In my last note we talked about the recent Fed meeting, and the announcement they made on the quantitative tightening program.
Beginning next month, they will sharply slow the pace that they have been shrinking the balance sheet.
For perspective, let’s step through the history of the Fed’s balance sheet response to the crises of the past 15 years.
If we look back at the housing bust and Global Financial Crisis (GFC) response, the Fed slashed rates to zero. But they couldn’t stabilize the financial system, until they started outright buying government and mortgage bonds (quantitative easing — QE).
It took not one round, not two rounds, but three rounds of QE to stabilize and promote enough confidence in the economy, to stimulate hiring, investing and spending again.
All along, rates were at or near zero.
Still, the economy stagnated, propped up by Fed life-support for the better part of eight years, and teetering on the edge of a deflationary bust and depression.
Then we had Trump 1.0.
He came in with a pro-growth agenda, and immediately the Fed began raising rates — mechanically taking rates from near zero to 2.5% over the next two years. And simultaneously, they shrunk the size of the Fed balance sheet (reversing about $700 billion of QE).
So, they pulled the monetary policy life support.
What happened?
The economy grew one percentage point faster than the growth rate of the prior eight years (average annual growth rate), despite the headwinds of tightening monetary policy.
But, by late 2019, the Fed’s attempt to “normalize” policy broke the overnight interbank lending market.
This chart …
Remember, the Fed described this as: “strains in money markets that occurred against a backdrop of a declining level of reserves, due to the Fed’s balance sheet normalization and heavy issuance of Treasury securities.”
And they saw it coming — enough to start slowing QT earlier that year, and cutting rates that summer.
But by late September the dam broke (the spike in the overnight lending rate).
The Fed was forced to slash rates, and go back to expanding the balance sheet (QE).
How does this all relate to the current situation?
This time, the Fed has been shrinking the balance sheet for the better part of the past three years — to the tune of about $2.2 trillion.
They slowed the pace of QT last June.
And last week, they dialed it down again from $25 billion to $5 billion a month. That’s a sharp reduction, to a small amount, which means they have effectively ended QT.
And once again, it was attributed to stress in money markets: “signs of increased tightness in money markets.”
Is this a clue that something in the financial plumbing is breaking, and a Fed response is coming (including QE)?
As we’ve discussed many times in this daily note, we’ve yet to see an example of a successful exit from QE. Until proven otherwise, it’s Hotel California — “you can check out, but you can never leave.”
On that note, as Bernanke once said, QE tends to make stocks go up. Stocks went up close to 20% over four months following the Fed’s 2019 response.