Unwinding Excesses in the Fed’s Balance Sheet

This column is based on testimony given to the House Financial Services Committee on April 4, 2017.  The testimony can be found here.

While the Fed’s asset purchases during the financial crisis in 2008-2009 were emergency measures that helped to end the financial crisis and recession, the subsequent Quantitative Easing (QE) asset purchases have served no economic purpose and are very risky. This is particularly true of QEIII and the maintenance of the current $4.5 trillion of assets by reinvesting the proceeds of maturing assets, which occurred even at the time that the economy and financial markets were functioning normally,

The Fed’s $1.8 trillion holdings of Mortgage Backed Securities (MBS) inappropriately involve the Fed in credit allocation.  By reducing mortgage rates, the Fed’s policies encourage increased credit allocation into the housing sector at the expense of other economic activities.

The Fed’s overall $4.5 trillion in assets is funded by short term-borrowing, which  generates over $100 billion in net profits that are remitted to the Treasury.  This gives the false impression that the Fed is reducing the deficit in a riskless way. In fact, the Fed is exposing the government and current and future taxpayers to large losses.  By blurring the role of monetary policy in fiscal policy, the Fed is jeopardizing its credibility and independence.

I recommend that the Fed embark immediately on a strategy that would gradually unwind the excess assets in its portfolio as part of normalizing monetary policy.  This would enhance economic performance and support a healthier banking system.

The financial crisis was severe and required emergency, unprecedented Fed interjections into markets.  But the Fed’s continuation of crisis management QE that has bloated its balance sheet has been a mistake.

The Fed’s QE, Operation Twist and sustained negative real Federal funds rate have stimulated financial markets --- pumping up the stock market and real estate and encouraged risk-taking—but since 2012 they have failed to stimulate nominal GDP growth.  These policies have increased wealth inequality and added financial burdens on poorer and older Americans.

The economy would have continued growing and jobs would have been created even without QEIII, Operation Twist, and the Fed’s reinvestment of its maturing assets.

Unfortunately, potential growth has been slowed significantly by higher taxes and a growing web of government regulation that have deterred businesses from expanding, investing and hiring.  Theses constraining factors are beyond the scope of the Fed’s monetary policy.

Former Fed Chair Bernanke and others have warned of the dangers of the Fed’s MBS holdings and have urged the Fed to move to an all-Treasuries portfolio.  The Fed has ignored that advice.

Following the financial failures of Fannie Mae and Freddie Mac, due to their excessive leverage and risky portfolios, and the similar failure of some large banks because they were similarly undercapitalized with too much leverage, it is ironic that the Fed maintains such a massive portfolio of long maturity assets funded by short-duration debt. Further, the Fed understates the risks. 

The Congressional Budget Office estimates that an increase of 1 percentage point from its baseline interest rate forecast would raise the deficit by $1.6 trillion over its 10-year projection period.  Based on the Fed’s own forecasts of the appropriate path of the Federal funds rate, and forecasts of moderate growth and 2 percent inflation, these budgetary risks are real.

If inflation rises further, as is likely, or if economic growth strengthens, which may occur if pro-growth tax and fiscal reforms are enacted, the costs in terms of higher deficits may be larger.  The Fed has been all too quiet about these risks.  Instead, the current net profits the Fed remits to the Treasury give Congress a sense of newfound, risk-free revenues that have led to budgetary misuse.

The Fed is encouraged to establish a gradual and predictable strategy for unwinding the excesses in its portfolio. What’s important is that the Fed should stick to a strategy and not waiver from it.  Moreover, its strategy must involve a material portfolio runoff, even if Wall Street begs and pleads for a minimal program. 

Step1: The Fed should announce that it will cease reinvesting maturing assets in its portfolio. This would result in a passive but fairly large runoff of its Treasury securities in the next three to four years.  Because the MBS portfolio includes primarily long-maturity securities, only a small amount of runoff would occur in the early years, reflecting the natural amortization in the portfolio.

Step 2: After the runoff is well underway, the Fed should announce a gradual swap program in which the Fed sells $150 billion per year in MBS and buys the same amount of Treasuries. Due to the combination of this swap program and the runoff of the maturing Treasury securities, by approximately 2025 the Fed’s balance sheet would be all-Treasuries and its excesses would be unwound.  Even with this program, excess reserves in the banking system would remain plentiful. 

Stretched out over a long period, this would have only a modest effect of raising Treasury bond yields and mortgage rates slightly.  The interest rate increases would not be large enough to harm the economy; in fact, economic performance would improve and bank lending would go up.  And importantly, downsizing the Fed’s massive portfolio and going back to an all-Treasuries balance sheet would reduce distortions in credit markets.

Mickey Levy is Chief Economist of Berenberg Capital Markets for the Americas and Asia and Member, Shadow Open Market Committee.

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