“Now is not the time to worry about shrinking the deficit or shrinking the Fed’s balance sheet.”
Steven Mnuchin
Treasury Secretary
New York | With the onset of the latest phase of quantitative easing or QE in March, the Federal Open Market Committee has pushed financial repression back up into the high 80s as measured by the Financial Repression Index. This index measures the distribution of bank interest income between depositors and other creditors, on the one hand, and bank equity holders, as shown in the graph below.
Source: WGA LLC
The negative impact of Fed market manipulation is profound when measured against financial repression inflicted upon savers. The Fed purchases US Treasury debt and agency mortgage backed securities, and remits back the income from this $7 trillion portfolio to the Treasury, less the Fed’s operating expenses. This example illustrates, BTW, that the central bank is an expense to and an appendage of the US Treasury.
By pushing down the cost of funds for banks, the FOMC is effectively transferring income from consumers and institutional savers to the shareholders of banks. This social engineering is intentional and done without apology by the Fed much less specific authority from Congress. Savers are at the mercy of economists.
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Fed officials argue that such machinations as diverting trillions of dollars per year from savers to debtors are "necessary and proper" to fulfill the Humphrey Hawkins mandate, but demur when it comes to the "net" benefit of taking trillions in cash away from consumers and investors. To be fair, other central banks around the world also subsidize their indebted governments by purchasing sovereign debt under the rubric of "economic stimulus."
Periodically you will hear some learned economist wax on about how low interest rates have reduced the cost of servicing the Treasury’s massive debt. But the blessings of neo-Keynesian economics go only to debtors. The US government is the single biggest beneficiary of QE.
The truth of the matter is that when the FOMC is buying Treasury paper and MBS at the present clip, the Treasury has no cost of funds at all. No less an authority that the Wall Street Journal noted last week that “U.S. deficit nearly tripled in first 11 months of fiscal 2020, Treasury Department says, but low rates reduce net interest costs by more than 10%.” And Chairman Powell reduced the Treasury's interest expense nearly to zero in 2020.
When Fed Chairman Jay Powell is giving the Treasury the interest earned in its Treasury portfolio and also remitting back the earnings on $1 trillion in MBS, Treasury Secretary Steven Mnuchin and Congress are flying for free. Just how is this stimulative to the economy and particularly consumers Chairman Powell?
The Fed is transferring hundreds of billions in income from private investors to the Treasury via QE, hardly an example of a progressive economic stimulus. Rather, it seems the monster is consuming the creator. While there are doubtless benefits for debtors in the Fed’s current scheme of forcing rates down and trying to gin-up inflation, holders of assets -- depositors of banks and bond investors -- are the sure losers.
Interest earnings forgone by bank depositors run about $500 billion annually thanks to the generosity of Chairman Powell and his colleagues on the FOMC. Figure at least another buck for bond interest and interest on a trillion in agency MBS that goes directly to Secretary Mnuchin. That's $1.5 trillion a year taken from consumers and other savers thanks to QE.
So even as we've see the system open market account (SOMA) grow to over $7 trillion since March, don't hold your breath waiting for it to come down a la 2018-2019. The FOMC will likely continue to purchase Treasury bonds and MBS indefinitely so as to keep the SOMA stable. This means that the double digit inflation of bank balance sheets may also be a permanent fixture in the financial world.
We can all pretend that inflation is low, but consumers and institutional investors will pay the cost. Call it monetary life support. This implies a continued transfer of hundreds of billions of dollars annually from depositors and bond investors to the US Treasury, encouraging further economic profligacy in Washington and more silly walks down Wall Street.
Indeed, one of the delicious ironies of the current situation as we approach the November election is that the Democrats and Republicans both assume that they can continue to expand spending and the national debt without any economic or political consequence.
When former Vice President Joe Biden talks about raising and spending $3 trillion in his first year, he means it. But that may or may not be possible, regardless of what our friends on the FOMC do or do not. We're waiting for a candidate that wants to raise taxes and not raise spending.
The FRBNY noted in a recent blog:
“Extreme economic uncertainty caused many market participants, such as asset managers and central banks, to exit Treasury positions to raise liquidity as volatility rose sharply. Broker-dealers, such as the primary dealers, make markets in Treasury and other securities: they purchase securities from sellers, holding an inventory over time, and ultimately sell securities to market participants looking to buy. Given the substantial sales in March, dealer inventories rose notably, particularly in Treasury coupons, as shown in the chart below.”
The primary dealers as a group almost got blown out in March, like most restaurants in lower Manhattan right about now. The Powell Fed knows that direct support for the Treasury market via QE is a permanent fixture on the economic scene.
And they know that the dealer banks have zero appetite for supporting a failing Treasury market, meaning that the Fed of New York is the market. Indeed, the Fed’s supposed change in policy regarding inflation targeting was really just window dressing, lipstick on the proverbial pig. The economists will talk about inflation, but the reality is in more or less continuous open market operations.
Just as with downside of manipulating interest expense, the economist fraternity misses the punch line. Inflation must be higher because the Fed must continue to buy trillions in Treasury debt and agency MBS each year. No matter who wins the presidential election in November, have no doubt that Chairman Powell is the most important man in town.
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