Andrew Huszar: Confessions of a Quantitative Easer

We went on a bond-buying spree that was supposed to help Main Street. Instead, it was a feast for Wall Street. ___ I can only say: I'm sorry, America. As a former Federal Reserve official, I was responsible for executing the centerpiece program of the Fed's first plunge into the bond-buying experiment known as quantitative easing. The central bank continues to spin QE as a tool for helping Main Street. But I've come to recognize the program for what it really is: the greatest backdoor Wall Street bailout of all time.

Five years ago this month, on Black Friday, the Fed launched an unprecedented shopping spree. By that point in the financial crisis, Congress had already passed legislation, the Troubled Asset Relief Program, to halt the U.S. banking system's free fall. Beyond Wall Street, though, the economic pain was still soaring. In the last three months of 2008 alone, almost two million Americans would lose their jobs.

The Fed said it wanted to help—through a new program of massive bond purchases. There were secondary goals, but Chairman Ben Bernanke made clear that the Fed's central motivation was to "affect credit conditions for households and businesses": to drive down the cost of credit so that more Americans hurting from the tanking economy could use it to weather the downturn. For this reason, he originally called the initiative "credit easing."

The fed doesn’t create “dollar balances,” i.e., money. It creates excess reserves in the banking system when it buys bonds. The problem is that this creates a situation where they then have to convince the banks not to circulate the excess they’ve created, for if the banks were to circulate 2 trillion in excess reserves we’d be in the middle of a true hyperinflation almost immediately.

You’ll find, as will the Fed, that the losses they take on their holdings are hardly meaningless if their equity balance ever approaches zero. Typically, the Fed turns over its profits to the Treasury, but if they have losses instead, they’ll have to go hat in hand to that same Treasury and ask for funding. At that point, Congress will finally be likely to want to better understand what the Fed has been up to the past few years.

In short, the Fed is taking a huge risk with our (taxpayer’s) money. They have taken a massive 2 trillion dollar position in long bonds at ridiculously low interest rates even while the Treasury has been attempting to lengthen the maturity of the public debt. But if the Fed is buying all the debt the Treasury issues, which they have recently been doing, the effect is to shorten, not lengthen, the maturity of the debt from the point of view of the taxpayer.

It’s important to realize that while the Fed is somewhat independent of the powers that be in DC, they are not independent of the taxpayer. If the Fed loses money, WE lose money, and vice versa. And, in my opinion, they are about to lose money on the scale of tens of billions of dollars in the near future, and possibly hundreds of billions. Losses of that magnitude are hardly meaningless; they come directly from the taxpayer’s pocketbook.

Also, the Fed isn’t fighting deflation currently. QE is an attempt, and a successful one, to lower long term rates by directly intervening in the long-term debt market in the hopes that lower long rates would influence economic activity. This is more or less a fool’s game although it has probably helped the housing market recover. In the end, long rates will reflect the inflation rate plus a small premium for risk, but in my experience long rates take a considerable period of time to reach a new equilibrium. If it turns out that the Fed is laying the groundwork for a double-digit inflation in the next few years, it will take long rates even years to acknowledge that.

As I think I said earlier, if short rates start to rise, the Fed will have to offer the banks a commensurately higher rate to entice them to continue to hold onto their excess reserves. Otherwise, they will certainly circulate them and we’ll be in a hyperinflation in no time. But offering that higher rate on over 2 trillion dollars will quickly erode the Fed’s equity position. For example, if they have to pay just 3 percent, that would be 60 billion dollars per year coming directly out of the Fed’s balance sheet.

In my opinion, the entire QE process has been a ridiculous exercise and it will be shown to be exactly that in due time. We’ll see. In any case, I can assure you that the Fed would not consider losses of the magnitude they are likely to have to take as “meaningless.” This isn’t play money; it’s real, taxpayer-provided, money that they’re using to manipulate the bond markets.

Typically, the Fed makes money every year because typically they take very little risk and earn interest on their short-term portfolio, which is funded by bank reserves.

The Fed has annually remitted its profits from its operations to the U.S. Treasury, which means that the taxpayer benefits.

Now, the Fed has a long-term portfolio and thus has taken on a significant risk. Should that risk work out badly, and I believe it will, the Fed will have no profits to remit, and will possibly be required to go to the U.S. Treasury for money to finance normal operations and to cover losses incurred by the operations required to reverse their present policy course.

Frankly, you don’t understand the situation very well. I don’t mean the policy implications. You really don’t understand the basic structure of the Federal Reserve and how they operate, and how those operations translate through to the rest of the government. You seem to think that they can lose as many billions as they want without any impact on the rest of the government. They can’t.

Furthermore, as a government entity, they have been shortening the effective treasury debt outstanding even faster than the treasury has been lengthening it. So, in a time when any logical entity would be financing as long term as possible, the Fed has contravened that policy by its actions. That, too, will come home to roost when rates move significantly higher someday.

“You really don’t understand the basic structure of the Federal Reserve and how they operate, and how those operations translate through to the rest of the government.”

Oh, I understand well how the Fed operates.

“You seem to think that they can lose as many billions as they want without any impact on the rest of the government. They can’t.”

Actually they can. They aren’t PIMCO. Their bond holdings aren’t investments. They are tools for adjusting high powered money in the banking system. The Fed isn’t relying on them for income. A capital loss on their bond holdings is irrelevant, they aren’t an investment house.

“Furthermore, as a government entity, they have been shortening the effective treasury debt outstanding even faster than the treasury has been lengthening it. “

That’s an interesting theory but the Treasury has the sole ability to determine what length of debt gets auctioned. I can’t imagine what mechanism you envision that would enable the Fed to adjust the length of outstanding Treasury debt.

“You don’t seem to understand that the Federal Reserve is an entity of the federal government. “

I used to subscribe the St Louis Fed’s Research Letter and and New York Fed’s Quarterly Review. I read Friedman and Schwartz’s ‘A Monetary History of the United States’. I think I know something about how the Fed operates and how it has changed since its founding but I’m always interested in learning more.

One interesting fact is that the FRB originally featured two members from the Treasury Department, a practice that ended very early on because it was felt that this led to undue Government influence on monetary policy- an odd concern if we are to accept your idea that the Fed is purely an entity of the federal government- in fact it is a hybrid of the government and the private banks that belong to the Fed system. The Fed was created to give legitimacy and government oversight to some gray area practices that banks and their Clearinghouse Associations were doing during panics- such as suspending specie payments and issuing “warehouse receipts” in lieu of specie. Perhaps this is well known to you.

However I have never before encountered anyone making the claim that the Fed can alter the effective maturity date of Treasury debt. I’m curious to learn what mechanism is used to make this happen. Please elaborate.

You might indeed know far more esoteric detail about the operations, and history, of the Federal Reserve System than me.

However, the Fed is hardly an entity independent of the federal government, although it is structured in a manner that creates some semblance of independence when it comes to making policy. Nevertheless, Congress can, with one act, abolish the Federal Reserve should it decide to do so. They could not, however, abolish Goldman Sachs or Citibank, which are in fact private, not public, entities.

Furthermore, despite your description of the two Treasury positions on the Fed board being eliminated, the fact that the Fed has traditionally remitted its annual profits to that same Treasury makes it clear that the Fed is a federal entity in the end, despite its independent status when it comes to policymaking. Furthermore, even that independence is somewhat illusory when you consider that the Fed Chairman is picked by the President. Almost certainly a Ronald Reagan would choose differently than a Barack Obama, so the Chairman we get tends to reflect the politics of the party in power at the time.

As to the Fed altering the “effective maturity of the Treasury debt”, the key word in that description is “effective.” Obviously the Fed can’t alter the actual maturity of the debt as they have no say over the issuance. However, since the Fed’s profits and losses are, in the end, borne by the taxpayer, it’s current decision to purchase more long debt than the Treasury is issuing has the direct effect of shortening the effective maturity of the debt held by the public even while the Treasury is trying to lengthen the maturity.

This is, in my opinion, insane, and will cost the taxpayers tens of billions, if not hundreds of billions, in the long run when interest rates inevitably once again begin to reflect reality. 1/4% is not reality, but rather is a fed-induced mania that is not likely to last much longer despite the Fed’s assurances that they will not raise short rates for a significant time. How will this affect the taxpayers? When there are no profits to remit, that costs the taxpayers, and if the losses exceed the Fed’s equity capital balance, Congress will be called upon eventually to restore equity to the Fed, creating another call on the taxpayer.

“However, since the Fed’s profits and losses are, in the end, borne by the taxpayer, “

This is where your idea of what the Fed is goes off the rails. The Fed’s losses are not born by the taxpayer. In fact the Fed’s losses on its bond portfolio are ultimately ephemeral. There’s no “equity capital balance” at the Fed.

The purpose of the Fed’s holdings of Treasury bonds is for controlling monetary policy and nothing more. When they want to reduce high powered money in the banking system they sell bonds. When they want to inject money into the banking system they buy bonds.

And since they have the unique ability to create money out of thin air they aren’t going to run out of money for buying bonds no matter what the market value of their bond portfolio becomes. They have no reason, ever, to come to the taxpayer for money. They can invent all that they want on their own.

You make a stronger case when you worry about our current artificially low interest rates- but the culprits here are the Treasury and Congress. Congress authorized the vast increase in Treasury debt and the Treasury decides the maturity date of what it auctions. Ironically the large holdings of the Fed cost the taxpayer nothing since the interest paid goes back to the Treasury. When the Fed sells that paper to soak up high powered money then the interest payments will be real.

That rates right up there with the “we didn’t land on the Moon” theory but thanks for playing.

The ‘USA’ money you mention with regard to JFK was the ‘United States Notes’ issue- these were nothing more than the Greenback notes first issued during the Lincoln administration to finance the Civil War. These notes were still issued as $5 bills as late as the 1963 Series, a Series which still included Silver Certificates.

But when US coinage had its silver removed both US Notes and Silver Certificates were absorbed into the larger Federal Reserve Note issue, since the distinction had ceased to have any meaning.

We’re going in circles now, I’m afraid. Nevertheless...

How can you say that the purpose of the Fe holding long bonds is for nothing more than controlling monetary policy when they have expressly said that the purpose of buying long bonds (instead of the usual t-bills and short notes) was to drop the yield curve in the long end? That’s not monetary policy, that’s direct manipulation of the bond markets. They could have used the same justification for buying up stocks in the stock market.

Say they wanted “green companies” to get easy financing. All they’d have to do is state a policy of buying $85 billion of green company stock every month. Companies would be issuing stock like crazy, building capital, and investors would be buying it and re-selling it to the Fed at higher prices.

Okay, if you consider bond market manipulation to be “monetary policy” then you’re right. I don’t. I consider it bond market manipulation, period. It’s far from traditional monetary management, so far that it’s never been attempted before. The only reason it’s being done now is because the Fed funds rate hit an effective rate of zero percent, so they couldn’t use their traditional monetary policy tool, lowering short rates.

As for my idea going “off the rails,” we’ll see about that when the Fed attempts to drain 2 trillion dollars and suffers a few hundred billion dollars in losses doing so. It’s really hard to create more money when you’re trying, simultaneously, to stop it from being created, no? I’m saying they will suffer losses of a significant magnitude, sufficient to impair all of their equity capital and then some, most likely. You’re saying that they can stop that by buying more bonds. How do they do that in the middle of an aggressive campaing of selling bonds, exactly?

Please explain. Or else just tell me how you envision the Fed eventually neutralizing 2+ trillion in excess reserves without it costing them billions of dollars?

Incidentally, your argument that the Fed’s losses don’t matter, apparently either because no one ever measures them, or because they can always get more money by creating it, reminds me of the stock analysts in the 1970’s who used to routinely ignore the reality of a company’s massive unfunded pension liability by using the argument that traditional accounting standards didn’t require those unfunded liabilities to be reflected on the balance sheets.

They were real, of course, as the eventual bankruptcies of many companies later proved, but as long as they weren’t required to be reflected on the books, analysts argued that they could be ignored.

I was a bond pension manager during that time and, regardless of the analysts’ near-universal agreement at that time (as evidenced by repeated phone calls during which they made their case), I sold the bonds of every company that had an excessive unfunded pension liability.

And if the Fed actually had stocks or bonds of its own outstanding, I’d liquidate those today. Unfortunately, the taxpayers don’t have that option, and the current Fed mess is going to cost us a lot in the end. As I’ve said a few times now, let’s wait and see....

“It’s really hard to create more money when you’re trying, simultaneously, to stop it from being created, no?”

For one thing they won’t try to do both at the same time. When the Fed decides to drain money from the banking system they will start selling off their hoard of bonds. This will remove high powered money from the banking system by replacing it with illiquid bonds. Banks can loan high powered money, they cannot loan bonds. The Fed can do this until they run out of bonds to sell.

Now let’s assume that they sell every single bond that they have- bonds that will sell far below the price that the Fed initially paid- will the Fed lose a trillion dollars and have to run to the taxpayer to be made whole?

No. Not at all. Because they can replace the money they ‘lost’ at will. They can turn around and purchase a trillion dollars of bonds by simply crediting the bond holders with newly created money. It’s hard to go broke when you have the ability to create new money.

>>For one thing they won’t try to do both at the same time.<<

No kidding. Because they can’t.

You’re trying to argue that unwinding the Fed’s current excess reserve problem (what you’re calling high-powered money) will not result in a catastrophic loss situation because the Fed can always unwind the losses by rewinding the excess reserve problem, i.e., by creating more “high-powered money” (excess reserves.)

So, what then? Rinse and repeat?

And besides, the losses themselves won’t be wiped out by creating more excess reserves. They will just have managed to re-create the excess reserve problem that they currently face.

You don’t seem to appreciate the fact that the Fed has a balance sheet, one that the current regime just might have managed to set up for destruction. If that balance sheet incurs losses that result in negative equity, they can’t restore that equity by creating more excess reserves. All that transaction would accomplish is increasing their exposure to additional losses in the future.

>>When the Fed decides to drain money from the banking system they will start selling off their hoard of bonds. This will remove high powered money from the banking system by replacing it with illiquid bonds. Banks can loan high powered money, they cannot loan bonds.<<

Just for clarification, when you say “high-powered money” you just mean “bank reserves,” right? And to the extent that the Fed supplies more reserves than are required by the banking system as a whole, that amount (the excess reserves) can then be circulated (loaned) resulting in an eventual increase in the overall size of the banking system.

Are we on the same page to this extent at least?

Incidentally, the bonds are hardly “illiquid.” They can easily be bought and sold. Instead, what they are is simply an asset similar to other bank assets like cash and business loans. If a bank sells a bond and makes a business loan with the proceeds all they’re doing is replacing one asset with another. Such a transaction won’t increase the size of the banking system unless the Fed supplies additional reserves to support an expansion. Instead, somewhere else in the system a different bank will be reducing its exposure to business loans while increasing its position in treasury bonds.

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