Like many of you I have been reading all the articles written about the US Fed ending its quantitative easing program. There is enough stuff there to choke Mr. Ed the talking horse. As I was reading it occurred to me that I am a total monetary geek. I was still wearing parachute pants when I took my first course in money and banking. Since then I have become a Fed Watcher and can’t wait until the minutes of the last meeting of the open market committee.
So let me say that I was mystified that little of what was written in the last week focused on one critical aspect of the Fed’s balance sheet. And there was a lot written. Much was a postmortem on quantitative easing. Did it work or not? And while looking at the past is always valued, we should spend equal time thinking about how the end of quantitative easing will affect the future.
The frustrating thing is that what was written about the future uses too many code words. I don’t know how many times I have read that quantitative easing has increased the size of the Fed’s balance sheet. How many of you know the definition of a balance sheet? How many of you took Professor Gamonida’s accounting class at Georgia Tech and learned about balance sheets? Aha – not many of you. How many of you have ever learned a thimble full of information about the Fed’s balance sheet? Aha!
So in the name of global harmony and to the tune of the Georgia Tech Fight Song, I will quickly and easily introduce you to the arcane basics of Federal Reserve Accounting – and more importantly explain why a key issue is being ignored.
The first thing to note about balance sheets is that they are not found on your mattress under the quilt. A balance sheet brings together much of your financial stuff. On one side its lists the value of all the good stuff like your cool Converse Chuck Taylors, what’s left in your bank account after your spouse went for her weekly facial, saving your saving account balance, your house, your car, cash stuffed in your pillow, and your Uncle Charles. Just kidding, your Uncle Charles in not an asset. All the other good items you own are called assets.
Your balance sheet also has another column that lists all your ouch stuff. Mostly that’s what you owe. So if you owe $46,000 on your Yugo, then the $46,000 loan is called a liability. You have liabilities or debts under such categories as credit card debt, car loans, mortgages, college loans, and so on. The money you owe to Pete your gambling friend is often not included in public balance sheets. If your assets do not equal your liabilities there is always a balancing item that makes your assets equal your liabilities plus balancing item. But we don’t need that fact to go forward.
Are we going forward? Are you awake?
The Fed has a balance sheet. It is very cool. The main asset the Fed holds is bonds. The Fed at last count has close to $4.5 trillion of bonds. Wow. $4.5 trillion could buy a lot of chicken wings at Buffa Louie’s. Most of these are government bonds with short-term maturities. But since quantitative easing started, more and more of these bonds are longer-term government bonds and housing market derivatives.
What you read about over and over is that the Fed’s balance sheet rose from just under $900 billion to about $4.5 trillion. Fed assets exploded because of QE. And like your waistline after a six month luxury cruise, the amount is still with us. In the name of colossal calamity, the Fed bought an extra $3 trillion or so of bonds and still holds them. As of last week they are no longer buying more bonds. But the stockpile remains.
Much of what you read focuses on this stockpile. Will the Fed let it slowly mature and just burn the cash when they receive interest and principle? Or will the Fed quickly get rid of all those bonds? Clearly if they did the latter it could be disruptive to credit markets. So the Fed is in a bond pickle and that’s what everyone seems to be talking about.
But that leaves out one spectacular element. Why did the Fed buy all those bonds in the first place? Is the Fed a bondoholic? Aha! They bought all those bonds because that is how they flood the economy with money. Between say 2009 and today, the Fed added about $3 trillion of money to the economy. The hope was that all that extra money would lead to bank loans, spending, and economic growth. But what happened was that after averaging almost zero in 2007 and 2008, bank excess reserves rose to about $2.8 trillion today. That is, banks did not loan out much of that money. They asked the Fed to hold onto it for them. Perhaps holding it for a better day when people really want to borrow money. Meanwhile the Fed is sitting on money that the economic system has shown it doesn't want.
All this information about money and bank reserves is what is found in that second column of the Fed’s balance sheet and is called liabilities of the Fed. And that is what is not being talked about much in the papers. Your kids came home from trick or treating with a mountain of candy. What are you going to do with all that stuff? Your kids do not need all that candy and Fed and the banking system do not need all those excess reserves.
The Fed could quickly get rid of those reserves but they worry it will disrupt markets. The way to reduce the excess reserves is for the Fed to sell their assets. All that selling could be disruptive to bond markets sending bond prices down and rates up. Yellen and her gang do not want to be held responsible for driving up rates. So what is there to worry about? The Fed is holding a bunch of money for banks who don’t want to use it. No big deal. Right? Wrong. As the economy recovers, borrowers will return to banks. And banks will have an almost limitless fund to make those loans. It is like all that Halloween candy. You can hide it from the kids for a while, but sooner or later they will find it and you will soon have a problem on your hands. Better to trash the candy on November 1.
QE was a travesty because we all knew this would happen. The Fed has put itself in a no win situation. It made a big announcement last week to stop doing stupid things. But now it is stuck with a mountain of stupid things. I guess we never learn.