The Fed’s Harrowing Search for Ample Reserves

Inserted between the push and pull of consumer price inflation and interest rates is the direct market intervention of central planners.  Decisions made one day can have lasting penalties upon the next.  Yesterday’s monetary policy blunders by the Federal Reserve bring forth adverse conditions today.

If you recall, during the quantitative easing (QE) orgy that took place during repo-madness and on through the coronavirus fiasco, the Fed exploded its balance sheet.  Up from $3.7 trillion in September 2019 to $8.9 trillion in May 2022.

The Fed, in practice, created credit out of thin air and used it to buy U.S. Treasuries and mortgage-backed securities.  Moreover, having the collective wisdom of several thousand economics PhDs, the Fed found it proper and fitting to buy these assets while yields were at 5,000-year lows.

The results of that low-yielding asset buying binge are highlighted each week in the Fed’s H.4.1 data.  As of May 30, earnings remittances due to the U.S. Treasury tallied at minus $171.9 billion, up 163 percent from the same week a year ago.

To be clear, negative remittances are analogous to operating losses.

In Finance 101 courses in junior colleges across the globe a simple natural law is taught.  When interest rates go up, bond prices go down.  This is fundamental to how capital markets work.  The Fed, having overlooked this basic insight, now carries a book of underwater Treasuries.

Whereas, in the pre-coronavirus world, Fed operating profits flowed to the Treasury as remittances.  They are now subtracted – as negative remittances – where they, in effect, become the liabilities of taxpayers.

If you work, earn wages, and pay taxes, ponder the fact that you’re financing Fed operating losses.  Does this give you a warm fuzzy when you arise at the crack of dawn on Monday morning and start up your weekly grind?

Tune In Tokyo

Monetary central planners gather from time to time to question their past actions.  What went right?  What went wrong?  How can monetary intervention make the world more prosperous?

These are the sorts of questions that are contemplated as part of the continuous improvement process (CIP) for monetary policymakers.

This week, on May 27 and 28, the Institute for Monetary and Economic Studies held its annual Bank of Japan BOJ-IMES Conference, in Tokyo.  This year’s spotlight was shined on the theme of “Price Dynamics and Monetary Policy Challenges, Lessons Learned Going Forward.”

Lessons learned are a key part of any hollow corporate CIP.  They’re supposed to inform change so that mistakes are not repeated.  In reality, lessons learned serve to spread accountability for a particular screw-up from the individual to the organization.

The idea is that, like tranches of subprime debt, if the accountability is spread thin enough, no one is responsible.  This model works great until the mistakes and lack of accountability stack up to the point of failure.

At this week’s BOJ-IMES Conference, European Central Bank executive board member Isabel Schnabel did her part to contribute to the conversation by offering a lesson learned on the topic of QE.  From Schnabel’s perspective, policymakers “need to carefully assess whether the benefits of asset purchases outweigh the costs.”

Like the Fed, the ECB is also operating at a loss on the bonds it purchased during the coronavirus years – just prior to subsequent rate hikes.  In fact, the ECB posted a €1.3 billion loss in 2023.  This marked the ECB’s first full-year operating deficit since 2004.

Lessons Unlearned

The downturn in the ECB’s finances has consequences.  For example, it has caused the ECB to eliminate the dividend – remittance – it pays to national central banks.

These dividend payments, which amounted to €5.8 billion between 2018 and 2022, are usually passed on by national central banks to Eurozone governments.  According to Schnabel the losses in 2023 are not so bad when compared to prior profits:

“These losses need to be viewed against the profits central banks made before the rise in interest rates, but they may still be weighing on central banks’ reputation and credibility.”

Perhaps Schnabel’s lesson learned for central planners is to not employ QE to stimulate growth when interest rates are low.  But is this really a lesson learned, shouldn’t it be common sense?

As far as we can tell, Schnabel’s lesson is more of a lesson unlearned.  What if nominal interest rates are high but real interest rates are low due to inflation?  Does that mean it is acceptable for central banks to buy assets?

The real lesson learned in all of this is that QE is a great big failure.

Alas, this lesson appears to be lost on Federal Reserve Governor Michelle Bowman and her cohorts.  At this point, she’s focused on the unwinding of past QE – i.e. quantitative tightening (QT) – so that future QE can be better utilized in the next financial crisis.  Speaking at the Tokyo conference Bowman remarked:

“While it is important to slow the pace of balance sheet runoff as reserves approach ample levels, in my view we are not yet at that point.  In my view, it is important to continue to reduce the size of the balance sheet to reach ample reserves as soon as possible and while the economy is still strong.  Doing so will allow the Federal Reserve to more effectively and credibly use its balance sheet to respond to future economic and financial shocks.”

The Fed’s Harrowing Search for Ample Reserves

Bowman’s comments are at odds with the Fed’s latest implementation note.  This note specified that starting June 1, the Fed will taper its monthly balance sheet reduction of U.S. Treasuries from $60 billion to $25 billion.  The $35 billion maturity limit for mortgage-backed securities will remain the same.

The FOMC meeting minutes show that a few participants would have preferred to continue the current pace of balance sheet reduction.  Bowman’s remarks indicate she was one of these few.

At the heart of the matter is the concept of “ample” reserves.  No one at the Fed or anywhere else knows what level of reserves are ample.  But it is something the Fed is searching for, nonetheless.

The lesson learned from the last round of QT is that if the balance sheet is reduced below the unknown point of ample reserves, bad things happen – like repo-madness.

If you recall, sometime between the night of September 16 and the morning of September 17, 2019, the overnight repurchase agreement (repo) rate hit 10 percent.  Short-term liquidity markets essentially broke.  Before long, the Fed was supplying hundreds of billions in credit every night to keep credit markets flowing.

Soon after, this was grossly overwhelmed by the coronavirus panic.  Where the Fed went balls to the wall and expanded its balance sheet by $5 trillion.  By the end of May 2022, the Fed’s balance sheet peaked at over $8.9 trillion.  And consumer price inflation hit a 40-year high.

Currently, the Fed’s balance sheet is about $7.4 trillion; it has been reduced by roughly $1.5 trillion.  And the Fed is getting edgy.

So, this time around, it wants to tread lightly in its harrowing search for ample reserves.

Regardless, the Fed won’t know it has reached the point of ample reserves until after reserves are no longer ample.  Yet by then it will have triggered the next mega-financial crisis.

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MN Gordon
for Economic Prism

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