Quantitative Easing Debate Misses the Point (March 21, 2023)

Recent central bank interventions suggest the elusive Fed pivot is here–with QE not far behind.

By Lisa Beilfuss
March 21, 2023

The debate about whether the Federal Reserve’s latest emergency lending is a stealth form of quantitative easing misses the bigger picture. Financial and economic conditions are deteriorating as lagged monetary policy bites, and overt QE is probably coming sooner than some investors appreciate.

In the week ending March 15, the central bank’s balance sheet expanded by about $300 billion, to $8.64 trillion, as banks tapped the Fed’s discount window and new Bank Term Funding Program for emergency liquidity. The new loans in aggregate are equivalent to the amount of quantitative tightening conducted over the past four months, where the Fed has been letting bonds roll off of its balance sheet to reverse some of its $5 trillion in pandemic purchases.

The latest infusions aren’t exactly QE. They are via bank loans as opposed to outright Fed asset purchases, and about half of those loans appear to be on account of a few troubled banks tapping the Fed’s discount window. Many economists and strategists say banks will hang on to the new cash that is intended to plug holes in banks’ balance sheets, versus lend it, meaning the money lent to institutions won’t stimulate the economy. Moreover, they say the Fed’s balance-sheet boom reflects the kind of pain that portends tighter credit conditions and broader economic contraction.

But some say it isn’t so black and white. Joe LaVorgna, chief U.S. economist at SMBC Nikko Securities, says the recent balance-sheet expansion is “a backdoor way to do QE,” arguing that while the Fed isn’t directly buying securities off of banks’ balance sheets, it is creating bank reserves. A related argument: It can’t be assumed that none of the new money flows out of bank reserves and into the real economy. The idea is that while the latest injections aren’t akin to the QE that fuels risk assets, second-order effects might resemble something more stimulative.

More important than the definition and technicalities of recent interventions is the signal they send to markets. The Fed is boosting bank reserves at a time when monetary policy has been focused on draining reserves. That is not to mention the emergency move to enhance swap lines, allowing foreign central banks to access dollars directly from the Fed daily instead of weekly. The financial strain central bankers are trying to ease now will only worsen as a year of aggressive interest-rate increases start to kick in.

While some strategists suggest the recent efforts to stabilize the banking system give the Fed room to continue tightening through higher interest rates and ongoing QT, any such effort to two-track macro prudential and monetary policy would probably be short-lived and counterproductive.

The Fed has run into the liquidity floor, and hard, says Lyn Alden, founder of Lyn Alden Investment Strategy. “QT is probably over,” she says, “since any further attempts to withdraw liquidity will need offsetting loans to avoid bank runs.”

That isn’t to dismiss inflation concerns. Consider that the Praxis index of essentials within the consumer price index rose 7.8% in February from a year ago, well above the Labor Department’s 6% headline figure. Even excluding the cost of shelter, which high-frequency private data suggest is falling faster than government reports reflect, Praxis finds the prices of basic foods, gas and utilities still rose nearly 8% year-over-year in the latest month.

But the reality is the financial system probably can’t tolerate more tightening–or even the already-implemented tightening that has yet to make its way through the financial system and economy. As Matthew Luzzetti, chief U.S. economist at Deutsche Bank, puts it, “everything, everywhere looks sufficiently restrictive, all at once.” He recently cut his forecast for the Fed’s peak rate to 5.125% from 5.625% and expressed “substantial uncertainty” about the Fed outlook.

Only weeks ago, some economists and investors feared a policy rate of around 6% would be needed to bring inflation back to the Fed’s 2% target. For context, at this time last year Fed officials predicted a terminal rate of 2.8%. Now, calls for substantially more rate increases are fading fast and markets have started pricing in rate cuts as early as June. Apollo chief economist Torsten Sløk quantified the impact of recent bank failures on financial conditions and lending standards, estimating the equivalent of an additional 1.5 percentage point increase in the Fed’s policy rate. That in effect suggests the policy rate has already breached 6%.

Traders have placed 15% odds on a pause when the Fed meeting concludes Wednesday, with the balance favoring another quarter-point increase. The latter result may give way to future rate increases should inflation remain stubborn or reaccelerate. The former outcome would probably speed up rate cuts and the return of QE. LaVorgna of SMBC Nikko predicts classic QE–the kind that fuels risk assets–will return in July, at which point he also expects rate cuts to begin.

Compared with some past tightening campaigns, the fast pace of rate increases gives the Fed more to cut this time before reaching the zero bound and resorting to quantitative easing. But the bank-related events and interventions of the past week suggest the elusive Fed pivot is here–whether or not the Fed follows through with a hike this week.