How Much Longer Will the Fed’s Huge Balance Sheet Represent Accommodative Policy?

On Friday, in his Jackson Hole Virtual speech Monetary Policy in the Time of Covid, Powell made statements on QE that caught my eye.

At the FOMC’s recent July meeting, I was of the view, as were most participants, that if the economy evolved broadly as anticipated, it could be appropriate to start reducing the pace of asset purchases this year.

We will be carefully assessing incoming data and the evolving risks. Even after our asset purchases end, our elevated holdings of longer-term securities will continue to support accommodative financial conditions.

For How Long?

Here’s a hint: QE is not money that was spent, is about to be spent, or ever will get spent. 

I discussed the QE misconception at length in Will the Fed Balance Sheet Get Spent into Circulation Causing Inflation?

The BIS is in agreement.

Unconventional Monetary Policies

The above image was taken from the BIS article Unconventional Monetary Policies. 

Key Points

1. Reserves do not play into bank lending decisions
2. The main constraint on expansion of credit is minimum capital requirements.
3. There is nothing inherently inflationary about large reserves.

Point 3 is interesting. While the Fed is building its balance sheet it is fostering inflation by fostering asset bubbles.

Q: But what happens when the Fed stops?
A: Banks have large reserves that do not figure into lending decisions at all. 

Those reserves are not spendable. And banks conveniently sit back and collect free money on those reserves parked at the Fed. 

Reverse Repos

Already, the Fed is struggling. Powell never explained how its current balance sheet expansion accommodates anything given it is conducting $1.1 trillion reverse repos daily.

On August 20, I noted There is a Negative Demand for Deposits to the Tune of 1.1 Trillion Dollars

A quick check today shows reverse repos as of last Friday are still at $1.1 trillion.

This is accommodating no one other than free money to banks as interest on the money banks park back at the Fed. The Money Market Mutual funds are outright choking on the alleged accommodation.

Powell never explained this because there is no reasonable explanation.

Explaining Powell’s Hesitance to Set a Date

• Traders will front-run the Fed if the Fed gives a date when it will reduce its balance sheet. The prior “Taper Tantrums” reflect that point.
• Powell’s phrase “could be appropriate to start reducing the pace of asset purchases this year” was purposely noncommittal to avoid taper tantrums.

To answer the key question, the moment the Fed reduces its balance sheet and perhaps even the moment the Fed stops asset purchases, that huge multi-trillion QE stops being accommodative. 

Given reverse repos, one might make a case right now.

Taking Powell’s statements at face value, I doubt the Fed understands that point.

And if interest rates start to rise beyond what the Fed pegs, the Fed will have a hell of a time doing anything but expanding its balance sheet.

Here’s one final point. Powell was very careful in how he phrased things. He specifically stated “our elevated holdings of longer-term securities will continue to support accommodative financial conditions”.

Does that remind you of anything? It should. 

Think Japan. The Bank of Japan cornered nearly the entire Japanese bond market for a decade. What precisely did that accommodate?

Transitory Debate

Meanwhile, the debate over transitory is still ongoing. Much will depend on precisely what Congress does with $3.5 trillion in new spending and the energy tax the Progressives want.

Regardless, please note the Impact of the Fed’s Balance Sheet on the Economy is Transitory not permanent.

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