The Federal Reserve's "$40 billion bond purchase" plan has been packaged as a technical operation, ostensibly to stabilize the interbank market, but in reality, it exposes the risk of an out-of-control balance sheet, posing a challenge for the new chair selected by Trump.
As the "beauty contest" for the next Federal Reserve chair, handpicked by President Trump, continues, it's worth considering the "consolation prize" Powell leaves for his successor—last week's FOMC meeting has dragged the central bank back onto the path of quantitative easing (QE).
After the meeting, most attention focused on Powell's rate-cut decision—the sixth since September 2024, bringing the cumulative policy rate reduction to 1.75 percentage points. However, the Fed also announced through a dry "implementation note" that it would purchase about $40 billion in short-term Treasury bills over the next month and continue buying unspecified (but likely similar) amounts of Treasuries at least through April. There is reason to believe that once the Fed restarts balance sheet expansion, it could continue indefinitely.
The Fed argues this is merely fine-tuning the financial system reconstructed after the 2008 crisis. The core issue lies on the liability side of the central bank's balance sheet and the corresponding changes following asset-side expansion due to QE bond purchases.
After the 2007-2008 financial crisis, the Fed began expanding its asset holdings by purchasing large quantities of Treasuries and mortgage-backed securities (MBS). These assets must be offset by liabilities on the central bank's balance sheet, with the most easily expandable liability being commercial banks' reserve accounts held at the Fed. The central bank creates new money to buy bonds, which flows into reserve accounts as compensation for bonds purchased from banks and their clients.
This operation established a new monetary loop between the Fed and banks. Previously, commercial banks met liquidity reserve requirements through various means, including trading in the overnight reserve lending market. Post-QE, the Fed expected banks to hold higher reserve balances at the central bank to meet emergency liquidity needs.
The term "expected" here is deliberately cautious. The Fed predicted that banks, facing stricter capital adequacy regulations, might prefer safer reserve balances. However, officials also pressured banks to maintain higher reserves through regulatory measures and interest payments on reserve balances.
This new "ample reserves regime" has profound and sometimes immeasurable effects. Due to post-2008 financial regulations treating reserves in risk calculations, high reserve balances (paradoxically) hinder banks from lending to the public and trading Treasuries. Now, another risk has emerged: the Fed losing control of its balance sheet.
This issue surfaced as the central bank repeatedly attempted quantitative tightening (shrinking the balance sheet by letting bonds mature without replacement).
Reducing the Fed's asset holdings necessarily requires shrinking liabilities, but this carries a risk—commercial bank reserve deposits could fall below levels banks deem necessary. No one knows exactly where this threshold lies. But once reserves dip below it, interbank overnight lending rates (where banks replenish reserves) could spiral out of control, deviating sharply from the Fed's federal funds rate target.
This happened in fall 2019, and officials now seem worried about similar signs of turbulence in the interbank market. That's why they decided last week to expand asset purchases (buying Treasuries)—to prevent reserve balances from dropping too low.
The Fed describes all this as technical, unrelated to broader policy. But refusing to call it QE doesn't change its economic essence. While claiming to remain in inflation-fighting mode, the Fed has been forced to restart a form of QE—with all its potential impacts on rates and inflation. This confirms that under the ample reserves regime, the central bank's balance sheet must remain large relative to the economy, with the current ~20% ratio now a new floor.
Worse, suspicions arise that the Fed is losing control of balance sheet policy. For most of the post-2008 period, officials first determined desired asset levels, then adjusted liabilities accordingly. Now, creditors dictate terms—commercial banks can force Treasury purchases simply by demanding more reserves. Otherwise, how to explain QE launched over interbank lending volatility concerns?
The ample reserves regime isn't without alternatives—a topic for future discussion. Among Fed chair candidates, Kevin Warsh appears most eager to abandon the current system. Whoever Trump ultimately selects, advancing this reform will be a worthwhile task.
Comments