by the Curmudgeon with Victor Sperandeo
The WSJ (on line or print subscription required) reported on Saturday January 26th that the Federal Reserve Board is close to deciding they will slow down or stop the shrinking of their bloated balance sheet and thereby maintain a larger portfolio of Treasury securities than they’d expected when they began shrinking those holdings two years ago.
After the financial crisis, the Fed bought mortgaged back securities or US notes and bonds for several years such that its balance sheet ballooned to about $4.5 trillion. When the Fed bought those securities, it electronically credited money to the bank accounts of its bond dealers who sell mortgage-backed securities and/or Treasury's. The Fed then added the securities to its balance sheet, while the sellers (Fed dealer banks) had their accounts increase by the same amount as the securities’ value. The Fed didn’t literally print paper currency to do this but created funds electronically that weren’t in the financial system before. That’s the equivalent of creating money out of thin air.
QT or Fed balance sheet run off is when that process goes into reverse. Instead of reinvesting the proceeds of maturing bonds, the Fed erases them electronically upon maturity. The money essentially vanishes from the financial system.
But apparently, the equity markets have become drug like dependent on the Fed continuing to buy bonds. The Fed has taken notice of stock market volatility, despite the fact that equity market stability is not one of its two mandates (which are low unemployment and a 2% target inflation rate).
The Fed began gradually shrinking its portfolio of mortgage and US Treasury’s in 2017 by allowing securities to mature without reinvesting the proceeds into other assets.
When the runoff began in October 2017, various officials estimated the portfolio—then around $4.5 trillion—could shrink to anywhere between $1.5 trillion and $3 trillion. New York Fed President John Williams said in April 2017, when he was the San Francisco Fed’s president, that runoff could last five years. “In about three or four years, we’ll be down to a new normal,” said Fed Chairman Jerome Powell at his Senate confirmation hearing in Nov. 2017.
Surprise! Looks like that won’t happen and the Fed’s balance sheet runoff could end much sooner. That caused US stocks to rally strongly on Friday with the NASDAQ and Russell 2000 indexes both up over 1.2% on the day.
The Journal said that The Fed’s decision about the size of its portfolio is being driven by a technical debate inside the central bank about reserves in the banking system, not over whether officials want to provide more or less stimulus to the economy. Indeed, bank reserves are the key issue here.
Bank Reserves are the funds Federal Reserve member banks keep on deposit with the Fed. When the Fed expanded its portfolio of bond holdings during and after the financial crisis, it greatly expanded the amount of reserves in the financial system, pumping banks with money as it bought bonds. The banks in turn kept the new money on deposit with the central bank and collected interest on that money.
We claim this is a circular loop of deception whereby the banks make free money, but the economy doesn’t benefit much, if at all. Here’s the scoop:
The Financial Services Regulatory Relief Act of 2006 authorized the Federal Reserve Banks to pay interest on balances held by or on behalf of depository institutions at Reserve Banks, subject to regulations of the Board of Governors, effective October 1, 2011. The effective date of this authority was advanced to October 1, 2008, by the Emergency Economic Stabilization Act of 2008.
Fed member banks collect interest on the money they’ve deposited at the Fed with the interest rate determined by the Fed Board of Governors. That rate as of 12/20/18 is 2.4% as per Federal Reserve Board - Interest on Required Reserve Balances and Excess Balances.
The secret owners of the 12 regional Federal Reserve Banks (who also own the Fed) thereby collect 2.4% annual interest on required and excess reserves at the Fed. But those reserves were greatly increased by the money the Fed created when it bought US notes/bonds and mortgage securities. So, the banks are getting increased interest due to the Fed’s debt monetization (see Victor’s comments below).
The commercial banks and private entities that own the 12 regional Federal Reserve banks also get a 6% annual dividend (mandated by law) from the Fed and that dividend surely increased spectacularly as the Fed earned much more interest in the Treasury and mortgage debt it bought. After paying the 6% dividend (presumably based on the Fed’s annual income NOT the dollar amount of its balance sheet), The Federal Reserve banks return all profits, after paying expenses, to the US Treasury Dept.
A New York Fed survey in December 2018 revealed that market participants thought reserves would stabilize at $1 trillion in a year’s time. That compares to $1.7 trillion last week and $2.8 trillion in 2014. At that rate, the Fed’s asset portfolio would shrink to $3.5 trillion, larger than previous estimates of $1.5 trillion to $3 trillion. It is around $4 trillion now, which is not much of a decrease from its $4.5 trillion peak.
Lorie Logan, one of the top officials responsible for managing the portfolio and an executive at the New York Fed, said in a speech last May she saw “virtually no chance of going back to the pre-crisis balance sheet size. The conversation is really about the relative amount of reserves.”
This new scheme of paying interest on required and excess bank reserves was meant to pay off the rich (i.e. those who bought /owned bonds, stocks, and real estate). The Fed’s QE did not cause more inflation, because banks were now paid to NOT MAKE LOANS (avoiding the risk that some might default). Therefore, there was no increase in the money in circulation as many predicted. Some thought it would cause double digit or even hyper-inflation. Nope!
The so called “wealth effect” from QE was supposedly to help the economy, whereby appreciating financial assets would give people and companies the incentive to spend and invest more. Since the majority of the public does not own stocks or bonds, that didn’t happen. Companies used ultra-low interest rates to borrow money to buy back stock and increase dividends- not to expand their business. The main beneficiaries of QE were the owners of bonds, stocks, and real estate. But not investors or miners of gold and other commodities.
Some believed the increased wealth of the 1% richest Americans would spur them to spend some of the increase to help the other 321 million people living in the US. That didn’t happen either!
Tell me the difference between this and “trickle down” economics? I claim it is far worse as fewer new jobs were created and there was no significant increase in capital spending on new plant or equipment as a result of QE and ZIRP. Instead, it became much easier to buy appreciating financial or real estate assets rather than invest in a real business with the goal of higher profits and lower taxes.
The corruption of helping one group over another has gone to tremendous extremes in the US. It has nothing to do with the US constitution or capitalism. Instead, it’s been a US government mandate of “SERVING THE RICH AND ENSLAVING THE POOR!”
Good luck and till next time…………………………………………………..
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Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.
Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.
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