There’s been a lot of public consternation where the Fed goes lately.
The masters of our financial universe have painted themselves into a corner the likes of which they’ve never seen before. Years of near-zero interest rates, as would be expected by any thinking economist, inflated the asset economy to precipitous heights, which is now being painfully corrected at the expense of the average investor’s portfolio.
But in addition, and thanks to a broken supply chain, about $5 trillion in Fed-funded stimulus spending has pushed consumer prices to levels that we haven’t seen in nearly half a century.
A bull market in stocks is one thing — a bull market in grocery prices is another altogether.
Once they finally moved past their denial/“transitory” phase, they got serious about reeling in this inflation monster.
In three rate hikes this year they’ve raised interest rates from 0.25% to 1.75%. A big move in a couple short months.
Many folks are worried that continued tightening by the Fed will push us into a recession.
There’s another threat on the horizon even more dangerous than the Fed boosting rates higher…
The Ugly Side of QE
The last time the global economy was pushed to the brink of collapse (the 2008 one), the Fed responded like they do to every financial crisis — they pushed interest rates to near zero. Essentially free money meant they could flood the market with capital to shore up funds that were overleveraged. But once you get to zero, what do you do?
That’s when the Fed (or someone in their marketing department) came up with the phrase “quantitative easing.” It was a fancy name for doing what they’re not supposed to do — purchasing securities (usually bonds) in the open market with money they would pull out of thin air. And thus keep injecting even more money into the financial system once rates had bottomed out.
Suddenly, the Fed began amassing a sizable portfolio. They call it their balance sheet. In theory the Fed should hold only as many securities as it needs to implement its monetary policy.
Prior to 2008, the Fed held about $900 billion in assets. Today they hold roughly $8.9 TRILLION. They’ve 10-Xed it in just under 15 years.
The Fed’s Balance Sheet
This represents another sizable liability. Because it’s excess money still sloshing around in the financial system that they need to drain.
If the Fed is serious about tightening monetary policy to get inflation under control, they need to reduce that balance sheet. They know it. They’ve talked about it. The question is, what can they do about it?
And that is a serious problem.
Two Options: Bad and Worse
There are two ways the Fed can reduce their holdings.
One, they could dump them in the secondary bond market which would effectively crush bond prices and send yields skyrocketing. That would effectively cause a nuclear meltdown in the fixed income market, so that’s really not even an option.
The other option would be to let them “run off” — simply let the bonds mature and collect their interest payments (drain money from the system) without reinvesting the proceeds. It’s a slower, more subtle tactic. But the results would essentially be the same — reducing demand in the treasury market, would eventually lead to higher yields/rates.
So what’s the problem? Isn’t this what the Fed is going for?
Not quite. I’ll explain the rest in your next letter.
Make the trend your friend,
Editor, Streetlight Daily