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Don’t Fight T-Fed

Summary:
The Fed I: Birth of T-Fed. What a difference a pandemic makes. Prior to the Great Virus Crisis (GVC), Fed officials were either dismissive of Modern Monetary Theory (MMT) or remained silent on the subject since it crosses into the realm of fiscal policy. Fed officials have had a very long tradition of never crossing that line. They do monetary policy. Congress and the White House do fiscal policy. Period! Nothing to see here. Move on. Since the GVC, Fed officials repeatedly and frantically have been exhorting the fiscal authorities to do much more to support the economy. They’ve made it very clear that they will continue to help finance the resulting federal deficits by purchasing most, if not all, of the Treasury debt issued to pay for more fiscal stimulus. They’ve certainly been doing

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The Fed I: Birth of T-Fed. What a difference a pandemic makes. Prior to the Great Virus Crisis (GVC), Fed officials were either dismissive of Modern Monetary Theory (MMT) or remained silent on the subject since it crosses into the realm of fiscal policy. Fed officials have had a very long tradition of never crossing that line. They do monetary policy. Congress and the White House do fiscal policy. Period! Nothing to see here. Move on.

Since the GVC, Fed officials repeatedly and frantically have been exhorting the fiscal authorities to do much more to support the economy. They’ve made it very clear that they will continue to help finance the resulting federal deficits by purchasing most, if not all, of the Treasury debt issued to pay for more fiscal stimulus. They’ve certainly been doing so since March 23, when they implemented QE4ever, which has already mostly financed the $2.2 trillion CARES Act signed by President Donald Trump on March 27. Consider the following:

(1) Consolidating the Treasury & the Fed. Over the past 12 months through August, the federal budget deficit totaled a record $2.92 trillion (Fig. 1). Over the same period, the Fed’s holdings of Treasuries is up by a record $2.26 trillion. Now that the Treasury and the Fed have joined forces in the MMT crusade to drown the virus in liquidity, we might as well consolidate the two of them into “T-Fed.” The result is that the federal government needed to borrow just $663 billion from the public over the past 12 months through August (Fig. 2)!

(2) The Fed’s portfolio of Treasuries. The Fed held a record $4.45 trillion in US Treasuries at the end of September (Fig. 3). That amounts to 24.2% of the Treasury’s marketable debt outstanding (Fig. 4). The Fed owns 20.0% and 36.9% of US marketable Treasury notes and bonds, respectively (Fig. 5).

(3) Good ol’ Feddie. During the Great Financial Crisis, mortgage giants Fannie Mae and Freddie Mac were placed in conservatorship on September 7, 2008. The Fed rose to the occasion and was transformed by then-Fed Chair Ben Bernanke into “Feddie.” QE1 was introduced on November 25, 2008. In this first round of quantitative easing, the Fed committed to purchase $1.24 trillion in mortgage-backed securities and agency debt (Fig. 6). Since QE4ever, the Fed has purchased $618 billion in such securities, bringing their total to a record $1.98 trillion during September. The result has been record-low mortgage rates, which has contributed to the housing boom caused by de-urbanization in response to the pandemic and mounting urban crime (Fig. 7).

The Fed II: De Facto Yield-Curve Targeting. What if another big round of deficit-financed fiscal spending pushes up bond yields and mortgage rates? That would be a big setback for MMT crusaders. The 10-year Treasury bond yield has averaged 0.68% since MMT Day (March 23) through Friday’s close. It rose to 0.79% on Friday, up from the record low of 0.52% on August 4 (Fig. 8).

Have no fear; the Fed is here with YCT (yield-curve targeting), which it will use if necessary to supplement MMT by keeping a lid on bond yields. Actually, the remarkable stability of the bond yield near record lows since March 23 suggests that the Fed may be capping the bond yield below 1.00% without officially saying so.

Ever since March 23, Powell repeatedly has stated that the Fed intends to keep interest rates close to zero for a very long time. At his June 10 press conference, he famously said: “We’re not thinking about raising rates. We’re not even thinking about thinking about raising rates.” He reiterated that policy in his July 29 press conference, saying: “We have held our policy interest rate near zero since mid-March and have stated that we will keep it there until we are confident that the economy has weathered recent events and is on track to achieve our maximum employment and price stability goals.”

Remember that the Fed lowered the federal funds rate by 100bps to zero on March 15. No target was set for the bond yield at that time or has been since then—so far. At the June 10 presser, Nick Timiraos of the WSJ asked Powell about the possibility of “yield caps.” Powell revealed that at the latest meeting of the Federal Open Market Committee (FOMC), the participants received a briefing on the historical experience with YCT and said that they would evaluate it in upcoming meetings. Here is the excerpt on YCT from the June 10 FOMC meeting Minutes:

“The second staff briefing reviewed the yield caps or targets (YCT) policies that the Federal Reserve followed during and after World War II and that the Bank of Japan and the Reserve Bank of Australia are currently employing. … [T]hese three experiences suggested that credible YCT policies can control government bond yields, pass through to private rates, and, in the absence of exit considerations, may not require large central bank purchases of government debt. But the staff also highlighted the potential for YCT policies to require the central bank to purchase very sizable amounts of government debt under certain circumstances … and the possibility that, under YCT policies, monetary policy goals might come in conflict with public debt management goals, which could pose risks to the independence of the central bank.”

So how might the Fed be keeping a lid on the 10-year bond yield? Simple: The Fed has been buying all the bonds that the Treasury has been issuing in recent months and then some. From February through September, the Treasury issued $259 billion in bonds with maturities exceeding 10 years. Over that same period, the Fed purchased $338 billion of such bonds.

The Fed III: How To Print Money. Fed Chair Jerome Powell’s important interview on 60 Minutes with Scott Pelley was aired on May 17. Pelley asked where Powell got the trillions of dollars that the Fed spent on purchasing bonds since March 23: “Did you just print it?” Powell forthrightly responded: “We print it digitally. So as a central bank, we have the ability to create money digitally. And we do that by buying Treasury bills or bonds or other government guaranteed securities. And that actually increases the money supply. We also print actual currency, and we distribute that through the Federal Reserve banks.”

Powell also acknowledged that there was no precedent for the scale of QE4ever: “The asset purchases that we’re doing are a multiple of the programs that were done during the last crisis.” Let’s review how T-Fed’s actions since MMT Day have boosted the M2 monetary aggregate:

(1) US Treasury’s deposit account at the Fed. The Treasury has been borrowing at a record pace in the Treasury market to fund the various government support programs aimed at reducing the economic damage and pain resulting from the GVC. The federal budget deficit has totaled a record-shattering $1.9 trillion from March through September. As a result, the US Treasury General Account at the Fed has jumped from $439 billion at the end of February to $1.7 trillion during the October 7 week (Fig. 9).

(2) The Fed’s US Treasury purchases. Over that same period, the Fed facilitated the Treasury’s massive borrowing with massive purchases of US Treasuries, totaling $1.99 trillion. The Fed now owns a record $4.46 trillion in US Treasuries as of the October 7 week (Fig. 10).

(3) Commercial bank deposits and cash. The Fed also facilitated the mad dash for cash that started during February as the viral pandemic triggered a widespread pandemic of fear. The Fed’s purchases of Treasuries and agency securities from the public boosted commercial bank deposits by $2.28 trillion from the end of February through the September 30 week as the public sold securities to raise cash (Fig. 11).

The huge 20% y/y jump in this liability item on banks’ balance sheets was offset on the asset side by “cash” assets, which are basically the banks’ reserve balances at the Fed (Fig. 12). They really aren’t cash per se, since the banks can’t make loans with these deposits at the Fed. They can make more loans by lending out the increase in their deposits less reserve requirements, which were lowered to zero on March 15. When they do so, the banks also create more deposits. That’s the way a fractional-reserve banking system works. (By the way, the answer to the oft-asked question of why the banks don’t lend out all that cash on their balance sheets is that they can’t, because it is a balancing item determined totally by the Fed’s balance sheet!)

(4) Commercial bank loans. The Fed’s MMT maneuvers also facilitated the $781 billion jump in commercial bank loans from the end of February through the May 13 week (Fig. 13). Commercial and industrial loans soared $715 billion over this same period as businesses cashed in their lines of credit, fearing a cash crunch (Fig. 14). The surge in loan demand was easily funded by the increase in deposits. Indeed, the brief surge in borrowing by banks during the weeks of February 12 through March 25 has been more than reversed subsequently (Fig. 15).

(5) Companies issuing bonds and paying down lines of credit. Now many businesses that had rushed to draw their lines of credit during the mad dash for cash earlier this year are paying them down. Nonfinancial corporations raised a record $1.44 trillion over the past 12 months through August at record-low yields, thanks to the Fed’s backstopping the corporate bond market as part of QE4ever (Fig. 16). And what are the banks doing with the cash from the loan paydowns? They are buying Treasuries and agencies to the tune of $527 billion since the start of this year through the September 30 week (Fig. 17).

The Fed IV: MMT Junkies. T-Fed was born on March 23, the day that the Fed adopted QE4ever. Ever since then, Fed officials have been basically saying: “More, more, more!” They want another round of MMT. They don’t call it that, but that’s what they are asking for.

Fed Chair Jerome Powell was asked about MMT during congressional testimony on February 26, 2019. He hated it back then: “The idea that deficits don’t matter for countries that can borrow in their own currency I think is just wrong,” the Fed chair said. The “US debt is fairly high to the level of GDP—and much more importantly—it’s growing faster than GDP, really significantly faster. We are going to have to spend less or raise more revenue.”

Powell rejected the notion that the Fed should enable fiscal spending: “[T]o the extent that people are talking about using the Fed—our role is not to provide support for particular policies,” he said. “Decisions about spending, and controlling spending and paying for it, are really for you.” In effect, he told Congress: “Fiscal policy is your domain. Leave us out of it.”

Again: What a difference a pandemic makes! Consider the following:

(1) March. In his March 3 and March 15 unscheduled press conferences, Powell said it wasn’t the Fed’s “role to give advice to the fiscal policymakers” and that fiscal policy would need to be handled on a “discretionary” basis.

(2) April. Powell’s fiscal pivot occurred during his April 29 press conference Q&A, when he said: “I have longtime been an advocate for the need for the United States to return to a sustainable path from a fiscal perspective at the federal level. We have not been on such a path for some time, which means … that the debt is growing faster than the economy. This is not the time to act on those concerns. This is the time to use the great fiscal power of the United States to … do what we can to support the economy and try to get through this with as little damage to the longer-run productive capacity of the economy as possible.”

(3) June. During his June 10 press conference, in prepared remarks, Powell said: “I would stress that [the Fed has] lending powers, not spending powers. The Fed cannot grant money to particular beneficiaries. … Elected officials have the power to tax and spend and to make decisions about where we, as a society, should direct our collective resources. The CARES Act and other legislation provide direct help to people and businesses and communities. This direct support can make a critical difference not just in helping families and businesses in a time of need, but also in limiting long-lasting damage to our economy.”

(4) July. During his July 29 press conference Q&A, Powell stated: “Fiscal policy … can address things that we can’t address. If there are particular groups that need help, that need direct monetary help—not a loan, but an actual grant as the PPP program showed—you can save a lot of businesses and a lot of jobs with those in a case where lending a company money might not be the right answer. The company might not want to take a loan out in order to pay workers who can’t work because there’s no business.”

(5) September. In prepared remarks at his September 16 presser, Powell said: “The path forward will also depend on the policy actions taken across all parts of the government to provide relief and to support the recovery for as long as needed.” In the Q&A, he warned that “as the months pass … if there isn’t additional support and there isn’t a job for some of those people who are from industries where it’s going to be very hard to find new work, then that will start to show up in economic activity. It will also show up in things like evictions and foreclosures and, you know, things that will scar and damage the economy.”

(6) October. At the National Association for Business Economics virtual annual meeting on October 6, Powell reiterated his call for more MMT: “By contrast, the risks of overdoing it seem, for now, to be smaller. Even if policy actions ultimately prove to be greater than needed, they will not go to waste. The recovery will be stronger and move faster if monetary policy and fiscal policy continue to work side by side to provide support to the economy until it is clearly out of the woods.”

An October 7 WSJ editorial commented: “It’s important to understand how unusual this is. The Fed’s job is monetary policy and financial regulation. Yet here is a Fed chief lobbying Congress, and the public, on behalf of one side of a fiscal debate.”

(7) Other talking Fed heads. And the beat goes on … On Thursday, Dallas Fed President Robert Kaplan said in a Bloomberg Television interview: “I think the Fed can do more, and I’m sure we’ll look at all our options, but those aren’t substitutes for fiscal policy.”

The same day, Boston Fed President Eric Rosengren emphasized in an interview with Bloomberg News: “There’s a limit to how far we can push the 10-year Treasury rate or the mortgage-backed rate down.” He added: “That’s not to say we shouldn’t do it. It just says the magnitude of the impact, when rates are already so low, is probably much less than what we want, which is why I think you’re hearing Federal Reserve speakers call out for more fiscal policy.”

The Fed V: MMT’s Best Friends Forever. The Fed isn’t the only central bank that has embraced MMT. Arguably, the Bank of Japan (BOJ) led the way with its zero-interest-rate policy, which has been in place since the late 1990s. The People’s Bank of China certainly has enabled China’s commercial banks to finance lots of government spending since 2008.

In her September 4, 2019 speech as the new president of the European Central Bank (ECB), Christine Lagarde called on “the other economic policy makers” to do “what they had to do” to stimulate economic growth. And that was before the pandemic. Since the World Health Organization declared the pandemic on March 11, the ECB’s assets have soared by €2.0 trillion to a record €6.7 trillion (Fig. 18). This past July, the European Union approved a €750 billion economic recovery fund, which will be financed by issuing common debt, providing more bonds for the ECB to buy.

On Thursday, September 17, BOJ Governor Haruhiko Kuroda pledged to work closely with the country's new Prime Minister Yoshihide Suga to support the economy. So far, Suga has indicated that he is not focused on the inflation target. Instead, a top priority of his administration is protecting jobs, reported Reuters. Suga’s emphasis on jobs may influence Kuroda to deemphasize the importance of the inflation target, as Powell’s Fed has recently done. Since the last week of February through the September 25 week, the BOJ’s balance sheet has soared 18% in yen (Fig. 19).

The three major central banks are all MMT’s BFFs (best friends forever).Their combined balance sheet has jumped $6.8 trillion to a record $21.2 trillion since the February 21 week through the September 25 week (Fig. 20). Here in dollars are each of their increases over this period and their most current record highs: Fed ($3.0 trillion $7.0 trillion), ECB ($2.5 trillion, $7.6 trillion), and BOJ ($1.3 trillion, $6.6 trillion).

It’s good to have friends.

Dr. Ed Yardeni
Dr. Ed Yardeni is the President and Chief Investment Strategist of Yardeni Research, Inc., a provider of independent investment strategy and economics research for institutional investors. In this blog, we highlight some of the more interesting relationships and developments that should be of interest to investors. Our premium research service is designed for institutional investors.

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