Is the Fed about to restart quantitative easing?

While the rate cut got most of the attention, the Federal Reserve made another move during its October meeting that is arguably more consequential. The central bank announced it will end balance sheet reduction (quantitative tightening, or QT) in December.

In practice, this means the central bank will stop reducing its holdings of Treasuries and mortgage-backed securities, maintaining the size of its balance sheet at the current level.

Could this be setting the stage for a return to quantitative easing (QE)?

I think it is.

Fed balance sheet operations: An overview

When the Fed buys assets – primarily U.S. Treasuries and mortgage-backed securities – it does so with money created out of thin air. Those assets go on the balance sheet, and the new money gets injected into the financial system and ultimately the broader economy.

This process is known as QE.

When the Fed reverses the process and shrinks its balance sheet (QT), it pulls liquidity out of the financial system by reducing bank reserves and shifting government debt financing to the private sector. This tightens funding conditions and market debt. It is effectively deflationary.

While Powell & Company would never admit it, the central bank has no choice but to end balance sheet reduction due to the federal government’s borrowing and spending problem. 

In effect, the Fed supports the government’s borrowing by creating artificial demand for Treasuries by purchasing bonds and holding them on the balance sheet. This drives prices higher and yields lower, lowering the U.S. government's borrowing costs. 

If the Fed weren’t holding so much U.S. debt, Treasury interest rates would be substantially higher.

An end to QT makes sense given that the federal government is paying more than $1 trillion in interest expense right now.

Why QE?

While an end to balance sheet reduction won’t inject newly created money into the economy, it will reduce the number of bonds the government has to sell on the open market, thereby easing supply, raising Treasury prices, and putting downward pressure on yields.

Simply ending balance sheet reduction might not be enough. Given falling global demand for Treasuries and persistently high yields, the central bank may well have to relaunch quantitative easing in the near future to press its thumb harder on the Treasury market. In effect, this would be a return to money printing.

I’m not the only person who thinks QE will resume in the near future.

The Telegraph World Economy Editor Ambrose Evans-Pritchard recently wrote an op-ed warning that the U.S. central bank “is preparing the ground for a rapid return to net bond purchases, deeming it necessary to ensure sufficient liquidity for the financial system.”

Of course, they won’t call it "quantitative easing." Evans-Pritchard said they will call it “open market operations,” and they will sell it as “a technical adjustment to manage bank reserves and the plumbing of the credit markets.”

This has happened before.

When the Fed tried to raise rates and shrink its balance sheet in the wake of the Great Recession, the economy got shaky, the stock market sold off, and liquidity problems started popping up in the financial system.

The Fed cut rates three times in 2019 and initiated open market operations similar to those Evans-Pritchard describes. The pandemic bailed the central bank out, allowing it to slash rates to zero and put QE into overdrive, effectively kicking the can down the road.

We still haven't dealt with the malinvestments and debt bubble created by the monetary malfeasance in the wake of the 2008 financial crisis. And then the Fed doubled down with pandemic stimulus.

Evans-Pritchard cites a former QE manager at the New York Fed who says, “liquidity has dried up, and the Fed will soon have to buy $150 billion of debt to stabilize the money markets.”

Evercore ISI analysts Krishna Guha and Marco Casiraghi say the Fed will likely start mopping up a net $35 billion in Treasury debt each month beginning as early as January.

This is debt monetization, pure and simple. Professor Tim Congdon from the Institute of International Monetary Research said the Fed is “aiding and abetting” monetization of America’s deficits.

“What on earth do they think they are doing?” he asked.

Debt monetization and inflation

When Ben Bernanke launched the first round of QE at the onset of the Great Recession, he assured Congress that the Fed was not monetizing the debt (When the Fed buys a bond with money created out of thin air, it is effectively turning that debt into money -- thus the term "debt monetization."). He said the difference between debt monetization and the Fed’s policy was that the central bank was not providing a permanent source of financing. He said the Treasuries would only remain on the Fed’s balance sheet temporarily. He assured Congress that once the crisis was over, the Federal Reserve would sell the bonds it bought during the emergency.

That never happened. 

And then the Fed doubled down, expanding the balance sheet by nearly $5 trillion during the pandemic.

This is, by definition, inflation.

Congdon said about two-thirds of the U.S. national debt is being monetized in one form or another.

This is why prices keep going up.

“The U.S. authorities are incubating another spasm of inflation a year or two hence, risking a repeat of the great monetary error made during the early phase of Covid. They seem to have learned nothing.”

Evans-Pritchard compared the situation to the roaring ‘20s. Of course, we know how that turned out.

“Forgive me for being an old cynic, but I would suggest that America is heading into an irresponsible financial boom akin to the final blow-off of the Roaring Twenties and the Roaring Nineties. The debasement trade is young yet.”