“Quantitative easing” is the name given to when the Federal Reserve buys debt outright—usually debt issued by the US Treasury or debt backed by a mortgage that is somehow secured against default by the federal government.
This policy has various rationales. For example, during the Great Recession of 2008-2009, there was fear in the markets that as home prices fell, the value of mortgage-backed debt would be much lower. Because many banks and financial institutions have such debts, the decline in the value of this debt threatens the bankruptcy of a number of financial institutions. In this context, Fed purchases of such debt calmed the markets and prevented panic. In addition, quantitative easing can be seen as a way for the central bank to stimulate the economy, when the central bank has already lowered its policy key rate to almost zero percent. The idea here is that when the Fed cannot lower interest rates again using traditional policy channels, it can still keep interest rates lower than they would have been by buying debt outright and then holding it.
However, a series of quantitative easing policies over time means that the central bank ends up with a lot of debt. Back in 2007, for example, the Federal Reserve had about $900 billion in total financial assets, which was viewed in terms of the central bank as a fairly basic amount for carrying out its functions. After three rounds of quantitative easing in 2008 and 2010 and from 2012-2014, the Fed had about $4.5 trillion in assets by the end of 2014. But then the Fed implemented a fourth round of quantitative easing, QE4, during pandemic, and total Fed assets have increased from $4.1 trillion at the start of 2020 to nearly $9 trillion by March 2022.
The rationale for QE4 at the start of the pandemic in March 2020 was clear. For a few days that month, there was turbulence in the US Treasury bond markets, and there was a brief period where the US Treasury debt market seemed to stop working so well. Daryl Duffy described it this way:
The US Treasury market has long been regarded as the most liquid and deepest financial market in the world. This assumption was called into question when the COVID-19 crisis triggered huge demands from investors for trading which overwhelmed the ability of traders who would normally act as brokers in this market. Over several tense days in March Yields have risen sharply, calling into question the long-held view that Treasury bills are a reliable safe haven in a crisis. Bid-offer spreads have widened dramatically, Treasury yields of similar maturity are no longer close together, and the number of settlement failures has jumped. Although the Fed, through an unprecedented amount of Treasury purchases and other measures, was able to restore market liquidity, the episode revealed that the Treasury market was overdue for an upgrade.
But while there are clear reasons for QE4, both in terms of saving the world’s turbulent financial markets and in terms of propping up the US economy during a very uncertain time, owning debt carries risks. In particular, if you hold a lot of debt that pays a low interest rate, and then interest rates go up, you’re locked into lower interest rates and a declining debt value. This is the opposite effect, for example of being a mortgage holder who locked in a low interest rate before the pandemic, and now have the advantage of paying off that mortgage in a situation where current rates of interest are much higher. Andy Levine and Bill Nelson provide an overview of the Fed’s financial losses as a result of building a portfolio of low-interest-paying debt at a time when interest rates are rising among groups, in The Fed’s Balance Sheet: Costs to Taxpayers of Quantitative Easing (Center Mercatus, George Mason University, January 10, 2023).
One way to look at this situation is that the Federal Reserve receives a relatively low interest rate from previous asset purchases of debt. However, the main mechanism the Fed uses to raise interest rates is to pay banks a higher interest rate on the reserves banks hold at the Fed – so the Fed’s financial situation is much worse. Another way to look at the situation is to see how much the value of low-interest Federal Reserve debt would decrease if the Fed had to sell that debt in today’s high-interest rate market. Levine and Nelson calculate that Fed assets have declined in market value by about $760 billion.
As I have already indicated, there were reasons for QE4 to explode in 2020. But there seemed to be little interest in the risks that higher interest rates would drive down the value of Fed debt. Levine and Nelson call the process “opaque and inertial.” For example, if the Fed originally announced that QE4 was a short-term move to calm markets during a period of turmoil, and then moved to sell US Treasury debt when financial markets stabilized by the summer of 2020, that might be the case. Owning trillions less low-interest assets by 2021.
But at least as far as I can tell, the Fed hasn’t considered such a policy, because in 2020 the Fed wasn’t anticipating higher interest rates. After all, inflation rates don’t start to rise until April-May 2021. Before that, and even for a short time after that, the Fed was focused on keeping interest rates low to support the economy as the pandemic progressed. Thus, the Fed seems to have completely missed the risk that it will hold a lot of debt and pay lower interest rates at a time when interest rates are rising.
The usual pattern for the Federal Reserve is that it is self-financing – in fact, it passes about $100 billion a year to the US Treasury. However, because of the financial losses the Fed has incurred on its assets, Levine and Nelson write: “The Fed will absorb this cost by suspending its entire transfers to the US Treasury for the next five years and paying minimal transfers in subsequent years.” It would have been possible The Fed’s transfers could exceed $100 billion annually over the next decade if QE4 is not undertaken.” In this sense, it appears that the Fed’s decision not to hedge against the risks of higher interest rates – for example, by selling a large share of its QE assets by early 2021 – will contribute to an even larger budget deficit for years to come.
The Fed and QE4 appeared first in Economist Conversational.