About the Author: Leslie Lipschitz is a former director of the IMF Institute, taught at Johns Hopkins University and Bowdoin College, was a visiting scholar at the Brookings Institution, and an advisor at Investec Asset Management.

The Federal Reserve and other central banks began buying large amounts of government bonds and other securities in 2008 to deal with the aftermath of the global financial crisis. This effort was renewed in March 2020 when the pandemic took hold.

To savvy monetary theorists, the advent of quantitative easing, or QE, and the huge expansion of central bank balance sheets seemed bold, brave and, perhaps, a bit risky. Difficult questions persist since the launch of QE. How much and for how long could this balance sheet expansion continue? Was or would there be an element of fiscal dominance involved, i.e. central banks were required to buy and hold huge amounts of government paper to finance government deficits and debt growing? Would a long period of very low interest rates lead to overinvestment and poor capital allocation? Could a problem of financial dominance emerge, in which central banks would be reluctant to tighten monetary conditions for fear of triggering a financial crisis? And, if and when an unwinding of QE through the sale of securities (quantitative tightening or QT) becomes necessary, could it wipe out central bank capital?

Let us first recall the facts about Fed actions during the period from March 2020 to March 2022. The Fed launched a new round of QE – large-scale purchases of Treasury securities and mortgage-backed securities – and this coincided with substantial additional government spending . The Fed’s securities portfolio has grown from less than $4 trillion to $8.5 trillion. A small portion of this securities accumulation was offset, on the liabilities side of the Fed’s balance sheet, by increases in outstanding currency and Treasury deposits, but the lion’s share of the increase in liabilities was made up of deposits. interest-bearing (deposits from banking establishments or reverse repurchase agreements). Since in the first year of this period inflation and inflation expectations remained low, and in the second year the Fed viewed the rise in inflation as transitory, there was no urgency to raise rates to contain inflation. Interest rates on the Fed’s liabilities were much lower than those on its securities. The Fed’s remittances to the Treasury from its profits have grown from $55 billion in 2019 to $87 billion in 2020 and $109 billion in 2021.

Rising inflation after the start of 2021 put an end to this narrative. The 12-month consumer price inflation rate was still below 2% in the first months of 2021. In the third quarter of 2022, it was above 8% and, clearly, politically unsustainable. Despite a weakening economy, the Federal Reserve was therefore forced to change course and adopt a much more restrictive position. The European Central Bank and the Bank of England have moved in the same direction, but not all at the same pace.

The Fed’s October 5 balance sheet – aggregated and somewhat simplified for our purposes – is indicative of the implications of monetary tightening.

Assets Passives
goods of treasure 309 Currency in circulation 2,280
Treasury Notes and Bonds 4,854 Reverse repos 2,635
Securities backed by mortgages 2,698 Reserve Balances 2,973
Other 952 Other 925
Total 8,813 Total 8,813

Source: Federal Reserve

For the Fed, determined to reduce inflation, a combination of two options is possible: it could raise its federal funds rate target or it could sell (or allow maturities to gradually reduce) the stock of assets on its balance sheet. . This latter option (QT) would reverse the previous QE and mop up some of the large amount of liquidity (reserve balances and reverse repos totaling $5.6 trillion) available to financial institutions.

It is difficult to raise the federal funds rate when banks are short of funds. Thus, one could imagine that the first step would be to drain some of the liquidity from the market via QT. But, given higher inflation expectations, market yields on fixed income securities held by the Fed would be well above rates at the time of purchase with correspondingly lower market prices. Moreover, a large-scale sale of these securities would further depress prices and increase yields.

On Oct. 5, the Fed held nearly $4.85 trillion in fixed-income Treasury securities (excluding short-term bills and inflation-linked securities) and another $2.7 trillion in asset-backed securities. mortgages. If these securities were marked to market, the fall in their value would far outweigh the Fed’s capital. Duration (not to be confused with the related concept of maturity) is the measure that relates the change in market prices to the change in yields. If, for the sake of illustrative simplicity (and, perhaps, a little conservatively), one assumes a portfolio duration of five years, the mark-to-market loss on a $7.5 trillion portfolio is about $375 billion for every percentage point increase in yield. But for creative accounting, the balance sheet numbers shown might call the Fed’s solvency into question — although, to the extent that the Fed can create dollars, it can never be insolvent.

If the Fed does not mark its securities on the market, these losses would not be realized or displayed. However, any significant sale of this portfolio, presumably of these securities closer to maturity and therefore of shorter duration, would force the Fed to realize a loss. The loss would be significant but less than the loss in market value: a larger change in yield (at least three percentage points since March 2020) more than offset by the sale of securities with shorter than average duration. Unsurprisingly, we are unlikely to see a large-scale sale of assets with corresponding realized losses. The QT will likely be gradual with a primary focus on maturing debt.

Now consider the other option: raise the target fed funds rate without QT on a large scale. As we said, it is difficult to raise the fed funds rate on its own when banks are holding very large excess reserves with the Fed at a relatively low interest rate. Given institutional constraints, an increase in the fed funds rate should be accompanied by a corresponding increase in rates on the interest-bearing liabilities of the Fed. A one percentage point increase in the Fed’s $5.6 trillion in interest-bearing liabilities would cost the Fed $56 billion each year. The federal funds rate has risen sharply since February. It is difficult to imagine that the eventual increase will be less than about four percentage points. Of course, assuming that an increase of this magnitude will be required to bring inflation back to target, profit transfers to the Treasury would quickly be eliminated. Fed losses thereafter would be accounted for as “deferred assets.” Transfers to the Treasury would be suspended – an eventuality with political implications damaging to the independence of the Fed – until these “deferred assets” are reduced to zero relative to future earnings.

Thus, the Fed, like other major central banks, finds itself in a position similar to that of private financial institutions with maturity mismatches, that is, longer-term, high-duration assets and short-term liabilities. That said, the financial implications of the lag are somewhat disguised if the Fed is not required to mark assets to market or recognize losses.

If we set aside the accounting treatment of the asset side of central banks’ balance sheets – whether or not they must mark assets to market – we observe an effective shortening of the average maturity of public debt. The government may have intended to lengthen the maturity structure of its liabilities, a sensible strategy of locking in low, fixed, long-term interest rates. But the purchase of these assets by the central bank (against the liabilities of reserve balances) effectively shortened their maturity to that of demand deposits.
As it was widely recognized, the Fed, the ECB and the Bank of England face many potential dangers in the current situation. They may face a conflict between their commitment to reduce inflation and the demands to prevent a financial crisis or severe economic downturn. Over the past few weeks, despite a commitment to QT, the Bank of England has been forced to buy gilts to avoid a pension fund crisis with wider contagion potential. If central banks act quickly to tighten financial conditions, the effect of a general decline in asset prices (the “wealth effect”) could reduce aggregate demand and GDP much more than expected. Potentially sudden moves in seemingly capricious risk premia are an additional imponderable.

The worrying implications for the balance sheets of private financial institutions and central banks have received less attention. On the one hand, if central banks fail to control inflation and inflation expectations, due to real or perceived irresolution or exogenous shocks, returns on long-term assets will rise. The resulting capital losses for bondholders can trigger financial turmoil – again, the recent reduction in collateral required by UK pension funds is a telling example. On the other hand, the tightening of monetary policy will itself create a hole in the balance sheets of central banks.

Like the ECB and the Bank of England, the Fed operates in an environment of extraordinary uncertainty.

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