Quagmires in the Fed’s War on Inflation

After the financial crisis of 2008, the Federal Reserve used two policies to prop up the economy: zero percent interest rates and pumping newly-created money into the economy through quantitative easing (QE). Because of 40-year-high inflation, the Fed has recently reversed policy and is raising its key interest rate target on overnight loans between banks. The Fed is also doing quantitative tightening (QT, the opposite of QE), and is withdrawing money from the economy.

There are two ways to do QT: “portfolio runoff” and selling assets. The Fed is doing only the former, runoff, which entails allowing its assets to mature and not reinvesting the proceeds. Beginning in September, the Fed will do portfolio runoff at a pace of $95B a month, $60B of which will be U.S. treasuries and $35B will be mortgage-backed securities. That pace works out to $1.14 trillion in a year. Nothing to sneeze at, but to really fight inflation could the Fed go faster and take even more money out of the economy each month?

Rather than relying solely on portfolio runoff of maturing assets, this writer recently suggested that the Fed also sell its assets prior to maturity in order to speed up the deflating of the money supply, and perhaps obviate continued interest rate hikes. Just as with portfolio runoff, the Fed wouldn’t reinvest the proceeds of its sales. Selling assets presents serious implications concerning prices and yields.

Reducing the Fed’s portfolio (balance sheet) through sales is a problem. Back in the Spring of 2020, during the height of the pandemic, the Fed bought assets for a time at the furious pace of a trillion dollars a month. Selling those assets will be more of a problem than was buying them. What if the Fed tried to sell off its assets as quickly as it bought them in 2020?

When it sells its assets, the Fed does so in secondary markets where prices and yields are subject to change. When too much of something is put on any market at one time, prices tend to fall. In bond markets, when prices fall yields rise.

The trick for the Fed in selling its assets is to sell them at high prices. The higher the price, the more money the Fed is sucking out of the money supply, thereby attacking inflation directly. But there’s another consideration: the relationship between the secondary market and the primary market.

In the case of the primary market for U.S. treasuries, they’re sold at par, or face value; what’s paid at maturity. So the way that that primary market could compete with its secondary market during times when the secondary market has better yields than its primary market is to raise its coupon rates, i.e. the interest rates on its treasuries.

Since interest on treasuries is an item in the federal budget, low prices for treasuries in the secondary market is a problem if they result in higher interest rates for new treasuries. The amount of interest on the federal debt that the taxpayer is to pay in ten years is already predicted to go up by a factor of three.

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