As long anticipated, the US Federal Reserve will begin this month gradually winding down the $3.7 trillion in Treasury and mortgage-backed securities it purchased in the wake of the financial crisis. But do not mourn the death of quantitative easing – the Fed will keep a much larger balance sheet than in the past and in the future return to QE as a principal tool of monetary policy.
Historically, the Fed regulated interest rates by targeting the overnight rate commercial banks paid to borrow reserves held at the Fed by keeping a tight rein on excess reserves in the banking system and buying and selling short term Treasury securities.
By regulating the federal funds rate, the Fed could push up and down the entire yield curve and influence the availability of short- and long-term credit to businesses and home buyers.
More recently, as the Fed raised the federal funds rate target range from 0-0.25 percent to 1-1.25 percent from December 2015 to June 2017, the 10-year Treasury and 30-year mortgage rate hardly budged, because the Bank of Japan and European Central Bank were aggressively purchasing long-term bonds and other assets driving investors in their markets to the United States in search for yield.
Now, as the Fed seeks to gradually raise the federal funds rate to 2.5 percent by the end of 2019, Wells Fargo’s economists expect, for example, the 10-year Treasury and 30-year mortgage rates to increase only 70 and 62 basis points respectively.
That is optimistic considering that Japanese and European central bank easy money policies will continue to drive investors into U.S. asset markets and the recent history of international interest rate arbitrage.
These days, the Fed actually pays interest on required and excess reserves, permits the banks to hold more excess reserves than in the past, and regulates the federal funds rate by setting the rate paid at the upper end of its officially announced target range – currently 1.25 percent.
Also changes in Fed operations – such as permitting the banks to hold more excess reserves and effectively offering interest-bearing deposits to money-market funds, asset managers and hedge funds through their clearing houses – now require the Fed to hold at least $2.5 trillion in assets, and Ben Bernanke estimates that figure will rise to $4 trillion over the next decade.
When the next recession arrives and the Fed wants to boost bank lending, it will not be able to accomplish much by lowering the rate it pays banks and asset funds on their deposits at the Fed–the financial crisis taught us that banks worry about getting repaid a lot more than their cost of lendable funds.
And it will not much affect rates on mortgage backed securities–as rates on those securities fall, bond buyers will flee to high quality European and Japanese debt pushing U.S. rates back up.
The Fed will once again be forced to step into long-term credit markets directly by purchasing Freddie Mac and Fannie Mae mortgage-backed securities to boost the housing market and longer-term Treasury debt to boost the availability of credit to businesses through the bond market instead of hesitant banks.
This is not as radical or extraordinary as indicated by popular descriptions of QE in the wake of the financial crisis. Whereas in past decades the Fed sought to influence the availability of housing and business credit by buying and selling short-term securities, it will now do so on a cyclical basis by buying and selling on the long end of the yield curve.
Peter Morici is an economist and business professor at the University of Maryland, and a national columnist. © 2017, The Washington Times.