The Fed’s Monetary Chicanery: No Finish to the Cash Printing

Right here’s a multiple-choice query I’ll be putting on an upcoming quiz in my financial economics class:

The Federal Reserve is like which of the next:

• A failed Nineteen Eighties Financial savings & Mortgage

• 2023 failure Silicon Valley Financial institution

• 2001 mega chapter Enron

Reply: The entire above. 

The Fed compares to S&Ls as a result of it’s banking backwards: borrow excessive, lend low. Previous time S&L bankers lived by the “3-6-3” rule: pay 3% curiosity on quick phrases deposits, lend at 6% on 30 yr mortgages, and be on the golf course by 3 pm. This enterprise mannequin labored properly with low, steady inflation, which saved  rates of interest regular. S&Ls started shedding cash when inflation—and the Fed’s belated response to it—pushed short-term rates of interest up properly above 6% (bear in mind Paul Volcker?), however a big portion of their mortgage books was locked-in at these 6% mortgages. A large number of regulatory blunders led to compounding losses of $175 billion by the point the mud settled on the S&L disaster. 

The Fed compares to Silicon Valley Financial institution as a result of it “invested” in extremely rate of interest delicate property (US Treasuries) which noticed a large decline in market worth as rates of interest started to rise. As finance college students know, “bond costs are inversely associated to rates of interest.” When rates of interest rise, present bonds, with comparatively low “coupons” (annual curiosity funds) turn into much less engaging to personal as compared with new bonds, issued on the new, increased coupon charges. Traders unload these older bonds, forcing their costs (capital worth) down till their risk-adjusted yields match the brand new, increased charges. SVB invested very closely in a seemingly “secure” portfolio of Treasury bonds, however their managers apparently by no means took a fundamental financial institution administration class, by which they may have discovered about rate of interest sensitivity, asset-liability administration, portfolio diversification, and danger hedging instruments like choices and swaps. When rising rates of interest, mixed with its bond-heavy funding guide, revealed looming capital losses in early 2023, SVBs depositors started to run on the financial institution, which compelled SVB to fire-sale its devalued bonds, perpetuating much more losses. The financial institution was liquidated by the FDIC in March 2023 at a loss to the insurance coverage fund of about $20 billion.

The Fed compares to Enron as a result of its monetary reporting makes use of “non-standard” (non-GAAP) accounting to cover losses on its earnings assertion. Enron’s accounting trickery—abetted by auditor Arthur Anderson— was refined and multifaceted, however amongst their largest tips had been overstating potential future earnings streams and utilizing “off-balance sheet” entities to masks the corporate’s true debt ranges. Enron’s monetary chicanery, mixed with an audacious rent-seeking grift by the use of regulatory arbitrage, made its earnings development seem unbelievably sturdy, and made its inventory one of many largest flyers of the dot-com period. The publicity of Enron’s fraud in late 2001 led to the biggest chapter in US historical past to that date.

To be honest, the Federal Reserve is neither a industrial financial institution, nor a for-profit company topic to GAAP, so my comparisons are in a single sense purely educational. Nevertheless, these parallels are fascinating and reveal some troubling facets of our present financial and monetary scenario. 

To know how the Fed pulled off this bad-finance trifecta—destructive yield unfold, capital losses on interest-sensitive “secure” property, and large accounting fraud—we have to assessment some current historical past and monitor how the Fed’s financial coverage working procedures have modified in response to main occasions. 

Right here’s a thumbnail sketch of how the Fed used to function, pre-2008 (I don’t essentially endorse any of this, however that is the way it was usually introduced in textbooks):

When the Fed desires to “stimulate” the economic system, it seems to be to chop rates of interest. The Fed reduces rates of interest by the use of “open market purchases” of Treasury securities. The Fed creates new cash (within the type of financial institution reserves) and makes use of it to fund these purchases of T-bills from banks. Banks swap T-bills for money, which positions them to extend their lending. The elevated provide of “loanable funds,” if massive sufficient, can push rates of interest down—at the very least within the quick run. This will trigger inflation to warmth up, because the elevated financial institution lending results in extra financial institution deposits and a bigger measured cash provide. Furthermore, decrease rates of interest mixed with Fed purchases of T-bills permits higher deficit spending by Congress. This will actually have an inflationary kick, as we witnessed with Covid stimulus checks places spendable funds instantly within the fingers of customers. To chill down inflationary pressures, the Fed raises rates of interest to place a damper on financial institution lending, and therefore enterprise and shopper spending. The mechanism right here concerned “open market gross sales” of Treasury securities. The Fed would promote T-bills to banks (at engaging costs) and this might draw financial institution reserves out of the banking system, as banks hand over reserves to the Fed in cost for his or her newly acquired T-bills. The Fed would then “extinguish” these financial institution reserves, and with fewer reserves readily available, financial institution lending would taper off, resulting in smaller charges of development within the cash provide and general spending, ostensibly placing downward strain on inflation. 

As a result of the Fed determined to undertake “quantitative easing” of their response to the Nice Monetary Disaster of 2008, we’ve arrived at a scenario the place good outdated “open market operations” are not possible. In its bid to suppress long-term rates of interest and increase whole spending, the Fed bought a completely big quantity of Treasury and mortgage-backed securities, one thing on the order of $8 trillion cumulatively by 2022. The comparatively small open market operations that the Fed used to depend on to control rates of interest and lending are not enough to the duty.

To impact a noticeable rate of interest hike, as an example, the Fed must transact multi-trillion greenback open market gross sales. Dumping this quantity of T-bills in the marketplace unexpectedly would danger huge market disruptions and doubtlessly wild rate of interest swings. Treasury costs would plummet (and their yields spike), negatively impacting not solely the US authorities’s ongoing funding operations, however the stability sheets of all method of companies which maintain important quantities of Treasuries. Thus right now, slightly than promote securities in a doubtlessly disruptive trend, the Fed has discovered a brand new mechanism to maneuver quick time period rates of interest round: the so-called “flooring mechanism” with the coverage instrument often called curiosity on reserve balances (IORB). The best way it really works could be very easy: the Fed pays banks curiosity on the reserves they carry on deposit with the Fed. This units a dependable worth flooring on market rates of interest, as banks will refuse to lend to industrial purchasers at any fee under what the Fed will reliably pay them to only sit on reserves with zero credit score danger. So these days, when the Fed must combat inflation, it merely ups this IORB fee, elevating banks’ alternative value of lending and thereby pushing all market rates of interest upward. 

Nevertheless a big downside has inevitably emerged, given the mixture of QE, IORB, and inflation. QE meant that the Fed issued trillions of {dollars} in new reserves, a big chunk of which banks have opted to only sit on, slightly than lend. IORB, particularly after the current rate-hiking cycle, has meant banks earn a tidy return by not lending this massive chunk of reserves. Inflation means the Fed has to boost rates of interest (and IORB), which suggests much more straightforward, passive earnings for banks by way of their un-lent reserve balances.

So right here’s the place it will get bizarre, unhappy, and fraudulent: we have now arrived at a scenario the place the Federal Reserve is paying extra money for the deposits it holds (by way of IORB) than it earns on its portfolio of investments in Treasurys and MBS that it acquired by all that QE. In different phrases, the Fed has gone full Nineteen Eighties S&L: borrow excessive, lend (make investments) low. This additionally means the Fed has turned over a brand new leaf: for the primary time ever, America’s central financial institution is shedding cash. In its 2023 working yr, the Fed system amassed whole working losses of $114 billion—this along with unrealized capital losses on its Treasury/MBS portfolio that started with fee hikes in 2022. Nevertheless, when you have a look at the Fed’s consolidated earnings assertion for 2023, you’ll see “complete earnings” (web earnings) reported at a optimistic $1.5 billion. Did the Fed have non-operating earnings to offset the truth that it paid $281 billion in curiosity, however solely earned $175 billion on its bond portfolio? Nope. The Fed certainly misplaced cash outright, S&L fashion. However in a transfer that may impress probably the most inventive accountants, the Fed merely engaged in “non-standard accounting practices” to cover that loss on its earnings assertion. In really Enron-esque fashion, the Fed listed the loss as, get this, a “deferred asset,” and magically waved it away. Right here’s the superb print from the Fed’s 2023 monetary statements:

In different phrases, the Fed admits it misplaced cash final yr, however it’s going to positively earn that cash again later, and subsequently it could possibly simply kick that loss down the highway, repackage it as a “deferred asset” and add it again on the earnings assertion. It’s recorded as a destructive, however it’s subtracted: a destructive plus a destructive equals a optimistic. If solely Kenneth Lay had lived to see it! 

The irony of Fed losses is wealthy. The Fed was created as a “lender of final resort” for the US monetary system. It’s job was to centralize the reserves of the whole monetary system (then: gold; now: Fed-issued base cash) and be prepared, keen, and in a position to lend freely to member banks throughout occasions of monetary disaster. The Fed acquired the reserves it held largely by regulatory mandate for member banks to maintain a sure sum of money on deposit—”required reserves.” Thus, the Fed would power banks to deposit cash with it at zero curiosity, and in flip the Fed would lend that reserve, as wanted, to banks at a optimistic rate of interest. Whereas the Fed was not in search of to earn fixed income on its reserve fund, it at the very least coated its working bills and acted as a financial institution usually does: “borrow low, lend excessive”—albeit with a restricted, crisis-oriented lending function.

At this time, issues are bass-ackwards for the Fed: it’s borrowing excessive and lending low. It’s so backwards that the Fed is shedding a whole bunch of billions of {dollars} yearly. If this had been a Fortune 500 firm, inventory values would have tanked, chapter proceedings could be ongoing, lawsuits could be flying, executives and auditors could be dealing with jail time.  

The distinction with the Federal Reserve, after all, is that it’s a government-chartered central financial institution with a monopoly on issuing base cash, so none of this issues, at the very least legally talking. In contrast to the badly-managed and/or fraudulent companies I in contrast it to, the Fed gained’t exit of enterprise. The Fed can endlessly create new cash to paper over its issues and proceed working as if all the things’s hunky-dory. And in a way, all the things is ok for the Fed, at the very least for now. The Fed is particular, it’s a central financial institution, it’s the federal government. It might excuse itself from commonplace accounting practices and it doesn’t have to show a revenue. Perhaps you’re okay with that, however let me go away you with a deeper observe of fear.

It seems we have now arrived at a second in time the place the answer to any and each potential downside is to print extra money. In spite of everything, printing cash—by way of QE to “stimulate” the moribund US economic system—is what bought the Fed into this case of needing to create a worth flooring on short-term rates of interest (the IORB mechanism). Printing cash to finance huge authorities deficits and stimulus checks is what triggered the largest inflation in 40 years. And now, to boost charges and funky the inflation it created, the Fed finds itself… printing extra money. However this time, on account of the brand new flooring mechanism and IORB, the Fed finds itself able the place it should pay out extra curiosity (on reserves) than it’s incomes (on its Treasury and mortgage bonds). The Fed has painted itself right into a nook the place the answer to each situation includes simply printing cash. Except drastic steps are taken to both cut back financial institution reserves and/or slash rates of interest, the Fed appears to be caught with the losses and the cash printing. This doesn’t bode properly for the way forward for the US economic system. 

Maybe I’ll add a follow-up query on that upcoming quiz:

The Federal Reserve is most definitely to enact which coverage within the near- to medium-term future: 

• Print cash to “stimulate” the economic system by way of QE

• Print cash to “combat inflation” by way of IORB-induced fee hikes

• Print cash to finance $2 trillion US authorities deficits