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The case against shrinking the Fed’s balance-sheet

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I believe that there are a few important facts that were not acknowledged in this article, albeit overall very informative.
1. The Federal Reserve appointed by President Trump and the GOP will be both less experimentive and less dovish. That's a fact simply represented by the GOP senate holding the keys, even if the President supports monetary doves.
2. The next Federal Reserve will be less powerful than the previous Federal Reserve. That's a reflection of the constraints many in the GOP want to put on Fed decision making, and the plan put into place by the current Federal Reserve board.
3. Hence, the decision made today was likely the wrong one for the long-term economic health of the United States. This monetary tightening is both premature and not forward looking, just like the December 2015 rate hike.

The dovish Federal Reserve has now set into place a monetary tightening plan that the coming hawkish Federal Reserve will put into play despite all evidence to the contrary. They've put their stamp on this program, and for all we know the future monetary hawks are going to increase the pace of this program while raising rates. We are staring straight at the cause of the next recession in the USA.

Barracuda008 in reply to Robin Newman

It is a lot more than a bookkeeping exercise. It is creating an immense financial bomb 12.3 trillion (US GDP is 19 trillion) that is there and dismounting it will take or 50 years or it will create a financial catastrophe (just as a reference Lehman Brother collapse was 0.6 trillion. Furthermore, it creates speculative bubbles in the real estate, bond markets, shares, capital markets, commodities, etc...
QE is just a financial crime


There is ANY case in favour of no shrinking the FED' Balance PERIOD. Only mad Keneysian and economic criminals believe that QE was not a clear destructive example of Central Bank intervention that produces more damage that benefits.
It is as though the Fed were riding on the back of a double-headed monster. It cannot hang on forever, but it cannot dismount the beast without being devoured. As it is, the U.S. Treasury depends on zero interest rate policy and QE to fund America’s ballooning debt. When investors flee an enfeebled dollar the Fed is likely to be the “buyer of first resort” so that the price of Treasurys does not fall, pushing up interest rates. (So far Treasurys with low yields are still in high demand.) So with the Fed insisting that short-term interest rates will remain near zero “for an extended period,” a phrase used for the past two years, a new round of QE is almost inevitable.
For its part, QE involves flooding financial institutions with excess liquidity to try to flatten out the yield curve and depress long-term interest rates in hopes of sparking a recovery. But QE has created a massive overhang of excess reserves in the banking system that constitutes repressed price inflation. And the sums involved are truly staggering: 12.3 TRILLION (just as reference US GDP in 18.57 trillion).
In the end, QE has been ineffective in restoring economic vitality while also creating a massive overhang of repressed inflation. Plus inflation in stock markets, real estate, commodities, speculative investments, antiques, etc....
QE is a crime against humanity.


How about we ask the Fed to stop trying to monkey with the market for money? This column is another example of the "intellectual-yet-idiot" class demonstrating the hubris of control. Sure, you can ARTIFICIALLY keep interest rates low, but you have destroyed any capacity to value assets... Sure, you can keep interest rates low, but then you run the risk of creating bubbles... Etc., etc.
Remind me of the expression they use to describe economics.... Oh yeah, the dismal science.

H.C. - The Economist in reply to kvaml

I stand by what I wrote, which was: "So an unexpected rise in interest rates could ultimately threaten the solvency of a central bank with a large balance-sheet. The taxpayer would have to plug the gap."

The Treasury would have to recapitalise an insolvent Fed because to go on creating reserves while insolvent would constitute monetary financing of the government's liabilities. Therefore, solvency is worth worrying about.

H.C. - The Economist in reply to kvaml

Thanks for your comment.

It is true that the Fed could operate with negative equity owing to its ability to create new reserves. However, this does not undermine my point. It is instructive to consider the government as one entity (ie, including both the Treasury and the Fed). Imagine that the Treasury issued a lot of very short-term debt, and then faced difficulty servicing it as interest-rates rose. The Fed could help the Treasury by printing money and retiring the debt. But such monetary financing would rapidly lead to inflation. The Fed would not be able to raise interest rates to see off the inflation, because that would only make the financing problem worse.

The same goes if the government's liabilities are issued by the Fed rather than the Treasury in the first place. So although you are right that Fed insolvency would not pose an operational problem, an insolvent central bank is probably a sign of monetary financing of government debt. In practice, I think the Treasury would need to recapitalise the Fed to avoid giving this impression (just as if it had issued the debt itself, it would need to raise taxes to pay it off).

The point is that inflation ( an increase of price) has increased a lot in many assets types (shares, commodities, cyber coins, etc... directly as a result of QE. Clearly, the impact on CPI (Consumer Price Index) has been extremely limited.
Now the reason why there has not be hyperinflation with the QE is that the Fed is paying interest on reserves, so they aren't actually monetizing the debt. That's true, but it's quite possible that the QE program would have created relatively little inflation even in the absence of IOR, as we saw in America in the 1930s, and more recently in Japan and Europe. However, some of the liquidity has been used for asset purchases creating a hyperinflation there.
The better argument is that temporary currency injections are not very inflationary. By temporary, I mean for as long as interest rates stay near zero. But once rates rise above zero, banks don't want to hold excess reserves, and all those reserves would flow out into currency in circulation. And that's highly inflationary.

Thanks for your comment.

I do not think that after the crisis people would have been unwilling to buy US government debt had there been no QE. In fact, markets were desperately demanding safe assets. If markets were unwilling to hold Treasuries, they should have been similarly unwilling to Fed bank reserves. But they have made no efforts to rid themselves of reserves, which is why QE has not been inflationary. As the blog post argues, Fed reserves and Treasuries are both interest-bearing government debt. Or are you suggesting that the Fed is somehow more creditworthy than the Treasury?

Robin Newman

"The Fed hoovers up Treasury bonds, and replaces them with newly-created bank reserves. Those reserves are just a different type of government liability. Just as the Treasury pays interest on bonds it has issued, the Fed pays interest on bank reserves."

I had thought that the money to buy Treasury bonds was created electronically (out of thin air) and so there would be nobody to pay interest on this "money" to...consequently I am at a bit at sea with the remainder of this article-any explanations appreciated !

Robin Newman in reply to Barracuda008

Treasuries mature so government repays Fed, Fed repays commercial bank deposits/reserves, commercial banks buy new Treasuries-everyone winds up where they started .....
I think that I must be missing some aspect of this !

Barracuda008 in reply to guest-aaawwwmj

You need to understand a lot more of finance that your extremely basic knowledge (with all the due respect). First, QE does not have anything to do with interest bank paid for deposits. Second, the Banks has received 12.3 trillion in FREE money by QE they can careless about depositors. If this 12.3 trillion has zero cost the banks keeping as reserves in the FED. By Law, they have to put zero capital the banks' profit is like 0.3 trillion per year without any risk or cost. The return on investment for the banks is $0.3 trillion (interest received)/ ZERO investment = Infinitive return.
If a bank gives a loan he needs to put 12% of capital + paperwork + risk of default + regulation. The return is a lot but a lot less than infinitive that receives with the FED

Barracuda008 in reply to old gobbo

It explained but you need to understand bank regulation and finance. I will give you an example (1) let's suppose instead to keep as reserves the bank decided to give a loan $100 mil at 10% (remember there is a risk in loans keeping the money in the FED is zero risk) by law the bank need to allocate 12% of equity for this loan. that means that the return over investment is $10 mil (interest received) * risk of default / $12 mil (equity needed) = 83% return. (2) Leaving the money in the FED is a free risk investment the capital required (by law) is ZERO. Let's suppose the return in 2.5% same 100 million the return over investment is $2.5 mil/ $0 investment = Infinitive.


"So an unexpected rise in interest rates could ultimately threaten the solvency of a central bank with a large balance-sheet. The taxpayer would have to plug the gap."

Since the central bank can create money as needed, where does the solvency risk come from? So long as the Fed's obligations are denominated in US $, the Fed can meet those obligations.

I realize the Economist was quoting from a research paper, but I would have expected an acknowledgment of the Fed's ability to meet ANY US $ obligation. The risks from a large balance sheet do not include solvency.


The point about creating safe short-term assets, rather than letting commercial paper create risky ones, is a valid one. But I still worry about remaining in QE. In doing so, we swap the previous financial environment, where we have decades of experience, for a new one, in which we have only a few years of experience. The article admits that the theoretical understanding of this new environment is lacking. Assuming that the new environment will be better (or even safer) than the old one seems unduly optimistic.
I also worry about QE turning into a mechanism for monetizing the government's debt. That always ends badly, no matter how clever the mechanism appears to be.

old gobbo in reply to Barracuda008

@Barracuda008 You write: " commercial banks pay almost nothing to borrow yet receive interest payments from the Fed to hold excess reserves, making them unlikely to extend new loans." On this account, banks win both ways: deposits earning interest plus almost free money that they can lend out at higher interest rates - so this cannot be why they are not lending.

Robin Newman in reply to Barracuda008

I can understand that the Fed buys Treasury bonds from commercial banks, and the money these commercial banks thus receive is, at least in part, reinvested back with the Fed.
This still leaves the initial "newly-created bank reserves" conjured up, so far as I can see, out of nothing and with interest payable to nobody.
Perhaps I am just betraying my bookkeeping training !


Throughout the Caliphate of Greenspan, I often thought of how much better it would be if Kindleberger were in charge.


While Fed deposits are in a sense just another form of government debt, they are a very cheap form. Because the Fed purchases Treasury securities through its primary dealers in the secondary market, some of its holdings in recent years were paying interest at rates as high as 11.5% while the Fed was paying 0.25% on reserves. Even with the Reagan era bonds maturing and interest on reserve increasing, in the first six months this year, the Fed collected $57.024 billion in interest on Treasury, Agency, and residential mortgage backed securities and paid $6.126 billion in interest on reserves and $422 million in interest on reverse repurchase agreements. That was $50.476 billion in savings for the American people and it leaves a great deal of room before the interest-rate risk mentioned in this article becomes a problem.

I would change one word in your comments. "but such monetary financing COULD (not would) lead to inflation. Practically speaking most of the world's developed Central Banks have been engaging in monetary financing. It is hard to argue otherwise, given the percentage of government bonds owned by the world's CBs. However, inflation (at least CPI inflation as opposed to asset inflation) is still not in sight. Inflation, as measured by CPI, might happen, but you can't say "would" as it hasn't happened yet after all these years of QE.