riceextremely inactive The Fed’s rate-setting committee is back in vogue. After the June 14 meeting, the Fed left its benchmark interest rate unchanged for the first time since January 2022, rather than raising it. There could be one or two more rate hikes in the future: Fed Chairman Jerome Powell suggested in his post that the meeting hold a press conference, which is what investors are looking forward to. However, the main debate among Fed watchers has gradually shifted from how high rates will rise to how long they will stay there before cutting them.
It’s a thorny question, made even trickier by the fact that core U.S. prices, which exclude volatile food and energy components, rose 5.3% in the year to May. Nor is this the only problem facing Mr Powell and his colleagues. Over the past year, they’ve been steadily shrinking the Fed’s massive stock of Treasuries and mortgage-backed securities (mortgage-backed securities), whose face value has fallen from $8.5 trillion to $7.7 trillion.The Fed is allowed to hold up to $60 billion worth of U.S. Treasuries each month, and $35 billion in mortgage-backed securities, matures without reinvesting the proceeds. Now it has to decide when to stop.
This massive portfolio was amassed through the Federal Reserve’s quantitative easing (Quantitative Easing) scheme by which it buys bonds with newly created money. It was conceived during the global financial crisis of 2007-09 and has been driven into overdrive during the covid-19 pandemic. Quantitative Easing Liquidity has flooded the market, prompting nervous investors to buy riskier assets — as the Fed has bought the safest assets, driving down their yields. This has allowed the supply of credit and other risk capital to continue to flow into the real economy. Critics denounced it all as reckless money printing. But with low inflation and the greater threat of deflation, they are easily overlooked.
The return of high inflation makes Quantitative EasingA reversal of (quantitative tightening, or QT) desirable aspects. Just as buying U.S. Treasuries lowers long-term interest rates, the disappearance of buyers should raise rates, complementing the tightening effect of rising short-term Fed rates. If the Fed isn’t buying Treasuries, someone else must be holding them. That means they don’t buy riskier assets like stocks or corporate bonds, reducing the supply of capital to an overheating economy. Both effects should keep prices in check.
QT It also strengthens the credibility of the Fed.if it only ever Quantitative Easing, and never reversed the process, the accusations of money printing and currency debasement will be harder to dismiss. Inflation expectations can be self-fulfilling, even catastrophic. So the Fed has to prove that it is willing to take dollars in and pump them out.
In that case, why stop? The simplest reason is that the Fed’s tightening cycle is drawing to a close. Eventually it will consider lowering short-term interest rates again, especially if the economy is cracked. Still pushing long-term stocks higher by then is like a driver hitting the gas and the brakes at the same time.
The more troubling reason is that, like raising short-term interest rates, QT can inflict its own harm. It’s only been tried once before, from 2017 to 2019, and it was much slower, and little is known about its side effects. That doesn’t make them any less dangerous.By sucking cash out of the system, the previous round QT It caused the near collapse of the money market – the place where companies borrow money to meet their immediate financing needs and one of the most important financial conduits in the world. The Fed cleared that hurdle with an emergency lending facility that later became permanent.also had to stop QT.
This time it will be something else that is broken. The stock market is an obvious candidate, if not threatened: only a devastating crash would threaten financial stability. A broader liquidity crunch would be worse. Credit markets, already strained after several bank failures and rising defaults, are more likely to seize. At the same time, the US Treasury will absorb more liquidity. It must sell more than $1 trillion in debt over the next three months to rebuild its cash buffer following the recent debt-ceiling drama. By increasing the risk of sudden market volatility, this increases the likelihood that participants will suddenly need to raise cash for a margin call — and the risk that they won’t be able to.
No matter how small the ideal size of the Fed’s balance sheet is, shrinking it further can be dangerous.so QT must be stopped before it risks sparking a crisis that needs to be returned Quantitative Easing. But when? This is the central bank’s next big problem.■
Learn more from our financial markets columnist Buttonwood:
Soaring Stock Markets Are Driven by Artificial Intelligence (June 7)
Investors Renew Battling Rising Rates (June 1)
US Credit Cycle at Danger Point (May 24)
Plus: How the Buttonwood column got its name