Federal Reserve Policy

Quantitative Tightening

     Benjamin Bernanke, the former Fed chief, helped rescue the financial system in 2009.  He started by slashing short-term interest rates.  But that didn't end the crisis.  Real estate caused the collapse.  That industry depends on long-term interest rates.  Bernanke needed to get those down, too.

     So he invented a completely new policy tool.  Since it was never done before, people still argue about whether it worked or not.  There's no yardstick to compare it against.  Most experts think the American economy would have recovered no matter who was in charge.  But they generally agree that "Quantitative Easing" had a positive effect.

     The methodology was two-fold.  The Federal Reserve printed money.  Trillions of dollars.  The entire U.S. money supply ("M2") today is $14.5 trillion.  Bernanke printed another $3.5 trillion.  The money was used to buy U.S. Treasury securities and Fannie Mae mortgage bonds.  That buttressed the housing market.  It also withdrew a lot of safe investments from circulation, forcing institutional investors -- insurance companies, pension funds, foreign governments, banks -- to find riskier bonds in their place.  The cost of capital declined.  Corporations gained access to money again.  The economy recovered.  Once that happened, and interest rates stayed low, stocks also became a great alternative.  IPO's and secondary stock offerings proliferated.  The market averages advanced.

     Traditional economists assumed inflation would skyrocket, after all that money was printed.  Bernanke's second trick was to drain the new money from circulation.  The actual money supply didn't increase.  The mechanism was arcane.  Most investors and economists never noticed it.  Throughout history governments have printed money to pay the bills.  Consumer prices normally rise as more cash chases the same amount of goods and services.  Instead of leaving it circulation Bernanke outbid the market for the new cash, paying a premium interest rate.   Rather than lend it out banks deposited the funds at the Fed (as "excess reserves").  It disappeared from sight.

     The current Fed chief, William Powell, is less self-confident than Bernanke.  Powell came into office staring at that $3.5 billion bond portfolio and feared it might blow up on him somehow.  "Get that out of here!"  And that's what he's been doing.  In late 2017 Powell began selling the Fed's portfolio.  At first it was a trickle.  In Q2 2018 he took it up to $25 billion a month.  Last October the pace increased to $50 billion.  The impact was the opposite of "Quantitative Easing."  Powell removed liquidity, making it more difficult for the economy to operate.  He simultaneously raised short-term interest rates, amplifying the effect.

    Under that weight the stock market collapsed in Q4 2018.  Midway through the quarter Powell reaffirmed his plan to continue raising rates.  He also said he'd keep the quantitative tightening "on autopilot."  The market downturn intensified after those remarks.  Finally, Powell relented in December.  He put further rate hikes on hold.  And claimed he would end the quantitative tightening in late 2019.  The stock market rallied on those statements.  But the economy slowed.  GDP growth declined sequentially in Q4.  It appears to have stalled altogether in Q1 2019, dropping to an estimated 1.5%.

     Interest rates currently appear manageable.  Those are manipulated by the Fed, though, and may not reflect the true nature of the underlying economy.  They might be too high.  The ongoing "Quantitative Tightening" is a more clear cut obstacle.  That program is continuing at a $50 billion a month pace ($49 billion in February).  S&P 500 earnings estimates are falling (6% so far).  Money supply growth has dropped below its natural level (4% vs. 6%).

     Bernanke knew what he was doing.  Powell is guessing.  Selling bonds back into the market could become a reliable policy tool.  But it needs to be saved for times when things are over-heated.  That's far from the case now.  "Quantitative Tightening" remains in place.  Let's hope the Fed hasn't gone too far.