In the fall of 2008, the Federal Reserve started its policy of wild monetary inflation. It became known as quantitative easing (QE). We have gone through QE1, QE2, and QE3. The last round (QE3) ended in October 2014.
The Fed somehow managed to approximately quintuple its balance sheet between 2008 and 2014 while keeping consumer price inflation relatively low. Much of the newly created money went into bank excess reserves, which helped prevent price inflation. If all of this new money had been multiplied through fractional reserve lending, we would have likely seen extraordinary consumer price inflation.
Long before QE3 ended, we heard from Bernanke and others that the Fed would one day sell off its assets to return to normal. In other words, the Fed would return its balance sheet somewhere in the neighborhood of its early 2008 balance sheet, or at least significantly reduce it from where it is now.
It has taken the Fed several years now just to hike its federal funds rate target by 0.75%. There seems to be no likelihood of a major selloff of the Fed’s balance sheet soon, but there has been a little bit more talk about it lately.
Here is the problem. It is not possible for the Fed to return to its early 2008 balance sheet, or if it does, it will be meaningless.
Of course, it is basically impossible politically speaking because the asset boom we have seen, particularly in stocks, is likely largely based on the Fed’s easy money. If the Fed engages in significant monetary deflation, the boom collapses.
But it might also literally be impossible for the Fed to reduce its balance sheet by over $3.5 trillion. In 2008, the Fed began buying other assets aside from U.S. Treasuries. It began buying mortgage-backed securities (MBS). It was one portion of the many bank bailouts, as the Fed bought these MBS for their original value instead of the actual market value.
Many of these mortgages were in default with the crash in housing prices. If you have a bunch of mortgages where the people aren’t paying and the collateral (the houses) are worth half as much, then the mortgages are worth a lot less than their original value.
Since 2008, the Fed has accumulated nearly $1.8 trillion in MBS, which far exceeds its total balance sheet prior to 2008. The problem is that we don’t know what these MBS are actually worth. If the Fed were to sell them on the open market, it would likely spike interest rates and severely damage the mortgage market. And there is no way that the Fed could get $1.8 trillion back on these MBS. We really have no idea what they are actually worth.
What if the Fed could only sell them all for $1 trillion? That means that $800 billion would be vanishing into thin air. Well, that is not exactly it. The $800 billion was already created and essentially given to the banks as part of a bailout. That newly created money is very hard to withdraw unless they somehow force the banks to buy back the mortgages at their original value. But this would just cause bank failures again.
So the only way the Fed can reduce its balance sheet back to early 2008 levels is by writing down this amount. It would be meaningless. At this point, it is just numbers on a graph or in a spreadsheet. The Fed could say that its $1.8 trillion in MBS is actually only worth $1 trillion and subtract $800 billion from its balance sheet, but it doesn’t change the situation. That money was already created out of thin air and given to the banks for their bad debts.
The Fed can sell off its U.S. government debt (Treasuries) or let them mature without rolling them over, but that would only go so far. Plus, this would eventually hurt the federal government’s ability to borrow at low interest rates.
In other words, there will be no significant reduction in the Fed’s balance sheet that means anything. Maybe we will see a couple of hundred billion dollars. But any sign of a recession or stock market crash and you can be sure that all bets are off. If anything, the Fed would starting inflating again.
We may still see a recession even if the Fed does not do anything. Since it hasn’t been inflating, its policy has been monetary stability for the last couple of years. But that doesn’t change its previous policy of massive monetary inflation and all of the malinvestment that went with it. At some point, it will be exposed.
I think we are more likely to see QE4 before we see any significant reduction in the Fed’s balance sheet.