift reserves within the bank-
ing system to where they are needed.
At the same time, the supply of re-
serveshasshrunkbyroughly$1.4trillion
sincethepeakin2014,thankstotheFed’s
unduefocusonkeepingthebalancesheet
fromgettingtoobig.WhentheFed’stotal
assetswerestable,itreducedtheamount
ofreservesbyallowingitsotherliabilities
to grow, particularly physical currency
and deposits from foreign central banks
andtheU.S.Treasury.ThentheFedbe-
gantoshrinkitsbalancesheetattheend
of 2017 in the hope of “normalizing” its
operations,eventhoughtherewasnoim-
minent need to do so. That further com-
pressed the supply of reserves. These
forceshaveputtremendousstrainonthe
moneymarketsoverthepastyearandex-
plainwhyarelativelysmallshiftindepos-
itsfromtheprivatesectortotheTreasury
caused such a massive spike in interest
rates.
In the mid-1980s, the Fed willingly
abandoned control of the size of its bal-
ance sheet to gain control of short-term
interest rates. Back then, the challenges
werefiguringouthowtoaccommodatethe
demand for physical U.S. currency and
how much “reserve pressure” needed to
be applied to get interest rates close to
thetarget.Thiswasalwaysmoreartthan
science, and the Fed often erred, with
ratesspikingupordowninthe1980sand
1990s.
After the financial crisis , the Fed
stopped targeting short-term interest
rates,whichitletsitatzero,andinstead
focused on targeting the size of the bal-
ancesheetbybuyingassets.Intheyears
since, the Fed tried to have its cake and
eat it, simultaneously targeting both the
size of the balance sheet and the level of
short-term interest rates.
Recent events make clear that it can
choose only one or the other. The Fed is
effectively back to the old regime of set-
ting a target on short-term interest
rates—butitisnowstrugglingtocalibrate
thesizeofitsbalancesheettogetinterest
rates where it wants them.
A better approach, suggested by Zol-
tan Pozsar of Credit Suisse just a few
weeksbeforetherecenttumult,wouldbe
for the Fed to let banks borrow cash
againstTreasurydebtasneededatafixed
premium to the target interest rate.
Markets,notbureaucrats,woulddeter-
mine the size of the Fed’s balance sheet.
TheEuropeanCentralBank,theBankof
England,andtheBankofJapanalldothis
already,whiletheFed’sminutesshowthat
some officials have been considering a
“ceilingfacilitytomitigatetemporaryun-
expected pressures.”
UntiltheFedcreatessuchafacility,it
will have to keep buying Treasuries and
expanding its balance sheet. Investors
shouldthinkofthoseoperationsasbeing
areturntowhattheFedusedtodobefore
thefinancialcrisis—andnotastimulative
effort aimed at inflating asset prices.
email: [email protected]
Balance Sheet Bounceback
With plans to purchase $60 billion of Treasury bills into the second quarter of 2020, the
Fed will effectively reverse the balance-sheet shrinkage it has overseen since 2017.
Sources: Federal Reserve Board; Barron's calculations
Securities Held Outright
Actual size of securities held on Fed’s balance sheet
Implied size of securities held on balance sheet after bond buying
2017 ’18 ’19 ’20
3.50
3.75
4.00
$4.25 Tril