The Fed and QE4

The Fed and QE4

The Fed and QE4

“Quantitative easing” is the name given to when the Federal Reserve buys debt directly–typically debt issued by the US Treasury or mortgage-backed debt that is guaranteed in some way against default by the federal government.

This policy has various rationales. For example, during the Great Recession of 2008-9, there was fear in the markets that, as housing prices fell, mortgage-backed debt would be worth much less. Because many banks and financial institutions held such debt, a drop in the value of that debt risked making a target="_blank" number of financial institutions insolvent. In this setting, Fed purchases of such debt soothed the markets and prevented panic. In addition, quantitative easing can be viewed as a way for a central bank to stimulate the economy, when the central bank had already pushed down its main policy interest rate to nearly zero percent. The idea here is that when the Fed can’t reduce interest rates any further using conventional policy channels, it can still keep interest rates lower than they otherwise would have been by purchasing debt directly and then holding it.

However, a series of quantitative easing policies over time mean that the central bank ends up holding a lot of debt. Back in 2007, for example, the Federal Reserve held about $900 billion in total financial assets, which in terms of a central bank was thought of as a fairly basic amount for carrying out its functions. After three rounds of quantitative easing in 2008, 2010, and from 2012-2014, the Fed had about $4.5 trillion in assets by the end of 2014. But then the Fed carried out a fourth round of quantitative easing, QE4, during the pandemic, and total Fed assets went from $4.1 trillion at the start of 2020 to almost $9 trillion by March 2022.

The rationale for QE4 at the start of the pandemic in March 2020 was straightforward. For a few days that month, there was turmoil in the markets for US Treasuries, there was a short period where the market for US Treasury debt seemed to stop operating well. Darrell Duffie described it this way:

The market for U.S. Treasuries has long been viewed as the world’s most liquid and deepest financial market. That presumption was questioned when the COVID-19 crisis triggered heavy investor demands for trading that overwhelmed the capacity of dealers who usually serve as middlemen in this market. Over several tense days in March [2020], yields rose sharply, calling into question the longstanding view that Treasuries are a reliable safe haven in a crisis. Bid-offer spreads widened dramatically, the yields of similar-maturity Treasuries were no longer close to each other, and the number of failures to settle jumped. Although the Fed, through an unprecedented quantity of Treasury purchases and other actions, was able to restore market liquidity, the episode revealed the Treasury market to be overdue for an upgrade.    

But although there were obvious reasons for QE4, both in terms of salving the world's roiled financial markets and in terms of supporting the US economy during a very uncertain time, holding debt has risks. In particular, if you own a lot of debt that pays a low interest rate, and then interest rates go up, you are locked into that lower interest rate and the value of the debt declines. This is the opposite effect, for example of being a mortgage-holder who locked in a low interest rate before the pandemic, and now has the advantageous position of paying off that mortgage in a situation where current interest rates are much higher. Andy Levin and Bill Nelson provide an overview of the financial losses of the Fed as a result of building up a portfolio of debt paying low interest rates at a time when interest rates have now risen, in The Federal Reserve’s Balance Sheet: Costs to Taxpayers of Quantitative Easing (Mercatus Center, George Mason University, January 10, 2023).

One way of looking at this situation is that the Fed is receiving a relatively low interest rate from its past asset purchases of debt. However, the main mechanism that the Fed uses to raise interest rates is to pay a higher interest rate to banks on the reserves that banks hold at the Fed–and so the Fed’s financial position is much worse. Another way to look at the situation is to figure out how much the value of the Fed’s low-interest debt would be diminished if the Fed had to sell that debt in today’s market of higher interest rates. Levin and Nelson calculate that the Fed assets have declined in market value by about $760 billion.

As I noted already, there were reasons for the burst of QE4 in 2020. But there was apparently little attention paid to the risk that the higher interest rates would cause the value of the Fed’s debt to fall. Levin and Nelson call the process “opaque and inertial.” For example, if the Fed had originally announced that QE4 was a short-term step to calm markets during a time of turmoil, and then moved ahead to sell of that US Treasury debt when financial markets stabilized by summer of 2020, it could have been holding trillions less in low-interest assets by 2021.

But at least as far as I can tell, the Fed didn’t consider such a policy, because in 2020 the Fed wasn’t expecting interest rates to rise. After all, inflation rates don’t start rising until April and May 2021. Before that, and even for a while after that, the Fed was focused on keeping interest rates low to support the economy as the pandemic evolved. Thus, the Fed seems to have just flat-out missed the risk that it would be holding a lot of debt paying lower interest rates at a time when interest rates would rise.

The usual pattern for the Fed is that it is self-funding–and in fact, it passes along about $100 billion per year to the US Treasury. However, because of the financial losses the Fed has incurred on its assets, Levin and Nelson write: “The Fed will absorb that cost by completely suspending its remittances to the US Treasury for the next five years and paying minimal remittances in subsequent years. The Fed’s remittances would have exceeded $100 billion per year throughout the coming decade if QE4 had not been conducted.” In that sense, it looks like the decision of the Federal Reserve not to hedge against the risk of higher interest rates–for example, by selling off a substantial share of its QE4 assets by early 2021–will contribute to bigger budget deficits for years to come.

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Timothy Taylor

Global Economy Expert

Timothy Taylor is an American economist. He is managing editor of the Journal of Economic Perspectives, a quarterly academic journal produced at Macalester College and published by the American Economic Association. Taylor received his Bachelor of Arts degree from Haverford College and a master's degree in economics from Stanford University. At Stanford, he was winner of the award for excellent teaching in a large class (more than 30 students) given by the Associated Students of Stanford University. At Minnesota, he was named a Distinguished Lecturer by the Department of Economics and voted Teacher of the Year by the master's degree students at the Hubert H. Humphrey Institute of Public Affairs. Taylor has been a guest speaker for groups of teachers of high school economics, visiting diplomats from eastern Europe, talk-radio shows, and community groups. From 1989 to 1997, Professor Taylor wrote an economics opinion column for the San Jose Mercury-News. He has published multiple lectures on economics through The Teaching Company. With Rudolph Penner and Isabel Sawhill, he is co-author of Updating America's Social Contract (2000), whose first chapter provided an early radical centrist perspective, "An Agenda for the Radical Middle". Taylor is also the author of The Instant Economist: Everything You Need to Know About How the Economy Works, published by the Penguin Group in 2012. The fourth edition of Taylor's Principles of Economics textbook was published by Textbook Media in 2017.

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