Much has been written of late about the pickle in which the Fed finds itself due to the President’s quixotic trade war. The Fed is indeed facing a dilemma setting monetary policy, but it confronts a Rubik’s Cube trying also to ensure financial stability. The reason: the more the Fed fights inflation, the less it can secure the financial system and the more it is forced to secure the financial system, the less able it will be to conduct monetary policy. This vise results from the Fed’s huge portfolio, yet another example of why the Fed should have reduced its portfolio as quickly as possible after both 2008 and 2020. Since it didn’t, it now has only bad choices if Treasury-market illiquidity turns toxic.
This negative feedback loop is the result not only of the Fed’s cumbersome trillions, but also of its unwillingness to make another hard decision: meaningful action to address identified systemic risks. Had the Fed heeded its own warnings going back to 2020, it might have done something to reduce Treasury-market dependence on high-risk, leveraged hedge funds. To be fair, the Fed cannot directly regulate hedge funds and the SEC lacks prudential authority, but both agencies had lots of ways to curtail systemic risk long before basis-trading hedge funds came to hold at least $1 trillion in assets.
So far, hedge-fund deleveraging is proceeding in a reasonably-ordered way, but risks such as these have a bad habit of cascading. Jamie Dimon already anticipates this, but he also thinks the Fed will step in. So too does at least one senior Fed official already willing to say so. The Fed can and probably will undertake yet another bailout, but macroeconomic stability could well be the price of this financial-market rescue.
Why? The Fed’s portfolio was rightly dubbed quantitative easing (QE) when the Fed sucked trillions onto its books in 2008, with the policy meant to reverse recession and deflation in the course of the great financial crisis. The Fed chickened out of reducing this portfolio as it knew it should in 2013 and kept it as big until 2020, when it got even bigger to stimulate as much growth as possible when the pandemic hit. The Fed only reversed course with quantitative tightening (QT) in 2022, well after inflation took off and restrictive policy was essential. Better late than never, one supposes, but the Fed’s portfolio still stands at a gigantic $7 trillion or about twenty-five percent of GDP.
One reason the Fed has been so squeamish about stepping out of the markets is that it has no clue about what portfolio policy it should have to balance macroeconomic objectives with financial stability. This is a grievous oversight more than fifteen years after 2008 and six years since the Fed suddenly discovered that stable repo markets need what it now calls “ample” reserves. But, what’s ample? We don’t know and the Fed has been afraid to find out.
As a result, QT has been super-cautious and the Fed is, as noted, still the financial market’s Big Daddy. Given this, it has only two bad choices if it needs to ensure financial-market stability.
The first is to go with its gut and get even bigger, acting as academics recently recommended to bailout hedge funds by buying their Treasury bonds to stoke more demand, reduce yields, and – hopefully – watch the dust settle.
But, if it does this, what of QT? When a central bank buys Treasuries or even pauses selling as the Bank of England did last week, it’s back to QE. This is super-dangerous now because QE is inherently inflationary – indeed, that’s its point – but a roaring trade war is not a good time to lower rates. This might make the President happy, but ultra-low rates combined with supply-chain shocks bring us right back to 2021 along with CPIs hitting nine percent or more.
I’m no fan of bailouts, but the Fed was able to execute one in 2019 with macroeconomic risk by virtue of buying billions of Treasury obligations when it rescued the repo market. Then, macroeconomic risk and inflation were benign; now, they’re not. Still, the Fed reinforced moral hazard, making the 2020 bailouts still more inevitable. That massive intervention leads markets now to think the Fed will do it again, with high-risk hedge funds seemingly secure in the knowledge that they can take all the profits because taxpayers will cover their risks.
Will Main Street need to pay for Wall Street’s rescue? The Fed will have no choice but again to side with one versus the other and, if it follows its instincts, Wall Street will win at still more cost to moral hazard, vulnerable households, and the equitable economy essential for political stability. The Federal Reserve was given the power along with its global glory because its independence is supposed to steel it for hard decisions. It still revels in its glory, but it has squandered its power along with its credibility over years of taking the easy way out.
If Treasury-market illiquidity stokes the next financial crisis, then the Fed will save financial markets not only because that’s its go-to, but also because its top priority is trying to save itself. The Fed has, though, dug itself into such a deep hole that it might not be able to climb out, subjecting the U.S. not only to yet another bailout, but also to stagflation. Prolonged QE made this dilemma, QT hasn’t solved it, and the Fed has given itself no good choices in the face of risks it knew it ran