Before the 2008 global financial crisis, the Federal Reserve’s balance sheet stood somewhere in the neighborhood of $900 billion. In the years that followed, the Fed would embark on a series of large-scale asset purchases—so called quantitative easing (QE)—that would effectively increase its balance sheet tenfold, to more than $9 trillion in 2022. This enormous expansion has erased much of the barrier between monetary and fiscal policy—and ceded key aspects of monetary policy to the politically appointed Treasury Department.
Monetary policy’s principal instrument has traditionally been changes in the short-term interest rate, but that rate can’t be lowered below zero without adverse consequences in the financial system. That’s why economists speak of a “zero lower bound” for rates. During and after the financial crisis, the Fed worried about deflationary risk and looked to provide more monetary accommodation, even after short-term interest rates hit zero. To do so, the central bank engaged in QE, buying longer-dated government bonds and mortgage-backed bonds issued by quasi-government agencies like Fannie Mae and Freddie Mac. The purchase of longer-dated bonds exerted downward pressure on long-term interest rates, providing the additional accommodation that the Fed sought. During the depths of the 2020 pandemic-caused recession, the Atlanta Fed estimated that the central bank’s extraordinary easing programs were providing roughly two percentage points worth of Fed Funds rate cuts to the total amount of monetary accommodation.
Quantitative easing blurs the line between monetary and fiscal policy, however, allowing the Fed to affect fiscal outcomes in several ways. First and most obviously, QE resembles the monetization of government deficits, since any additional bonds sold to the public by the Treasury Department can be offset by the Fed buying them. If the Fed projects that its balance sheet will be permanently higher, as it says is needed to accommodate Basel II bank regulations, then the purchase of these bonds mimics many effects of monetization.
Second, the choice to buy mortgage-backed bonds amounts to credit allocation favoring one sector of the economy (housing) at the expense of others—an inherently political choice and thus nonmonetary. Finally, by altering the maturity profile of Treasury debt available to the public, the Fed is intervening directly in decisions traditionally left to fiscal authorities. Choosing maturity profiles to manage public finances is part of Treasury’s core responsibility.
Years of QE have resulted in operating and capital losses to the Fed as well. Because the QE programs have boosted the quantity of reserves in the banking system so massively, the central bank had to introduce a system whereby it pays interest on reserve balances, providing monetary subsidies to banks. As the interest rate the Fed pays on bank reserves exceeds the rate on its bond portfolio, its operating losses have passed $100 billion. As of the third quarter of 2023, mark-to-market losses on the Fed’s bond portfolio were over $1.3 trillion.
The flip side of the Fed being able to creep into fiscal policy is that Treasury can also creep into monetary policy. As part of its tightening cycle, the Fed decided to let maturing bonds slip off its balance sheet—quantitative tightening (QT)—instead of reinvesting the proceeds into new issues as it had previously done. This QT process increases the net amount of Treasury issuance that must be absorbed by markets, since the central bank takes down less of each auction. In that manner, it provides monetary restriction on the economy, mirroring how QE provided monetary accommodation.
But this procedure also enables the Treasury Department to interfere in the stance of monetary policy. Historically, when Treasury issues debt, on average about 20 percent of the funds raised come via the sale of short-term debt of less than one year’s maturity, called bills, while the other 80 percent are in longer-term notes and bonds. Because notes and bonds carry interest-rate (or “duration”) risk, whereas shorter-maturity bills generally do not, their effects on markets and the economy differ substantially.
Quantitative easing and quantitative tightening work by changing the amount of interest-rate risk provided to markets. If interest rates move by one percentage point, Treasury securities can see swings in market value from a few percent—for Treasury securities in the belly of the yield curve—to almost 20 percent, for 30-year bonds. By contrast, short-term debt will fluctuate only by a fraction of a percent. At any given price, though, investors have only finite desire to take risk. If investors must absorb more duration risk, they are likely to reduce the risk they take elsewhere, unless prices change to make it attractive to take more risk overall.
Thus, an increase in interest-rate risk provided to the market will put upward pressure on risk premia for other assets like equities, pushing stock prices down. That downward pressure on stock prices can lead to corresponding downward pressure in labor markets, as executives try to cut costs to boost earnings, helping to contain inflation.
We haven’t seen this up to now because for most of the past year, the Treasury Department has offset QT by increasing the share of total issuance for bills far beyond the norm. The increased duration risk that QT supplies to the market has been nullified by the reduced duration risk supplied to the market by changes to Treasury’s issuance profile, and political actors at Treasury have managed to run roughshod over the stance of monetary policy.
The heart of the current problem is that the Fed wants QE to be perceived as monetary policy, but not QT. Indeed, former Fed chair Janet Yellen notably said that she thought QT would be “like watching paint dry.” Suppose QT is monetary policy and the Fed is targeting a given total level of restrictiveness: then an intervention by Treasury to offset QT should be countered by even more QT from the central bank. However, if Fed Chair Powell believes QT is merely technical in nature and not monetary policy, then they will ignore Treasury’s intervention, as he seems to have done.
Moreover, even if the Fed aimed to increase its balance sheet reductions meaningfully, it would have to actively sell assets from its portfolio rather than allow them to roll off at maturity, as it currently does. Doing so would realize the enormous mark-to-market losses on its securities profile, implicitly saddling taxpayers with the burden for the central bank’s monetary follies.
It’s clear that Treasury’s interventions have affected markets enormously, with term premiums on ten-year Treasury notes collapsing almost 70 basis points to negative levels since the November 1 refunding announcement. Mortgage rates have gone from over 8 percent to about 6.75 percent, priming a still-tight housing market for further price appreciation, which risks, with a lag, bringing inflation materially higher.
Worse, the Fed has handed Treasury the power to force it to bring forward the date at which it slows the pace of QT and potentially ends QT altogether. Years of unorthodox policy and the Basel III bank regulation process have forced the Fed to create a reverse repurchase facility, or RRP, through which the Fed borrows overnight from market participants. The Fed created the RRP as an arcane matter of monetary plumbing. Because Fed RRP and Treasury bills are both short-term assets with no credit risk, they are near-perfect substitutes—by increasing bill issuance, Treasury ensures the RRP drains more quickly.
By keeping bill issuance high, Treasury is able not only to counteract the QT performed by the Fed but also to force the Fed to taper QT. This is an abomination: monetary policy under the control of fiscal authorities.
Years after the financial crisis and the Covid-19 shock, we are still dealing with the aftermath of the Fed’s QE decisions. It is becoming increasingly obvious that QE can be a useful policy during an event like the financial crisis or the pandemic but not materially afterward. The Fed has engaged in large-scale asset purchases in 11 of the 16 years since the financial crisis—a wildly inappropriate normalization of emergency tools.
The Fed’s abuse of large-scale asset purchases allowed it to change the stance of fiscal policy, but it has now allowed the Treasury Department—and its political leadership—to change the stance of monetary policy. By severely shortening the maturity profile of its issuance, Treasury has provided significant monetary-fiscal easing in the past year, partially offsetting the central bank’s tightening cycle. Allowing Treasury to set monetary policy is extremely dangerous.
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