26 Sep 2017 20:19 IST

The Fed begins to correct its balance sheet

Macro-economics experts are likely to have a fun ride now

With the world consumed by anxiety over an armed conflict between North Korea and the US, and escalating tensions in Iran following the UN meetings in New York, many missed an important headline: The US Federal Reserve will begin withdrawing some of the trillions of dollars it had invested in the wake of the 2008 financial crisis.

When reserve banks and governments act on monetary issues, extreme measures are talked about for generations. India’s demonetisation of 2016 will be one such example because of the impact it had on every man, woman and child in the nation.

The 2009 decision

If one were to measure actions by global impact, the decisions taken by the Fed in 2009 have no modern parallel. With the US facing a huge cash crunch after the 2008 financial meltdown, the government injected $800 billion into the economy to help save banks and companies, chiefly General Motors and American International Group, through a fiscal measure (tax, borrow and spend) called the Troubled Assets Relief Programme (TARP).

When the Fed realised this move​ was a drop in the bucket and unlikely to correct the situation, it launched a series of monetary policy actions. It began to print money to buy up US treasury bonds and mortgage-backed securities. The goal was to pump additional cash to the financial sector beyond TARP — cash that, the Fed hoped, would be lent to consumers and businesses to motivate economic growth.

A measure of this scale — flooding banks and financial institutions with enormous amounts of cash — was unprecedented. Because treasury and mortgage securities are held by organisations world over, this amounted to flooding the world with cash.

At its peak, the Fed was buying $85 billion-a-month of assets, leading to a total asset accumulation of $5 trillion. Parts of this $5 trillion got pumped into emerging markets such as India, lifting stock indices and shoring up the rupee; it was lapped up by banks to increase business lending worldwide for working capital and investment reasons.

In short, the Fed’s buying spree, dubbed quantitative easing, or QE, helped save the world from certain economic doom, although that was never its goal. The US Congress, in 1977, required the Fed to do whatever it could to keep US unemployment rate low. This dual mandate of maintaining the dollar’s value (managing inflation) and managing US unemployment resulted in its unprecedented QE programme. In other words, the Fed was simply doing what it was required to do by law.

Aside from political expediency

Can a country’s central bank have so much power? The answer is a resounding ‘yes’. The privilege (and global responsibility) of deciding the supply (and hence, the value) of the dollar belongs to the seven unelected governors of the Fed. Once nominated by the President and confirmed by the Senate, a governor serves for 14 years unquestioned. A member who serves a full term may not be reappointed.

Career protections allow members to act on their wisdom, conscience and experience without regard to political expediency: a 14-year term spans more than three presidential terms. Contrast this situation with what happened in Delhi last year, when the term of former RBI governor Raghuram Rajan, a brilliant academic trained in the Chicago school of conservative economics, was not extended beyond three years because he had differences with the mandarins of the Finance Ministry.

Balancing the ledger

Getting back to the Fed’s QE programme. From a strictly accounting angle, what the Fed did is a collection of simple debit/credit transactions, the kind we all learn in a basic accounting class. Cash (although manufactured from thin air) was spent to acquire something — and so, this would be a credit transaction appearing on the right hand side of the Fed’s ledger. It received treasury bonds and securities as a result of the transaction, and this appeared as a debit on the ledger. For a balance sheet to equalise, credits must equal debits.

The move was brilliant in that all the assets it acquired, such as bonds, had an expiry date. When a bond matures, the Fed has an obligation to return it to the original holder (this would be a credit entry in the ledger) and demand cash in return with interest, a debit entry. Because the values of the two entries are identical, the balance sheet is, again, unchanged. All that has happened is that the content of the Fed’s sheet has changed from bond to cash.

The impact on the economy is, however, quite significant. The bond holder has to corral cash from somewhere to pay the Fed and receive the bond or security instead. This amounts to vaccuuming real money from the economy to return to the Fed — an action exactly opposite to the flooding of cash by the Fed eight years ago.

This tightening means that the world, used to an excess of $5 trillion of cash in the last eight years, has to slowly see it all returned. As a result, money in the economy becomes scarce and increased demand for the dwindling money results in rising interest rates. The red-hot US economy will likely cool a bit but the hope is that it can overcome the action and continue to grow. Over time, if all other things are equal, the dollar will likely rise and the rupee will fall.

Luckily, the Fed has decided on a soft landing approach wherein it gradually shrinks its bond portfolio, only as they mature, at a rate of about $10 billion per month or $30 billion a quarter. Over time, it will increase the pace until it reaches $150 billion a quarter, or a monthly rate of $50 billion. It is expected to maintain this pace until it has essentially sucked all the excess money back into its vaults, in effect, causing it to vanish. Easy come, easy go.

Worldwide impact

As I have noted before, the Fed’s actions have an oversized impact not just in the US but around the world. The supply and demand equation of the US dollar still drives international trade, invoicing and settlement. Most commodities worldwide (oil, gas, soyabean, wheat and more) are priced, sold and bought in dollars. Sixty per cent of the dollar’s circulation is outside the United States. According to the Bank for International Settlements, the dollar was on one side of 87 per cent of all international trades in 2013; in contrast, the rupee was on one side of just 1 per cent of all international trade.

Quantitative easing was one of the biggest macro-economic strategies of the last 30 years. Now, we are in an era where this policy is slowly being reversed to Quantitative Tightening. No one knows yet how this will play out but students of macro-economics are likely to have a fun ride.

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