The Fed, The Assets, and The Taper
When the music stops and securities go looking for buyers.
Alright, this week’s post is [hopefully] going to be a lot shorter than usual. Why? Because I was out of town all weekend and I’ve been doing a lot of non-finance/economics reading lately. To be frank, this week’s essay is mostly just me yammering on about the Fed’s balance sheet.
I have previously argued that the only axiom of American monetary policy is that no one is ever allowed to have a liquidity crisis. Following the bankruptcy of Lehman Brothers, the powers that be in Washington and New York decided that the damage brought about by such a collapse was greater than the moral righteousness felt in letting markets regulate themselves. Due to the operational independence of the Fed, it is unsurprising that the central bank took responsibility for ensuring that there are always enough dollars floating around to stave off cash crunches.
You see, the problem at Lehman was that while it had ample long-term assets to cover short-term funding gaps, these assets could not be sold off quickly enough in markets that were grinding to a halt. The best analogy here is that of a farmer who is land-rich but cash-poor. In the wake of the bank’s collapse, the Fed realized that in times of crisis it ought to serve as the true liquidity window of last resort. In short, if the market moves in a manner out of step with what the government and central bankers want, the Fed starts writing cheques for assets. Which is the simple way of explaining Quantitative Easing (QE).
Now, QE sounds great in theory because, it looks like a perpetuation of the market in times of market ‘irrationality.’ However, the problem with QE is that it is decidedly not a component of the market. Given that the Fed can – so long as the assets are there to justify it – generate new dollars to cover purchases on demand, the central bank does not behave like a normal market participant. Instead, the Fed is both a competitor in the market and, for all intents and purposes, is the market in times of extreme stress.
What the Fed does is effectively say, ‘the market is behaving in such a manner as to negate the informational accuracy of the price system. Therefore, we are going to pay the ‘true’ price of the asset which is whatever we determine it to be.’ This of course leads to asset price inflation so long as the Fed is purchasing. What the central bank does is create an artificial – from the point of view of the pre-Fed action market – floor for asset prices. In short, if there is always a buyer willing to pay more than anyone else in the market, and this buyer has infinitely deep pockets, then the buyer defines and distorts the market.
How large of a market are we talking about here? Well, the Fed’s balance sheet is currently sitting at just north of $8-trillion. So....it’s a pretty big market.1
But what’s the issue here? The house ain’t on fire right now. The problem is what happens if the Fed starts to sell off its balance sheet. Now, again, this is not a massive problem right now because the Fed is basically scared shitless of winding down its assets. Currently, the Fed buys about $120-billion in Treasuries and Mortgage-Backed Securities each month. The intention is to ‘taper’ these purchases starting around November.2 One suspects that the Fed might never sell these assets and instead let them run their course and convert themselves into cash. Assuming that the longest dated securities on the balance sheet are for 30-years then sometime in 2051 the Fed could hypothetically be a shell institution consisting of little more than the largest Scrooge McDuck money pit known to humankind. Obviously, that’s not gonna happen, but still.
What would happen if the Fed – and central banks around the developed world – decided to gradually sell off their assets? Well, we’d have to look at what these purchases did in the first place. By buying so many Treasuries and MBS, the Fed raised the general price which in turn dropped the yield. If the flows were to go in reverse, then supply would increase and prices would drop, thus increasing yields. The result is that those particular securities would appear more attractive to investors and institutions. In order to compete with these higher-yielding instruments, other fixed-income securities, in general, would have to up their yields. By upping yields, debt becomes more expensive. This phenomenon trickles throughout the debt markets and suddenly everyone has to pay more for credit in nominal terms. The solution? Increase taxes – if you’re a government - or increase prices – if you’re a corporation.
Outside of debt markets, equities also get hit. For example, the increase in the cost of debt shows up in valuation models that utilize a Weighted Average Cost of Capital. A higher WACC means you get a higher denominator in discounting calculations. Consequentially, you’d expect stock prices to dip. If they dip then you’d want to find growth elsewhere such as in the higher-yielding bond market. Oh, how the fixed income trading desks would love to see such inflows after ‘the great moderation.’
Also, rising prices and debt costs would insinuate the return of inflationary regimes beyond what we have grown accustomed to.
Seems kind of ominous doesn’t it? Yea, except as I previously mentioned, the Fed does not have to sell any of its securities. They can sit on them till the cows come home. What we’d be more likely to see is that with the Fed stepping back from purchasing securities, the securities’ prices ought to fall, thus raising yields gradually. The issue though is the role of expectations.
The Fed is relatively transparent in terms of its operational forecasts. If Jerome Powell says ‘we will wind down our purchases starting on day X,’ there’s a pretty damn good chance that the central bank will do just that. However, the act of Mr. Powell saying such broadcasts to market participants that they can expect a rather significant event to occur on day X. Participants would be stupid not to act upon this information. For example, if I think that treasury yields will start to rise (no matter how slowly) starting on day X, then why the hell would I except record low yields in the days, weeks, or months, leading up to day X? Instead, I would want time-adjusted comparable yields now. Why? Because if I were to buy a hypothetical security today then on day X the investment would be underwater. Thus, the announcement, if carried through, shifts the parameters of the market today – prior to the actual event even occurring.
The worry associated with these projected actions by the Fed is that inflation will occur a lot quicker than folks would otherwise expect because of the role that expectations play in shaping market behavior today. Folks look at the money supply as the cause of inflation, but really, the cause is the bond market. Why? Because the bond market is all about contractual obligations to provide cash flows. A company can opt to not issue a dividend: the issuers of bonds can’t similarly skip a coupon payment. Thus, cash must be found in any way possible which typically ends up involving price increases. Now, MBS and Treasuries aren’t in the business of selling products, but their movement shifts the credit market since they serve as the risk-free, or low-risk, baseline of the market. If the rate floor rises, so do all other borrowing costs.
This leads us to my woefully underqualified opinion as to what is going to happen. I think that there is no political – let us not forget that central bankers are political actors – will to let inflation get out of hand through the mass-selling off of the Fed’s balance sheet.3 I wish there was, but alas, here we are. The Fed will just let the securities sit on its balance sheet until they’re all converted to cash. What will it do with this cash? Who knows. Imagine a wad of money worth 20x the total assets of Apple. An abomination to be sure, but I don’t know what else you’d do with it except keep in on the books. You can’t release the assets or cash (which, obviously is an asset but let’s divide them for fun) without inflation.
In terms of tapering purchases, I don’t see a way out of it. You can’t just go on buying up assets indefinitely. At some point, we would all just keel over and die laughing at the absurdity of doing so. Thus, there ought to be inflationary pressures going forward. Even if it takes years to do so, the inflation will show up eventually.
I suppose that my hot take is that in the contemporary world Milton Friedman is wrong. Inflation is not everywhere and always a monetary phenomenon. At least not in the way we tend to believe it to be. The matter at hand is not the dilution of the monetary base. ‘Printing’ money is not the problem. The problem is what happens when the printing stops. It’s not that mo’ money equals mo’ problems. It’s that an influx of purchasable assets – remembering that Fed purchases reduce the purchasable supply – raises competition amongst sellers which in turn beget higher yields. Put differently, the crux of the matter is the relative size of cash to non-cash assets within a system. When the Fed purchases and holds onto assets, the outstanding assets in the system rise in value. When the Fed sells or reduces its purchasing of these assets, the price drops, and yields rise. It’s as simple as that.
Photo by Morgan Housel on Unsplash
https://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm
https://www.wsj.com/articles/fed-officials-prepare-for-november-reduction-in-bond-buying-11631266200
https://foreignpolicy.com/2020/05/13/european-central-bank-myth-monetary-policy-german-court-ruling/