The Problem With Quantitative Tightening (US Federal Reserve)

Federal Reserve Chair Jerome Powell has given a number of speeches announcing the Fed is starting Quantitative Tightening. The problem with Quantitative Tightening is that many people do not understand what it really means, so I am going to be breaking it down for you in this video.

The most shocking financial chart of the last decade is the balance sheet of the Federal Reserve. This is a chart of Assets held by the Federal Reserve. You can just look at this and know that this is not normal financial behavior. The Federal Reserve has operated for decades with very few assets on the balance sheet. Then suddenly, in 2008, the assets shoot up. This is called quantitative easing. The Fed would essentially print money to buy assets and stimulate the economy. We can see this was followed by a short period of quantitative tightening, when the Fed starts to sell off assets. We are once again starting a period of quantitative tightening where the Fed is selling off assets once again.

Monetary Policy of the last decade has been dominated by these new tools of quantitative easing and quantitative tightening. Old monetary policy would be to mainly use the Fed Funds rate to influence the economy. Raising the rate would cool the economy down and lowering the rate could speed it up. Asset purchases were used, but for limited purposes including open market operations and discount window lending. But under modern monetary policy, the Fed can use both the Fed Funds rate and quantitative easing.

It is important to remember why the Fed started using Quantitative Easing. It was first used during the 2008 financial crisis. Bad home mortgages were bundled into mortgage-backed securities. These financial instruments became toxic. They were defaulting, no one was expecting it, and banks were counting on receiving that income. The global financial market was about to collapse. If the banks started failing, that means that ordinary people may not be able to withdraw the money from their savings account. This was going to hurt everybody, even people who did not have any exposure to mortgages. No one wanted financial collapse.

Quantitative easing was one of the answers to avoid global financial collapse. It allowed the Fed to buy up all the bad mortgages. People understood Quantitative Easing was an unprecedented action that was necessary to address this emergency. The big question is, “how did we get to where we are today?”

The balance sheet grew to $2.2T at the start of the 2008 crisis. The balance sheet is $8.4T today. What happened? The original idea was that this was for an emergency and, once the emergency was over, the Fed could sell off the assets. But that is not what happened. The Fed simply never sold them. Then the pandemic happened. Rates were already at near zero, so the Fed had to do even more Quantitative Easing. Now the balance sheet is at $8.4T.

Jerome Powell has explained that the Fed is starting quantitative tightening again. But what exactly does that mean? On May 4, 2022, the Federal Reserve released their official “Plans for Reducing the Size of the Federal Reserve’s Balance Sheet.” In this statement, they describe how they are going to sell a little bit of assets every month. T he interesting statement is buried at the end where they say, “Thereafter, the Committee will manage securities holdings as needed to maintain ample reserves over time.”

What does that mean? The Congressional Budget Office released their interpretation in September 2022 with their understanding of the term ample reserves. “QT is expected to continue until 2026, at which point the Federal Reserve is projected to purchase enough Treasury securities to keep reserves as a share of gross domestic product (GDP) at a constant value consistent with prepandemic levels.” What? So, the plan is that the balance sheet is never going to go back down. They are going to keep assets at least at $2.2T. This is the problem with Quantitative Tightening. People think Quantitative Tightening means the Fed will sell off all the assets. But it actually means they will only sell off a little bit, like they did in 2019. In fact, in January 2019, this plan was presented to Congress. The Federal Open Market Committee (FOMC) stated “The Committee intends to continue to implement monetary policy in a regime in which an ample supply of reserves ensures that control over the level of the federal funds rate and other short-term interest rates is exercised primarily through the setting of the Federal Reserve’s administered rates, and in which active management of the supply of reserves is not required.” This statement to Congress was the announcement that the Fed will not return back to pre-2008 levels. The Fed plans on keeping ample reserves on their balance sheet forever.

Let me walk you through this series of events. In 2008, the Fed activated emergency powers to load up their balance sheet in a temporary measure. Jerome Powell takes office in 2018. In 2019, it is announced that the Fed actions were now permanent. In 2020, the Fed activates their emergency powers again. This looks surprisingly similar to an old con artist tactic called “bait-and-switch.” This is where you present something up front that is acceptable, but at the last minute, you switch it for something else. When history looks back at Jerome Powell’s term at the Federal Reserve, he will be known for this sneaky maneuver of making Quantitative Easing permanent.

There are four key ideas that explain why this is problematic.

1. There is no free lunch. This is a central concept in economic theory. You cannot get something for nothing, and if you are, somebody else ends up paying for it. Quantitative Easing says the opposite. It is based on the idea that the US can print and hold all this extra reserve money, and not face any consequences. The Fed thinks they have found a free lunch. The reason the Fed thinks this way is they have been doing Quantitative Easing for the last ten years and the economy has been great. They have not seen many negative consequences. But I disagree. Look at these charts of the Fed Funds Rate on top and the Fed Assets on bottom. We have had zero interest rates. That is great for the economy! We had no inflation during this time. We got all this benefit for free, right? You must keep in mind that this is not natural economic activity. You can look at our history back to the 1950s and see this is not natural. Interest rates are supposed to reflect risk in the system. The higher the risk, the higher the rate. It is not like risk disappeared from the market. Risk was still there. It is just that the banks were not paying for it. So, who was paying for the risk? The American taxpayer. The Fed was printing money, which is a hidden tax on Americans. The Fed is effectively creating a hidden subsidy for the banks that no one voted for. The Fed took all the risk from the banks and gave it to the American people. We did not see inflation then, but it did create a big problem in the economy. All those years of risk-free lending has created an economy overflowing with debt. Now everyone is starting to realize that the American economy is in big trouble. We have massive debt, rising interest rates, and inflation. Inflation hurts the little guy for the benefit of the banks. This economic mess was created by our own Federal Reserve and quantitative easing. To be fair, there is a growing number of economists who disagree with the idea that “there is no free lunch.” These economists claim that Quantitative Easing does create a free lunch. They suggest that we should be able to print as much money as we want and it will actually create a buffer against inflation by having extra reserves in the banking system. They will point to the fact that the economy has not yet collapsed as evidence that they are right. But I find their arguments unconvincing, and disturbingly similar to comments that you always hear before a market crash that “things are different this time.” What history continues to teach us about economics, is that there is no free lunch. In my opinion, the economists claiming there is a free lunch are wrong, and they certainly are not in the majority opinion about economic theory.
2. Quantitative Easing is Untested. You can see from the chart that this has never been done before. The Fed is running a massive experiment with your money. If you read the literature about Quantitative Easing, you start to realize that we do not know what we are doing. We are just guessing. There is no data on how this is going to turn out. It could become the worst decision in financial history. We just do not know. Even in 2008, when Ben Bernanke was the Chair of the Fed, Ben Bernanke was dubious of the prospects of Quantitative Easing. He said, “The problem with Quantitative Easing is it works in practice, but it doesn’t work in theory.” He was saying that it does not make economic sense that the Fed could simply print money, hold it, and not face any consequences. There is no free lunch. Keep that in mind when the Fed is making statements about their plans for holding ample reserves, because it is based on very little solid evidence. In fact, all the Fed’s actions are based on one academic paper, published by the Fed in February 2020, conveniently one month before the pandemic and the start of the next massive wave of Quantitative Easing. This paper lays out the “Ample-Reserves” Approach. The paper is based on this stylized chart. You can see that there are no numbers on the chart, because it simply represents that the Fed has complete control over determining the level of reserves. The reserves should fall somewhere between line A “ample reserves” and line B “super plentiful amount of reserves.” These are the actual terms used in the paper. This paper is basically saying that the Fed should be allowed to do whatever it wants with reserves. It is based on the reason that the Fed has held enormous reserves for the previous decade during a strong economy and nothing bad happened. This is the paper that the Fed refers to whenever it talks about quantitative easing. There is very little academic work backing up their decisions. They do not know what they are doing.
3. Jerome Powell is not an economist. This is an important point to understand. In fact, Jerome Powell is the first Fed Chair to not be an economist. Jerome Powell was an investment banker. This seems like a pretty big conflict of interest. Jerome Powell is the person who changed Fed policy to make Quantitative Easing permanent and not temporary. He made a decision that prioritizes the interests of his friends on Wall Street at the expense of the American people. And he is not even an economist. Investment bankers do one thing. They look around at their environment and figure out how to make themselves and their friends the most money possible. That is not a bad thing. We need people like that in society. But it is a bad thing for the Federal Reserve. We need an economist that understands the basic economic theory that there is no free lunch.
4. The Fed’s Actions are Illegal. The Federal Reserve can only perform actions that are strictly allowed under the law. When you actually read the laws, quantitative easing is not allowed under the Fed’s powers in statute. The Federal Reserve was established by the Federal Reserve Act. Section 2A explains their purpose as achieving maximum employment, stable prices, and moderate long-term interest rates. They can only do three things. I do not see quantitative easing on that list. The Fed will claim it is a tool they need to achieve their three goals, but that is a stretch of logic. The Fed’s specific powers are listed in detail under Section 13 of the Act. Quantitative Easing was performed in 2008 and specifically justified under their “Emergency Powers” in Section 13.3.A. This section describes that the Fed can purchase assets in “unusual and exigent circumstances.” This is consistent with the Fed actions to save the economy from collapse. But it does not cover Jerome Powell’s decision to make the temporary reserves permanent. He has no legal authority to do this. The Fed holding $8.4T in reserves today based on the “unusual and exigent circumstances in 2008” has no legal basis in law. When you look at the statements released from the Fed today, they are very strangely worded. I would encourage you to go and read them. It becomes obvious that they are worded so strangely because they are trying to get around the fact that there is no legal basis for what they are doing. I wish a reporter would ask Jerome Powell about this. Just ask him to his face, “What is the legal basis for making quantitative easing permanent?” He cannot answer that question because there is no legal basis. Jerome Powell is trying to justify $8.4T dollars in reserves as normal banking operations. He thinks he is merely holding reserve funds and all banks do that. But $8.4T is clearly not standard banking reserves and has no basis in history. This is a massive power grab by the Federal Reserve. Think about it. The Fed is assuming powers they have never had before. The Fed is printing money at will, with no limits, no oversight, no restrictions, and taxing the American population through inflation. Who gave them the power to do that? No one. They are just doing it, and I do not understand why no one is calling them on it. I understand Jerome Powell does not want to sell off the assets, because it would slow down the economy. I get that it is a hard thing to do. But the alternative is high inflation. The result is that Americans are paying to give a subsidy to the banks that we never voted for. It is not right. It is not fair. And it is illegal.

Personally, I am a fan of the Federal Reserve. I am not one of these people who think we should get rid of the Federal Reserve. I think it is an important institution. But it must be managed properly. I do not think anyone can look at this chart of assets and conclude that this is managed properly. This is the problem with Quantitative Tightening. People hear the term and think the Fed is going to get rid of their assets, but they are really only going to get rid of a little bit of them. If the Fed wants to proceed with this crazy experiment of ample reserves, Congress needs to pass a bill giving them the power to keep ample reserves. Until then, they need to sell them. The plan they released for keeping ample reserves is illegal. Now of course, the Fed is going to continue to try and do whatever it wants. I hope that state Attorney Generals will sue the Federal Reserve to keep the Fed operating within their legal restrictions. But in the meantime, what can regular people do? We need to tell them to stop. All we have to do is for people to start saying, “I do not like this.” I do not like the Fed giving themselves unlimited powers. I do now like the Fed printing money. I do not like the Fed holding all these assets. All we have to do is start saying, “I do not like this.”

SOURCES

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Neither Zach De Gregorio or Wolves and Finance shall be liable for any damages related to information in this video. It is recommended you contact a CPA in your area for business advice.