The Fed has no urgent need to unwind its bond holdings, and good reasons not to do so. The central bank is banking on inflation to inflate away the problem.
In such settings, the stock market will continue to march upward and onward thanks to the ample liquidity.
Which, in a nutshell, explains why the Fed is tough on banks: To keep speculative excesses and imbalances from having systemic consequences in this golden age of liquidity.
In my article of Jan. 23, 2014 with the title "Inflation Is The Last Piece Of The QE Puzzle", I argued that the Federal Reserve (the Fed) is committed to maintaining very low interest rate to rekindle inflation, and U.S. equities will continue to rally as a result. So far, the prediction is looking good. The S&P 500 has been hitting records on expectation that the Fed will stay highly accommodative for a considerable time.
It is a no-brainer to suggest that the market's run-up is in large part due to quantitative easing (QE), during which the Fed has purchased more than $3 trillion in Treasuries and agency mortgage-backed securities (MBS) - a very significant amount vis-à-vis the size of the stock market (about $23 trillion) or the size of the economy (about $17 trillion). But to see how the mechanism works, we can start with a hypothetical case that the Fed buys from JPMorgan, say, $1 billion worth of MBS paper that the bank has bought in turn from an individual called Tom. Because the Fed needs to issue $1 billion credit to JPMorgan's reserves, while JPMorgan needs to credit the same amount to Tom's deposit account, the result is a $1 billion increase in both bank reserves and bank deposits (see Figure 1). This is plain and simple.
Now, let's see what happens in the real situation. Figure 2 below shows the Fed's balance sheet since 2007. During this period, the central bank purchased $3,016 billion of MBS and Treasury securities, which should result in an increase of $3,016 billion in both bank reserves and bank deposits, ceteris paribus. In normal times, banks would respond by increasing lending, simultaneously creating more loan asset and more deposit liability on their balance sheets. Yet, this is not the case today because banks do not "lend out the new reserves" (this is in layman's words, though not correct because banks cannot lend out reserves to customers); instead, they just buy up more MBS and government securities at a time when they are selling those securities to the Fed.
As can be seen in Figure 3, private depository institutions gobbled up $1,090 billion of Treasury securities, Agency- and GSE-backed securities and Municipal securities over the period of 2007-13, in contrast to a drop of $161 billion in bank lending. There are two implications: Firstly, although the Fed is purchasing assets from banks, it is in fact purchasing assets from the public. This essentially means the central bank is replacing the Treasury and MBS securities held by the public with bank deposits. All this has the private sector ending up with abundant bank deposits that pay almost no interest. The other implication is that these deposits are not created by extension of bank credit, which is why the link between bank deposits and bank lending breaks down in recent years (see Figure 4).
As discussed before, asset purchases by the Fed and by private depository institutions account for a total $4,106 billion ($3,016 + $1,090) increase in bank deposits. Although $394 billion of which was withdrawn by depositors and held in the form of currency outside banks (see Figure 2) while $161 billion was reduced due to credit contraction (see Figure 3), bank deposits still increased a hefty $3,551 billion - or to be exact, $3,208 billion after including all minor factors that affect the deposit creation process (see Figure 3). This surfeit of bank deposits (or QE deposits as I call them) creates demand for goods and services. It drives the economy when interest rates can go no lower. Ditto the stock market, with tremendous cash balances waiting to be put to work.
Needless to say, such an explosion of money supply may reduce the value of money. In other words, the time value (interest rate), external value (exchange rate) and internal value (purchasing power) of dollar may go down. Yet this poses no worthy risk to the economy, for a variety of reasons.
First of all, it is true that prolonged period of low interest rates could lead to excessive investment and asset bubbles. But as tight regulations have kept banks from lending recklessly and investment spending has not been robust during the current recovery, speculative excesses are not easy to build up. And even if they do (in some assets, for example), the risk of a burst bubble taking down the financial market is not high. This is because QE deposits are not created by bank lending and, therefore, the contagion effect should be moderate since investors are losing their own money rather than borrowed money.
Then there is exchange rate. As noted earlier, $3,208 billion of new deposits are now sitting in the hands of the public. The fear is that if a sizable number of depositors choose to convert this money into an alternative currency, then the US dollar may crash.
This is a real enough concern, but set against it is the fact that major central banks of the world are inflating money supply through QE policies as rapidly as the Fed. Add to that the greenback remaining the world's primary reserve currency, and the odds of a dollar slump are low. Even more, asset purchases by banks and by the Fed do not create more dollar assets into the economic system. It is a swap of bank deposits for MBS and government securities - all are US dollar assets.
The more legitimate worry is inflation. As Nobel laureate Milton Friedman put it, "Inflation is always and everywhere a monetary phenomenon." Currently, banks are flush with deposits but short of lending prospects. Tight regulations and scrutiny also make them less eager to extend loans. However, as sentiment continues to improve, credit activity will pick up along with investment. Holders of the $3,208 billion QE deposits are also more willing to spend. When aggregate demand exceeds aggregate supply, inflation kicks in.
To curb inflation, the Fed has two options. It can either raise the rate paid on reserve balances to discourage bank lending, or it can sell the Treasury and MBS securities that it has acquired through QE, thereby reducing bank reserves and bank deposits.
Both options have drawbacks, though. Paying higher interest on reserves would squeeze the budget of the central bank. A back-of-the-envelope calculation is this: At the end of 1Q14, depository institution reserves stood at $2,444 billion. If the rate were 2.5%, then the Fed would need to pay out $61 billion every year. So unless the Fed made a substantial profit somewhere, it would need to "print" more money and create more bank reserves, digging itself deeper into the hole.
Nor is the unloading of the Fed's massive bond holdings a viable option. It is because with the economy still fragile, and mindful that banks are holding large amounts of government and MBS securities on their books, even a small unwinding of the Fed's balance sheet may lead to a sharp spike in bond rates and huge losses on banks' bond portfolios, jeopardizing the recovery. This gives policymakers a conundrum: Without large-scale asset sales, the Fed cannot stage an exit from QE and normalize its balance sheet.
Hence, the Fed has no incentive to end its ultra-loose policies. In any event, it is more prone to wait until inflation picks up meaningfully and the economy overheats. By then, the housing market would have recovered sufficiently for the Fed to dump its assets, with less potential for wreaking havoc. The plus here is that because the Fed purchased many of its MBS securities at near face-value, it could avoid massive portfolio losses by getting them off at better prices. More important, the real value of those bank reserves and bank deposits injected through QE could be reduced by a period of high inflation. The magic of compounding goes somewhat like this: 4 years of 7% inflation would wipe out one-quarter of this money. Couple this with 3% real economic growth, and the ratio of this money to nominal GDP would come down by one-third.
That said, Fed chair Janet Yellen is unlikely to view rising prices as a major concern in her first term of office. Her utmost concern is that banks will not foster credit excesses or speculative imbalances in the buoyant liquidity environment. For that reason and others, the Fed will continue to keep a tight grip on financial institutions, limiting the sector's ability to extend loans, take risks and make profits. This means banking stocks will continue to be an underperformer at the current stage of economic recovery. But for the broad market, there is scope for more upside. The party is not over yet.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.