Is the Federal Reserve exercising its “nuclear option” and initiating its exit strategy?
It seems like this same story surfaces every few years. But is the Fed serious this time? What if it is?
CNBC reported yesterday on the plans of the Federal Reserve:
Federal Reserve officials said the shedding of the $4.5 trillion in bonds the central bank is holding on its balance sheet will begin this year.
The consequences of such a move will be severe. But it’s not the first time this story has surfaced. Last time, in 2010, it was just huffing and puffing. Nobody’s house was blown down. But is this time different?
REVERSING THE GREAT RECESSION
In unprecedented and multiple rounds of mass-purchasing of mortgage and Treasury bonds from 2008 to 2015, the Federal Reserve expanded the monetary base from around $800 billion to $4,000 billion, or $4 trillion.
There was no economic theory that supported such a drastic measure. It defied the logic of Keynesian economics, which is the stuff you learn in high school and college. In other words, it was a Hail Mary, a miracle play intended to reverse what was seen as the deadliest economic threat to grip the United States since the Great Depression.
As a consequence of this, the mortgage meltdown was reversed. The banks were saved. And America entered the worst-performing, post-recession “recovery” in its history. Wages are down. More people than ever before are still out of work — many of them just quit looking altogether, so they’re no longer counted as unemployed. That makes the statistics look better. The headline unemployment rate, as of February 2017, is 4.7%. But if you include the people who are so discouraged that they aren’t even looking for work anymore, that number rises to 9.2%.
So, here we are, the worst economic “recovery” in history, with unemployment still high, with GDP falling, with government debt the highest it has ever been, and household debt already returning to the levels they were at in 2008 before the last crisis hit…
…and the driver of it all, marginal as it was, was Federal Reserve inflation. The most dramatic increase of the money supply ever recorded.
And now, there’s talk that they want to “unwind” their $3.5 trillion in post-2007 purchases? What kind of effect will this have on the economy?
THE CONSEQUENCES OF SELLING
Buying bonds lowers interest rates. That’s the basic rule of investing. In the last 8 years, the Fed purchased more mortgage and Treasury bonds than in the history of mankind. Unsurprisingly, mortgage rates remain at historical lows. Treasury bond rates are the same: the lowest they’ve ever been.
Low mortgage rates stimulate housing demand. In the wake of the biggest housing collapse in the nation’s history, the Fed’s goal was to reverse the collapse and rejuvenate sales. Whacking mortgage rates with a steel hammer was the only way they figured they could do it.
So now, if the Fed begins selling the trillions in mortgage-backed securities it has sitting on its balance sheet, that will drop the price of mortgage debt because supply will increase. The rule of bonds is that as their price declines, their rates increase. So, unwinding its balance sheet by selling mortgage-backed securities into the market will raise mortgage rates and destroy the lackluster housing market recovery.
The economy will go with it. Selling US government bonds will have the same effect: raise their interest rate. The US government has enjoyed historically low interest rates. That means it can borrow virtually for free. Look at how little of the annual budget interest payments on our debt currently takes up:
It’s at 6%. The average rate it pays on its debt is somewhere around 3%. What happens when that rate jumps to 15% or more? Which programs will be cut to fund the increase?
There will be political hell to pay. Somebody will be thrown out of office.
WHAT NOBODY HAS NOTICED
The article reports that the Fed will “do its best to communicate its intentions clearly.” It says the selling of bonds will begin this year. But whoever wrote the article didn’t look at the Fed’s own published chart of its balance sheet:
The monetary base peaked between 2014 and 2015. Since then, it appears some $300 billion of the Fed’s bonds have been sold. The trend is down.
Strictly speaking, the Fed has already begun to unwind its balance sheet. It just hasn’t told anyone. It began last year. And yet they said they’ll begin this year. They said they’ll communicate their intentions clearly.
If the Fed proceeds with its unwinding, the economy will experience convulsions. When that starts to happen, what will the Fed do? Continue selling, and make the recession deepen?
Or do what it always does: attempt to reverse the recession by inflating the monetary base?
So, how long?
How long must we sing this song?