Fed Speak: Using Fed balance sheet as a tool of monetary policy

29 May 2024 , 08:31 AM

ASSET PURCHASES AS A TOOL OF MONETARY POLICY

At the peak of the global financial crisis in 2008, some of the biggest financial services in the US and other parts of the world were on the brink. The implosion of Bear Sterns and Lehman Brothers were just the tip of the iceberg. There were scores of financial institutions like Citibank, Goldman Sachs, Bank of America, Morgan Stanley, Fannie Mae, Freddie Mac, Sallie Mae, and GE Capital that were loaded with toxic assets and were close to collapse. The only way out was for the US government to rescue them. Thus, was born TARP (Troubled Asset Relief Program). Under this program, the US Fed bought these mortgaged bonds from the various troubled institutions. In this period, the Fed bought US bonds to the tune of $430 Billion. By the end of the TARP program in 2010, the balance sheet of the Fed had expanded to beyond $4 Trillion. The Fed was not alone. Even the other big central banks like the European Central Bank (ECB), Bank of England, and the Bank of Japan also expanded their balance sheet by an equivalent amount.

The debate is still open on whether the Fed strategy of expanding its balance sheet was a good idea. Today, there are divergent views. However, at the peak of the crisis in 2008, it was more of a Hobson’s Choice. That was the only way the government and the central bank could prevent scores of large banks from going bust, and that is exactly what they did. The experience almost repeated in 2020 at the height of the COVID pandemic. With economic activity all but shut down, the government and the central bank had to infuse an unprecedented amount of liquidity into the system. The result was that the Fed balance sheet once again expanded from $4 Trillion to $9 Trillion. Since the start of 2022, the Fed has been winding down its balance sheet and that is now down to a tad over $7 Trillion. However, the question is still open on whether balance sheet expansion of the central bank can really be a monetary strategy. These are hard questions and to provide answers, we look at what the Fed governor, Michelle Bowman spoke on this subject at the Bank of Japan New Year Conference in Tokyo. In her address, Michelle Bowman looks the pros and cons of such a move and whether it can be used as part of future monetary policy strategy.

LEARNING FROM THE GLOBAL FINANCIAL CRISIS OF 2008

It is said that the global financial crisis (GFC) was unprecedented in its scale and impact. Very few countries were left out of the impact of the GFC. The TARP, better known as the Large Scale Asset Purchase (LSAP) program was used extensively during this crisis in 2008. That is when the central bank aggressively bought the toxic mortgage assets from the bank and gradually managed to dispose off the entire stock over time. As Michelle Bowman put I very succinctly, “The key challenge for the FOMC following the 2008 financial crisis was how to provide additional support to an economy that was experiencing high unemployment and subdued inflation.” That is because the Fed had taken the interest rates to near zero levels to support a revival in the US economy. It was not just the US, but even other economies like UK, Europe and Japan cut rates sharply. In all these countries, the rates went to near zero; even dipping to negative in the case of EU and Japan. It was like a dual strike to improve growth. On the one hand, interest rates cut to the extent of almost making money free. Additionally, the toxic assets from the financial companies were bought by the government as a support initiative. The entire LSAT process was also called quantitative easing (QE). The idea was to reduce longer-term interest rates further by lowering the yields of specific longer-dated securities being purchased and by reducing term premia. As a result, long term bonds were only earning as much as short term bonds, and at times even less.

Between the years 2009 and 2014, the US Fed aggressively purchased a mix of Treasury securities and agency mortgage-backed securities (MBS) as part of its QE programs from the various beleaguered financial institutions. When the quantitative easing started in 2008, the Fed balance sheet stood at $0.50 Trillion. By the time the QE program had been completed in 2014, the Fed balance sheet size had risen to $4.25 Trillion. A quick look at the data tells us that the Fed achieved almost all its objectives. For example, by raising the prices of bonds, it reduced the yields on the targeted class of securities. In addition, the sustained asset purchases also helped to lower the term and risk premia across other asset classes, including corporate securities. One argument is that the purchase of agency MBS by the Fed resulted in banks boosting their lending as the price of their off-balance sheet MBS holdings increased in tandem with QE. While QE managed to dispel the crisis and ensured jobs and price stability, it did drive investors to take undue risks as the opportunity cost of holding funds was almost zero.

The post–financial crisis period experience showed that securities purchases in a specific asset class could be effective for those asset classes that had experienced stress, as was the case with MBS during that period. So, the logical inference would be that QE works perfectly when the focus of the policy is narrow and granular. However, whether it works as a macro strategy is still unclear. From 2014 to 2018, the Fed continued its quantitative tightening (QT), but that is when it had to end due to the early signs of the COVID crisis in late 2019. The balance sheet expansion in the COVID phase was to be larger than in the first phase.

COVID-19 AND THE SECOND QUANTITATIVE EASING

As Michelle Bowman rightly put it, COVID was more complicated since there was no specific asset class to target. The 2008 crisis was about mortgage backed securities. In contrast, the 2020 crisis was about growth, incomes, and employment. The economies of the world needed to be pump primed and the benefits were still debatable. To add to that, the prolonged lockdown in China was creating an unprecedented problem of supply chain bottlenecks. Like in 2008, the strategy in 2020 was almost the same. The Fed first cut the rates to near zero levels. The Fed started buying $80 Billion of treasuries and $40 Billion of MBS each month. The net result was a phenomenal expansion in the Fed balance sheet from $4 Trillion to $9.1 Trillion in March 2022. Since then, the expiries are not being rolled over and that has now resulted in the Fed balance sheet tapering to $7.30 Trillion levels.

The Fed deployed large scale asset purchases (LSAP) strategy in 2020, just like in 2008. The Fed guidance at that point was that it would continue to purchase these assets “until substantial further progress had been made toward the Fed maximum employment and price stability goals.” Here it must be said that the pace of the asset purchases post the pandemic was much more frenetic than during the global financial crisis. Unlike in the 2008 crisis, the banks and financial institutions had been very robust during the pandemic and that can be largely attributed to the safety checks and stress tests post the GFC, which had made the banks stronger and more stable. However, it was the housing market that suffered post early 2022 when the Fed started raising rates at a frenetic pace and combined that with a drawdown of the bond portfolio held by the Federal Reserve. The big question was whether such a large loosening program was needed in 2020 at all?

One cannot ignore the fact that the nature of the crisis in 2020 was very different from the nature of the crisis in 2008. That is what raises the question on whether painting all the problems with the same brush was a good idea or not. It was almost like a one-size-fits-all kind of approach that the Fed appeared to have taken to revive growth and boost spending. The general view is that with strong banks and no real challenge, the COVID may not have warranted so much of monetary loosening. Of course, we would never know the answer, since these are hypothetical in nature. In an economic crisis, the solution has to be forwards looking and looking at the rear view mirror does not help much. One objection is that had the Fed not just extrapolated the 2008 model, it would have probably started rate hikes in late 2021, rather than in March 2022. But, once again, these are hypothetical assumptions and the policymakers do not have that leeway.

KEY QUESTION FOR FED – 2008 VERSUS 2020?

What the Fed should have done and how it should have been done would be debated for a long time. However, here is a quick comparison of the 2008 versus the 2020 situation.

• The general opinion among experts and economists is that while the robust and rapid response by the FOMC was appropriate in 2020, the question was whether the Fed was justified in carrying on the QE process for so long, or should it have been stopped earlier. It may not change the reality of today, but it will surely offer a more reasonable template for any such crisis in the future.
• The bigger debate is on the QT (quantitative tightening). If one looks at the pace of rate cuts between March 2022 and July 2023, the hike of 500 bps in a short span of 16 months led to unnecessary tightness in the market. That was at a time when the US economy was just about starting to recover from the supply chain constraints bestowed on manufacturers across the world caused by China. The counterview is that Fed should have started rate hikes earlier (end 2021 instead of March 2022) and been more gradual in rate hikes.
• There is also the issue of dichotomies within the Fed. For instance, the FOMC is largely split between the members who prefer the status quo, members who want to again see rate hikes and the members who are all for rate cuts. The public statements have also displayed such variances and that only ends up confusing the public at large. A more considered and cohesive view would be a better option.

To sum  up, the crisis of 2008 was more focused on toxic assets in real estate while the 2020 crisis was more about boosting growth. However, the banks and financial institutions in 2020 were much stronger and resilient compared to what they were in 2008. There could probably have been a different approach, but the Fed chair has held the view that this was the best approach. Perhaps, he is right!

WHY FED BALANCE SHEET WILL STILL BE A KEY TOOL?

The experience of 2008 and 2020 underline that Fed balance sheet management is not only workable but also brings about a rapid implementation of the policy objectives. In the financial sector, all crises are crises of trust in some form or the other. The best answer to trust in the financial sector is liquidity and that is what the Fed has been endeavouring to do. One cannot gainsay that the past experiences of the Federal Reserve using the balance sheet as a tool of monetary policy is workable and has now stood the test of time. To quote Bowman, “it can be an effective way to ease financial conditions and support the economy in periods in which the conventional monetary policy interest rate tool has reached the zero lower limit.”

For the central bank of any country, the biggest debate is the choice between doing too much and too little. Given a choice, the central banks will always prefer to do too much over too little, as that helps manage public expectations from the central bank. Remember, central banks like the Fed do not have the advantage of driving with a rear view mirror.