Why is the Fed slowing its QT program?

Nearly all measures of consumer and producer price inflation have failed to reach their stated targets, and are now accelerating again. Why would the Fed reduce the only anti-inflation measure it currently has in place?

On May 1, 2024 the Fed announced that it would be reducing its upper bound for monthly sales of securities from its balance sheet from $95 billion per month to $60 billion beginning on June 1. ?They have reduced their balance sheet by about 17% since sales began in 2022, but it remains at over 700% of the level that prevailed prior to the bailouts in the wake of the failure of Lehman Brothers.

The Official Narrative

The stated rationale is that continuing to drain liquidity at the current pace will create stress in the banking system , which will then spill over into the real economy. ?Proponents of this theory tend to point to the repo market failures in September 2019, but there are substantial differences between the environment that existed at that time as compared to today:

1. Under the cover of the financial crisis in 2020, the Fed eliminated all banking reserve requirements. ?This freed up hundreds of billions of dollars that can be used for credit.
2. The level of total reserves in the banking system is more than twice as high today than at the time of the repo market breakdown, and has actually been rising rapidly due in part to the runoff of the Fed's reverse repo program:

Given this backdrop, the narrative that the Fed needs to stop reducing its balance sheet to prevent liquidity problems (at least any time in the near future) seems implausible.

A More Realistic Explanation

There are two major reasons why the Fed will need to not only end its quantitative tightening (QT) program in the near future but restart the process of monetary inflation via the next installment of quantitative easing (QE).

Inflation is one of the key ways that the US government finances its spending

While inflation has been a key source of financing for governments around the world for centuries, there has been a sea change in the scale and consistency of these programs in the US since the Global Financial Crisis. ?As mentioned earlier, the Fed's balance sheet increased more than tenfold from the eve of the Lehman failure to its peak in 2022, a period of just under 14 years. ?Besides levitating every single asset class and financial product (large cap equities, Treasuries, crypto, real estate, venture capital, tech stocks/AI, SPACs, private credit, private equity, and so on) it provided the means for an unprecedented increase in US government expenditures. ?

Without an ongoing (if intermittent) inflationary process, it would not be long before Treasury rates explode higher and ultimately become unsellable. ?Since this would result in the greatest deflation in history, it will certainly not be allowed to happen.

The banking system is not particularly illiquid, but large swaths of it are insolvent

It has been widely discussed (though rarely by mainstream financial news outlets) that banks are sitting on enormous unrealized losses in their securities and loan portfolios. ?According to a recent report by the American Enterprise Institute this hole amounts to $1.5 trillion due to interest rate losses alone. ?It does not try to quantify the credit losses that will be coming due to the commercial real estate slow-motion train wreck.

In 2023 as the riskiest and most insolvent of banks began to fail, the Fed created the Bank Term Funding Program to allow banks to hide these losses. ?Not only did it provide cheap financing, it allowed banks to receive the full face value of their assets even though they were actually worth much less. ?This program is now in runoff, but it seems likely that similar concessions will be made available in the future to continue the bailout

Takeaways

• The beginning of the end of QT is not a declaration of victory over price inflation by the Fed, but rather an admission that it is preparing to surrender. They must continue to create money indefinitely in order to pay for runaway government spending and a partially insolvent banking system.
• It is not possible to predict exactly how this new money will appear, and therefore we can't say with confidence whether it will primarily result in asset inflation or consumer price inflation. ?The period after the GFC was mostly the former, while the post-2020 period also displayed the latter due to direct payments to consumers.
• In recent times, some of these QE programs were designed to create a steady stream of new money per month and ran for several years. ?Alternatively, in 2020 the Fed created $3 trillion in new money in three months. ?Investors should not plan on being able to rebalance when the hard pivot comes as the shockwave may arrive before any meaningful adjustments can be made.
• Most investors continue to be wrong-footed for an inflationary (and possibly stagflationary) secular environment. ?The only inflation-hedging asset class that is represented in most portfolios in a meaningful way is real estate. ?However, this time around, most of those assets were purchased at bubble prices and terms, and underwritten to what is now clear were impossible assumptions. ?For most investors, they will not provide the desired protection.
• Many other types of assets that would perform well in this type of environment have been shunned exactly because they did not benefit from the prior bubble periods, and can still be found at reasonable prices (e.g. energy and mining equities, precious metals, energy commodities, certain infrastructure assets, and some sectors with the ability to pass on increased costs like utilities or consumer staples). ?They can be used to mitigate inflation risk and produce a much more robust portfolio overall.

[This story originally appeared on the Artifex web site at https://artifexrisk.com/commentary/f/why-is-the-fed-slowing-its-qt-program ]