QE’s Cost: Fed Exit May Hit Economy Faster Than in Past Cycles

The Federal Reserve will have to confront the costs of its massive balance-sheet expansion when policymakers raise interest rates.

The U.S. central bank’s exit strategy from unprecedented stimulus looks set to send big ripples through the financial system once it begins. These could hit the economy faster than they did in past tightening cycles, as rate rises radiate through a banking system constrained by new regulations and flooded with cash created by the Fed’s bond-buying program.

The question is what that means for the economy and how it alters Fed Chair Janet Yellen’s calculus over the pace of tightening. Understanding the plumbing of the new financial landscape will be vital for policy makers trying to fine-tune the economy and investors navigating turbulent markets.

“There are three or four things about how the financial system works that most people didn’t understand and didn’t really need to understand before 2008,” said Peter Stella, who led the central banking and monetary and foreign exchange operations divisions of the International Monetary Fund from 2005 to 2009. “They still don’t understand them, so I think there’s a lot of risk of volatility when things actually start happening.”

New Tools

Yellen and her colleagues on the Federal Open Market Committee wrap up a two-day meeting on Thursday to debate whether to increase the benchmark federal funds rate, which they have held near zero since late 2008. If and when they do move, it won’t be like before, and they’ll be using new tools to lift rates higher.

In the past, the central bank kept the fed funds rate at or near the target chosen by policy makers by injecting or draining bank reserves from the system via the New York Fed’s trading desk. The amounts of cash involved were small and the Fed was pretty good at hitting its desired rate. Not anymore.

Three rounds of so-called quantitative easing from 2008 to 2014, in which the Fed bought bonds to support the economy, has swamped banks with cash — deposited with them by investors who sold bonds to the Fed. That added $2.6 trillion of reserves in excess of requirements to banks’ accounts held at the Fed. It also boosted the size of the Fed’s own balance sheet to $4.5 trillion, a five-fold increase from pre-crisis levels.

“We don’t know what’s going to happen when we lift off,” Simon Potter, the New York Fed official in charge of the trading desk, said in April, answering questions after a speech. “We’re pretty sure that we have the ability to lift rates at the initial point.”

Money Markets Swamped

With so much cash and little need for banks to borrow in the fed funds market, the Fed has lost the ability to lift the funds rate in the way that it did before the crisis. It has also decided for now against selling the bonds back to investors, which would shrink its own balance sheet and extinguish the excess reserves.

Instead, Fed officials designed new tools to help the central bank raise rates without reducing its balance sheet, which it hopes to slowly shrink over years by letting the bonds it now holds mature, without reinvestment. Officials say they expect to phase out reinvestments sometime after liftoff. Their main innovation, an overnight reverse repurchase agreement facility, is a powerful solution, but heavy usage may cause problems for banks trying to comply with new regulations installed in the wake of the financial crisis, said Zoltan Pozsar, director of U.S. economics at Credit Suisse Securities USA LLC in New York.

The facility promises to drain reserves from the banks by encouraging investors to withdraw the deposits created when they sold bonds to the Fed, and place the cash in money-market mutual funds.

Through overnight reverse repos, the Fed can borrow the cash from money funds at a specified rate and post securities as collateral, unwinding the trades the next day. In effect, the Fed will be borrowing back the money it created to buy the bonds while cutting out the middlemen in the banking system.

Deposit Flight

The problem: Banks aren’t sure exactly how much of their deposits they will cede to money-market funds once the Fed starts raising rates, or whose money or how fast. All of those things are important to understand for banks trying to stay in compliance with the liquidity coverage ratio, a major new pillar of global post-crisis banking regulation.

“To the extent that the financial regulations affect behavior in the overnight markets, that will make a difference,” said Stephen Williamson, an economist with the St. Louis Fed. “These are all things we’re thinking about.”

The liquidity rule requires banks to hold more cash and other “high-quality liquid assets” like Treasuries and government-backed mortgage bonds against their deposit base to protect themselves from runs. Because they can hold less cash against retail deposits than investor deposits, they will probably raise retail-deposit rates aggressively to hang on to these customers, according to Pozsar, who previously studied the plumbing of the post-crisis financial system in positions at the New York Fed and U.S. Treasury.