Last Wednesday, the Federal Reserve officially announced it will begin reducing its balance sheet. The $50 billion-per-month decrease would cut its holdings below $3 trillion by 2020. But even that figure is almost four times larger than the Fed’s balance sheet until 2008.
To put that in perspective, the Fed’s balance sheet is 100 times larger than its $41 billion net worth and the Fed is now more leveraged than Lehman Brothers was before it collapsed.
The Fed’s leaders need to address this $4.5 trillion elephant in the room. These assets consist of $2.5 trillion in Treasury securities, $1.8 trillion in mortgage-backed securities, and $200 billion in other holdings, such as gold.
In 2008, determining it was necessary to keep the crumbling U.S. economy from slipping into a depression, the Fed began a program of Quantitative Easing. The Fed would purchase, on a monstrous scale, U.S. treasuries and government-supported mortgage-backed securities.
It apparently worked. Our economy is now performing well. We enjoy a robust labor market, with unemployment currently at 4.3 percent, and inflation at 1.9 percent.
President Donald Trump, a vocal critic of Fed policy, hastened the Fed’s decision to reduce its balance sheet.
Trump advocated that the Fed sell assets to cut its holdings rapidly. Former Fed Chairman Ben Bernanke disagreed. In a January 2017 blog post entitled “Shrinking the Fed’s balance sheet,” Bernanke warned: “I worry that attempts to actively manage the unwinding process could lead to unexpectedly large responses in financial markets.”
Bernanke reminded his readers of what happened in May 2013, when a Fed announcement that it would taper its $70 billion-a-month bond-buying program caused panic selling in the U.S. Treasury market and interest rates soared.
Richard Bove, a highly respected bank analyst, has criticized the Fed sharply. Bove wrote Sept. 20 in a CNBC commentary that the Fed could be insolvent because it has “a terribly mismatched balance sheet that is headed for meaningful trouble.” Bove cited a report published by the Fed that said the central bank owns approximately 34 percent of the U.S. mortgage-backed securities, making it the largest owner of that class.
Bove argued that if the Fed cut the prices of its mortgage-backed securities enough to sell them, it would wipe out its estimated equity.
The Fed cannot just hope that its mortgage-backed portfolio will disappear. These securities are illiquid and if interest rates rise, then the Fed’s borrowing costs will outstrip their interest income.
At a minimum, I believe that the size and illiquidity of the Fed’s holdings of mortgage-backed securities deserve congressional hearings. At these meetings, economists should debate whether we needed to undertake the Quantitative Easing policy for nine years. The economy was out of crisis several years ago.
I share Bove’s concern that, over the next few years, the Fed might prioritize its balance-sheet problems rather than instituting appropriate monetary policy measures.
If the Fed’s bloated balance sheet stymies its efforts to control inflation, the U.S. will be unable to replicate former Fed Chairman Paul Volker’s policies of the early 1980s, when he drove short-term rates above 20 percent to choke off inflation.
Given our $20 trillion deficit, we cannot let short-term rates go above 5 percent. Paying $1 trillion in interest costs would require deep cuts in infrastructure spending, foreign aid and basic research.
We need to recognize that the Fed has historically made errors and will make mistakes in the future. Milton Friedman, a Nobel laureate, showed that the Fed in the 1930s pursued an erroneously restrictive policy, actually exacerbating the Great Depression.
Action is needed now to prevent the Fed’s failure to recognize the subprime mortgage threat from proving to be another mistake of historic proportions.
Originally published in the Sarasota Herald-Tribune
