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Federal Reserve officials gathered in Jackson Hole heard a pessimistic assessment of the benefits of quantitative easing and their ability to smoothly trim back the Fed’s bloated balance sheet.
“Shrinkage of the central bank balance sheet is not likely to be an entirely benign process,” New York University professor Viral Acharya and his co-authors wrote in a paper presented Saturday during the annual retreat in Jackson Hole, Wyoming. “Our work suggests careful reconsideration of the merits of quantitative easing.”
Quantitative easing, or QE, refers to the massive bond-buying campaigns launched by the Fed during the 2008 financial crisis and unleashed again as the pandemic spread in 2020.
The paper, whose co-authors include Raghuram Rajan of the University of Chicago, was a word of warning for US policy makers, who have begun shrinking their balance sheet -- a process known as quantitative tightening -- even as they raise interest rates to curb hot inflation.
The paper analyzed what happened to liquidity demands on commercial banks during QE and if these claims fell when the balance sheet shrank. It found that the claims grew a lot and didn’t fall by as much during QT. That meant there was less liquidity in the system than suggested by the level of reserves, with implications for financial stability in future periods of strain.
Furthermore, the Fed’s bond buying was designed to support the economy by boosting lending by lowering long-term borrowing costs. But the paper also found that banks didn’t take advantage of the opportunity.
Dampening Effect
“Instead, they have been shortening the maturity of their liabilities, even within deposits, over the period of QE,” they wrote. “This behavior dampens the effectiveness of at least this channel through which QE might work.”
The paper analyzed what happened during the pandemic, plus the Fed’s earlier QE campaign and its experience of shrinking the balance sheet from 2017 until 2019.
The Fed’s balance sheet more than doubled to $8.9 trillion as it flooded the financial system with cash as the pandemic spread in 2020 by buying Treasuries and mortgage-backed securities.
It financed the purchases by crediting the accounts of the institutions that it bought the assets from, thereby creating trillions of dollars in additional reserves. These were parked at commercial banks, which in turn used them to generate extra fees by expanding demandable deposits and lines of credit, the authors wrote.
But the banks did not shrink these claims on their liquidity when the Fed undertook QT in 2017.
The Fed took a gradual approach back then by allowing assets to slowly run off the balance sheet. Yet it still ran into problems when overnight market rates jumped sharply in late 2019 as reserves got too scarce, forcing officials to halt the process and actually push the size of the balance sheet back up by a bit.
This time around it is shrinking the balance sheet much faster. Having started in June, it will step up to a $1 trillion-a-year pace from next month.
“We argue that this asymmetric behavior can explain tightening liquidity conditions and occasional stress when quantitative tightening is underway,” wrote Acharya and co-authors Rajan and Rahul Chauhan of the University of Chicago, and Sascha Steffen of the Frankfurt School of Finance and Management. “Such behavior can make the banking system dependent on the central bank for ever larger liquidity infusions during stress,” they said.
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