It may sound strange, but reading Ben Bernanke’s recent book on the history of the Fed, I was reminded that we once experienced “quantitative tightening,” or QT, between 2017 and 2019. Along with everything else back then… Trump’s trade wars and tariffs, the Fed’s shift from rate hikes to rate cuts, the longest government shutdown in history – the Fed’s record hasn’t hardly been a big topic of discussion.
This, of course, was what Fed officials wanted; that the process of shrinking the balance sheet by letting securities mature and passively drain each month would be “as exciting as watching the paint dry,” as Fed member Patrick Harker said at the time. And for a while it was – until the pension crisis in 2019.
The Fed, remember, had gone through three rounds of quantitative easing, or QE, from the financial crisis through the years of anemic post-crisis recovery until it ended its bond purchases at the end of 2014. This spiked his balance sheet by about $900. billion before the crisis to 4.5 trillion dollars in October of the same year. But the Fed was eager to cut it as the economy recovered, lest the resulting excess bank reserves ignite an inflationary spark, and also to help restore some semblance of normalcy to financial markets.
They only hit $3.75 trillion in August 2019 before the trouble hit. That September, as Bernanke recounts, “turmoil erupted in the repo markets” and the short-term repo rate soared to 10%. What’s strange is that the banks didn’t take their reserves from the Fed and get a quick 10% return; “Perhaps out of concern for regulatory constraints, banks have not believe they had enough reserves” to drive some away from where they were parked, earning around a 2.25% overnight interest rate at the Fed. ”
At the time, as Bernanke admits, officials had no idea what the “right” balance sheet size was now supposed to be because QE had completely changed financial markets. Before the crisis, the Fed controlled overnight rates by altering the supply of bank reserves to the market, a so-called “rare” regime. But after QE, and because of regulation, banks now had tons of reserves (an “ample” regime) and no longer needed to lend to each other as much. The Fed needed a new way to move interest rates, which is now to pay interest on excess reserves.
So the repo crisis was neither an accident nor a fluke; it was a consequence of major changes to the financial system and the role of the Fed in the markets. To resolve the crisis, the Fed became more entrenched in the repo markets by providing liquidity itself. It also began to increase the balance sheet again, rising to $4.2 trillion by the time the pandemic hit; it was technically not considered QE because it was achieved by adding short-term treasury bills instead of longer-term treasury bills. And so $4.2 trillion became the “new normal” for the size of the Fed’s balance sheet.
Of course, we are well above that level now; at $8.9 trillion. But the thing is, so much has changed and there are so many new things happening in the financial system that it’s as great an experience as the last, relatively unnoticed QT, if not a greater one. We should expect the unexpected, to say the least.
Fortunately, there are encouraging signs that “normalization”, as messy as it may be, is at least starting quietly. “The Fed may be creating less money, but the banking system seems to be creating more,” wrote Michael Darda of MKM Partners the other day. While money growth has slowed dramatically — sucking liquidity from financial assets — velocity, he notes, has actually accelerated, and banks’ “loans and leases have grown at an annualized rate of 14 %” those last weeks.
That’s how it should be. No one wants to be stuck in a permanent QE world where the Fed is the financial system, lender and buyer in first and last resort. You sometimes worry that if we don’t hand over the baton to the banks and the private sector now, it won’t even be there in the future.
See you at 1 p.m.!