CNBC ran an article titled: The Fed is looking at a new program that could be another version of ‘quantitative easing’.

The article states that Federal Reserve officials are floating the idea of getting banks to reduce their reserves while increasing their ownership in U.S. Treasuries (sometimes purposely misspelled as “Treasurys”).  This would supposedly enable the Fed to reduce its balance sheet further, while still maintaining some liquidity for banks.

The Fed massively expanded its balance sheet from 2008 to 2014.  With that, commercial banks increased their excess reserves by a huge amount.  In other words, a good portion of the money that was created by the Fed was not lent out by banks, but instead parked at the Fed “earning” a small interest rate.

The Fed has been trying to reduce its balance sheet from the previous unprecedented monetary inflation, and it has been doing so recently by $50 billion per month.  However, it has signaled that it would wrap up its balance sheet reduction program this fall.  This coincided with its halt in raising the federal funds rate due to a shaky stock market and a nearly flat yield curve.

The Fed is basically trying to juggle two fears here.  On the one hand, Fed officials are worried about a recession, as they should be with the recent brief inversion of the yield curve.  On the other hand, the Fed is also seemingly concerned about its massive balance sheet and what that could mean for the future.

And what happens if we do hit a recession in the next year or so?  Will the Fed dare to expand its balance sheet even more?  There has to be a limit at some point. That limit will be a loss of faith in the U.S. dollar.

The Fed tried a lot of new tricks starting in 2008 from buying mortgage-backed securities to paying interest on bank reserves.  It has seemed to work out so far, at least from the Fed’s perspective. Sure, it has massively misallocated resources and made our living standards lower than they otherwise would have been, but most people don’t understand this stuff.  If unemployment and consumer price inflation statistics look good, then the Fed must be doing a fine job.

But just because everything has worked out for the Fed for the last decade, it doesn’t mean it will last.  And just the fact that they are discussing these unusual ideas should tell us something. I’m just not sure if it is a sign of overconfidence that they can just keep tinkering with the market and everything will keep humming along; or if it is a sign of fear that something bad is about to happen.

With this latest plan, banks would be substituting Treasuries for actual bank reserves. Treasuries are not as liquid. Just how liquid they are depends on their maturity term.  I have to believe that the Fed will quickly swap back liquidity (bank reserves) for the Treasury bills if an emergency situation came up.

There’s No Free Lunch

It’s not clear what this talk means, let alone what would actually happen if implemented.  I think the Fed just wants to have options on how to deal with a future recession and/ or financial crisis.

When the recession/ financial crisis struck in 2008, the national debt was less than half of what it is now, and the Fed’s balance sheet was about one-quarter of what it is now. So if another recession started right now, the Fed would be building on top of all of this.  Its starting line is way ahead (or is that way behind?) where it was last time.

Is Congress going to double the national debt again within the next decade?  Is the Fed going to quadruple (or more) its balance sheet again?

We still haven’t felt the full effects of the loose monetary policy of 2008 to 2014.  The misallocations have largely not yet been exposed.  When things get tough, they will get tough quickly.  We could see falling housing prices and falling stock prices as we did over a decade ago.  This time, I think the fall in stock prices will be even worse than the fall in housing prices, unless you live in a really bubble area such as San Francisco.

Just because things have been humming along (despite the middle class struggles), it doesn’t mean it will just continue to do so.  Even the Fed has limits.  It can only digitally print so much money until there is a loss of confidence in the dollar.  This doesn’t seem likely to happen any time soon, but emotions change quickly, especially during difficult times.

When the next recession hits, the Fed will likely start another round of so-called quantitative easing.  But no matter how people react, it will just do more damage in the long run.  It might curtail investment even more, while the investment that does happen is malinvestment that is consuming resources that would have been used in other areas to satisfy consumer demand.  And if the Fed really gets carried away, then eventually we will see rising consumer prices.  It may be like the stagflation of the 1970s.  I can’t imagine the Fed letting the CPI rise beyond 10% without acting as Paul Volcker did, but you never can be sure during times of crisis.

It is quite difficult to predict anything at this point, but we know that the Fed is considering its options for when it needs them.  The Fed will continue to play its monetary tricks, but ultimately it can only engage in monetary inflation or monetary deflation.  They aren’t sure which way to go right now, but we know which way they will go when the next recession becomes evident.