By: Tim Hayes Financial Advisor - posted in: Economy, Markets, and Interest Rates - Last updated Nov 18, 2018

2017: The Year the Federal Reserve Is Living Dangerously

by | Economy, Markets, and Interest Rates

Starting in 2009, the Federal Reserve added a couple trillion dollars of new money to the economy through a quantitative easing program of buying bonds from banks and non-banks. Now the Feds reportedly want to cut their balance sheet by selling those bonds.

Selling bonds to banks will extinguish excess reserves—a non-event. If, however, non-banks buy those bonds, it will decrease the money supply, which may hurt the economy.

What’s Been Happening over the Past Few Years

During the period when QE was in effect, the Feds bought a total of $4.5 trillion in bonds from banks and non-banks. Even though the Feds stopped QE in 2014, they continued to buy bonds with any proceeds they had received when a bond had matured.

Remember, when a bond matures, its owner receives payment from the issuer for the bond’s face value. Up until now, the Feds have been reinvesting that money back into the economy.

J.P. Morgan Warns the Banks

In a May 8 story, Bloomberg Markets reported on investment bankers at J.P. Morgan hoping to drum up business by confidentially urging small and mid-sizes banks to merge in order to fend off the risks associated with the Feds selling bonds back to the marketplace.[i]

The investment bankers are warning that, when the Feds sell bonds to non-banks, the buyers will pay with bank deposits. Moreover, unlike everyday transactions, in which a seller deposits any proceeds into the bank, this time the Feds will extinguish the money, leaving the banks without the deposits needed to fund loans.

By warning that the shrinking deposits could cause lending to slow, the investment bankers are getting the relationship between lending and deposits wrong: lending creates a deposit, not the other way around. Thus, any risk to mid-sized and small banks is due more to the shrinking of the money supply causing a recession than a lack of deposits to fund loans.

Why Would Anyone Buy Bonds?

This is especially true for non-banks that are sitting on cash they had received from selling bonds to the Feds or to institutions that already bought financial assets with proceeds from bond sales. Why would those non-banks buy bonds now, when the Feds are saying the economy is getting better, and when interest rates are going up? (Remember, bonds do poorly when interest rates go up.)

Furthermore, why would banks want to use their excess reserves to buy bonds when the Feds are forced to pay them more interest each time the Fed fund’s rate is raised? (Currently, banks earn 1% on their roughly $2 trillion of excess reserves.)

Why the Fed Pays Banks Interest on Excess Reserves

In normal circumstances before the 2008 financial collapse, the Feds did not pay banks interest on reserves. So banks kept only what was required by law, thus making it easier for the Federal Reserve to control interest rates. Now with two trillion of excess reserves, the Fed must pay banks interest on them, if they didn’t banks would lend them to other banks making it impossible for the Fed to influence interest rates.

The Second Half of This Year Should Be Interesting

The Feds seem primed to raise rates again in June. Plus, they seem bent on selling bonds (will see if there are any buyers) to reduce their balance sheet. Each of these moves may destabilize the economy, and both demand investors’ attention.

[i]    Monks, Matthew, “JPMorgan Tells Banks to Partner Up as U.S. Deposit Drain Looms,” Bloomberg Markets, May 8, 2017, https://www.bloomberg.com/news/articles/2017-05-08/jpmorgan-tells-banks-to-partner-up-as-u-s-deposit-drain-looms

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