The Fed's QT is “like Watching Paint Dry”…. Really?

“The US govt has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many US dollars as it wishes at essentially no cost. …Ben Bernanke, Nov 2002.

When the central bank needs to tighten financial conditions to manage an overheating economy and quell inflation, it can raise the policy rate with no upper limit. If a 10% interest rate isn’t enough, try 15%; if 15% isn’t enough, how about 20%? And so on. Knowing that the central bank has unlimited leeway to raise rates, the public’s inflation expectations—a key driver of inflation outcomes—are likely to remain well “anchored” near the central bank’s 2% target.

However, the situation differs when the central bank needs to cut rates to stimulate economic activity. Here the central bank has a finite amount of room to cut rates before it hits the zero (interest rate) bound. For instance, in the easing cycle the Fed began on July 31, 2019, it started with only 225 b.p. of interest rate ammunition, and, thanks to the pandemic shock, hit the zero bound on March 15, 2020. As the ECB, the BOJ, and few others have shown, a central bank can set the policy rate below zero. But pushing it much below -75 b.p. is difficult, particularly politically. Negative rates imposed by the central bank are basically a tax on banks, and banks will want to pass on that tax to depositors; else they will be earning “negative carry” on that part of their B/sheet. But the depositors can obviously move from negative-yielding bank deposits into non-interest-bearing banknotes. This limits the ability of banks to pass on the negative rates to depositors.

Enter QE. At the effective lower bound, central banks have a tool they can use to ease monetary policy: they can start to buy up assets (typically govt debt securities) financed by the creation of central bank money. And there’s no theoretical limit on its ability to do this, other than the supply of available assets in the world. Thus QE gives the central bank an unlimited ability to ease monetary policy akin to the unlimited ability it has to tighten monetary policy by hiking interest rates.

On the other hand, in a QT, a central bank can (passively) let maturing bonds roll off its B/sheet or it can (actively) sell them back into the market; in both cases, reserves drop by the amount of the bonds exiting the asset side of the B/sheet. QT is just the reverse of QE—the central bank shrinking its B/sheet rather than expanding it. QE takes bonds out of pvt sector portfolios, QT puts them back in; QE creates reserves, QT expunges them; QE refinances bonds into reserves, QT refinances reserves back into bonds; QE reduces the term premium, QT increases it. There’s nothing enigmatic about QT—it’s just QE with the opposite (mathematical) sign!

But wait…

Central banks in developed nations are making large losses resulting from money creation and asset purchases over many years. How?

• The central bank earns the coupon from the bond it has bought and the money used to buy the bonds lands up as pvt deposits in commercial banks.
• These banks have an excess of these deposits and park them overnight at the central bank where they are rewarded at the policy rate.
• When interest rates are low or zero, the coupons exceed the overnight interest rate and the central bank makes a profit, which is generally passed back to govt.
• But if interest rates rise, as they have, the overnight rate exceeds the return on assets, producing a net interest loss (-ve carry).
• Also, as rates rise, the bond value falls and when it’s redeemed, it’s generally worth less than the amount that was paid, although it depends on the bond coupon and the price paid.
• So, as rates rise, central banks tend to make both a net interest loss and capital loss on redemption.

Countries account for these losses in all sorts of ways, with the UK being transparent and taking them upfront while the US, EU and others tend to delay putting them into their public accounts. It’s messy!

BoE:

• For UK, losses are at 8% of GDP. The MtM capital losses in late 2023 for the UK were 23%, compared with 13% for the Fed and Eurozone and 11% in Canada.
• Since QE is a maturity transformation of overnight interest-bearing debt swapped for longer-dated bonds, higher losses arise when: 1) more QE is undertaken; 2) when policy interest rate rises further; and 3) when the maturity of bonds bought is longer, since their value falls more when rates rise. The UK was on the wrong end of all of those parameters!
• UK accounts for QE and QT well. It means the QE process made good profits in the 2010s when overnight rates were close to 0 but this ended in 2022 as rates rose. With the BoE engaged in active sales of bonds, sometimes bought at very high prices and sold at low ones, major capital losses are expected in the years ahead and a falling interest loss as QT shrinks the BoE’s B/sheet.
• The BoE has an indemnity arrangement with the UK govt, covering it for losses. These are real losses, with the govt losing and the pvt sector gaining. The net interest losses are accounted for when they happen and they rightly show up in the UK public finances as an item that contributes to the public deficit.
• What about public debt? Again, the UK accounts for this properly. It’s consolidated at the public sector level. At the point a bond matures or is sold, QE is over. Money has been created, used to buy an asset and destroyed. If there’s a loss on that trxn, it is added to public debt as a financial trxn.?

Fed and ECB:

• When QE makes profits, the treatment is the same as in the UK becoz the Fed pays profits to the US Treasury by law. But when the Fed suffers losses, it doesn’t lead to the Treasury cutting a cheque!??
• Instead of a symmetrical money flow from the US govt to the central bank, they sit in the Fed’s accounts as an accumulated “deferred asset”, which will be reduced in future once the Fed starts making profits again. The Fed issues an IOU essentially monetizing its own deficits.
• The Fed has stopped paying money to the US Treasury until it repairs its own losses. It was paying around 0.4% of GDP each year until 2022 and now it pays 0!
• It will not get back to 0.4% until 2033 becoz rates have stayed higher for longer, worsening the Fed’s losses. The cumulative lost revenue, and thus extra debt, for US taxpayers is 3.2% of GDP, or $900bn.
• If the UK is a paragon of virtue in correctly accounting for losses, the US is the opposite!
• The Fed raised its deferred assets to $133bn, the amount it needs to earn before it’s able to contribute anything to the US Treasury. The Fed’s accounting moves from a “flow” when it is making profits to a growing “stock” of a deferred asset when it’s making a loss!
• In Jan, the Fed revealed a mind boggling $114.3bn in operational losses for 2023. This is the first time that the Fed has made losses. But their officials surprisingly seem unconcerned about this performance. This attitude may be more concerning than the losses themselves!
• Like any financial institution, the Fed receives revenue from the assets it holds and it must pay interest on its liabilities. But the Fed asserts that a “deferred asset has no implications for the Fed’s conduct of monetary policy or its ability to meet its financial obligations.”
• The Fed’s recent history jeopardizes the perception that it is independent, which is a key element for the effectiveness of monetary policy.
• Claiming that deferred assets have no implications for the Fed’s ability to meet financial obligations acknowledges the Fed’s power to essentially “print” any amount of dollars it deems fit.
• The fact that the Treasury does not cut a cheque to the Fed to cover its losses doesn’t mean the Fed’s losses are a free lunch. (We all know there’s no such thing!) The Fed’s losses are paid by the implied inflation that was created in the Fed monetizing its own deficits. This is a “gibberish” form of accounting of a possibly “deeply negative conventional equity or net worth”.
• Most of the Euro system adopts the same approach as the Fed, although without the “deferred asset” naming convention. ECB has made losses for 8yrs, which could have a “serious effect on the ECB’s credibility”.
• And what about public debt? The Fed and the ECB again are “living on the never-never”. Since losses are kept in central banks they don’t show up as public debt until some future point when they have repaired their B/sheets. On the Fed’s B/sheet, there is a $1tn MtM loss on the assets it currently holds…about 3% of GDP.
• The US, in any case, is not too keen on fiscal discipline at the moment, so QE is not the biggest issue in its fiscal list of horrors. “If rates come down, losses should decrease and end sooner”.

However a country accounts for QE and QT, the eventual effect is the same. UK is taking the pain upfront on its accounts at the time the trxns take place, while others brush them under the “tomorrow’s problem” carpet and take hits later once QE is long over. But these losses are real (and do matter) becoz:

• ultimately taxpayers pay.
• the politics of losses might complicate the institutional independence of monetary policy. A classic example of QE blurring the line between monetary and fiscal policy stated earlier.
• losses affect the cost benefit analysis of QE.

So, was QE worth it?

?Not so long ago the QE cost-benefit analysis was quite simple:

• On the benefits side, we had profits made from lower-cost public borrowing and improved macroeconomic outcomes.
• On the cost side, we had a sense that lower rates had artificially inflated asset prices and pushed them beyond the reach of the ordinary folks.

Now we know that the exit from QE has involved significant losses to taxpayers.

Studies suggest that QE had the effect of lowering interest rates, boosting equity prices and easing liquidity pressures. Bernanke famously said, “the problem with QE is that it works well in practice, but not in theory”. While economists have found that QE is effective at lowering rates and boosting inflation, it’s not known exactly how it works. The central banks have an incentive to overstate the QE impact: research says the authors of papers reporting larger effects of QE on growth enjoy more promotions later.

Compare this to the world of medicine. Anyone undergoing surgery will likely be put under general anaesthesia. And yet, until very recently, scientists didn’t really know how general anaesthetic worked, They knew it did, they could see it in the data and test and calibrate with accuracy, but they weren't sure of the mechanism. That didn’t mean that when we were in a medical emergency we refuse to use anaesthetic!

QE is like Hotel California: you can check in (start doing it), but you can never check out (bring it to an end). That’s a nice line, but not true: there’s nothing inherently unpleasant about QT. The asymmetry between QE and QT effects could be explained by markets anticipating QT better than QE. QE was implemented at times of stress and brought relief, while QT happened in calmer moments. But that doesn’t mean QT is easy for central banks to do. In 2022,?prominent academics?were arguing that QE might be easy to rollout but agonising to undo.

But it looks like QE is becoming a standard part of the toolkit. QT has caused few ripples so far—a contrast with both the “taper tantrum” of 2013 and the turbulence of 2019.

• Central banks in Australia, Canada, the euro area and the US announced passive QT — allowing bonds to roll off their B/sheets when they matured. By end-2023, aggregate securities holdings were down by 40% in Canada and Sweden, 25% in NZ and 15% in the UK.
• The Fed has reduced its assets by about 16% to $7.5trn since the start of this round of QT in mid-2022. Yet its B/sheet remains 80% bigger than in early 2020.
• Shrinking its assets further would give the Fed more scope to expand it again by buying bonds (printing money) when the next crisis strikes. Managing to do so without crashing markets would also help answer critics who view QE as a cause of high inflation and asset bubbles.
• No one knows the right size for the central bank’s holdings. The Fed’s goal is to return banks to “ample” reserves, down from their “abundant” level today. Before the pandemic, such reserves came to about 10% of their assets. Now, they are about 15%.

The central banks’ large holdings of securities are generating political storms as higher interest rates translate into large losses that are passed on to Treasuries. Continuing to hold large parts of bond markets could raise tricky questions about the role of central banks. In a speech to the Riksdag, Sweden’s parliament, governor Erik Thedéen said it was crucial the Riksbank did not “end up in a situation where we regularly need to go to the Riksdag to ask for more capital. This would go against the principle of financial independence”.

Coming back to the Netflix thriller, after being cornered by the cop, El Profesor offers her a crash course in Economics: “In 2011, the ECB made €171bn out of nowhere..just like we’re doing. Only bigger. They called it liquidity injections…I'm making a liquidity injection right here, in the real economy.”

While this article isn’t in favour of bank heists, El may have a point!

When inflation is looking like it will be lower than it should be, QE can raise money supply and get the economy back to its target. But there’s a limit. If central banks were to continue to print more and more without limit, the result would be too much inflation, with prices rising fast and eroding the value of the newly printed money at too fast a rate - making people worse off. While central banks get to have their finger on the printing press button, they should be less trigger-happy so that increase in money is “just right”.

Watching paint dry is boring but the central banks must be confident that once fully dry, it transforms into a masterpiece, not an ugly painting! As Spiderman said, with great power comes great responsibility!??