In the middle of July the stock market finally awoke from its QE-induced coma and realized the Federal Reserve's tapering, which has been going on for the last six months, was for real. Like a child, who becomes accustomed to a parent that threatens punishment but never follows through, the market had been in denial to the Feds withdrawal of monetary stimulus. But now, thankfully, the ending of Fed asset purchases will be the pin that pops this QE-inflated market and economy. But please do not confuse the end of QE with the Fed actually fighting inflation and selling trillions of dollars' worth in Treasuries and mortgage backed securities (MBS)…because that will never happen.
The Fed has increased its balance sheet by an unprecedented $3.5t since 2008. They accomplished this by purchasing Treasuries and MBS from banks in exchange for Fed credit. A credit from the Federal Reserve is a nuanced way of saying "new money". This new money is transferred as a credit to the banks with the idea that the Fed can and will reverse this transaction at its discretion. Like an army releases reserves, the Fed (with the help of private banks) has marched many of these new dollars into the economy to "save us" from deflation. Once the job is done, the Fed intends to call these dollars back and shrink its balance sheet back to pre-crisis levels. This all sounds great in theory, but as we will soon see, the practical applications of shrinking the Fed's massive Balance Sheet has become impossible without creating a monetary depression.
For the past few years, the central bank's credit and inflation has been predominantly deployed in bonds, real estate and equity assets. However, recently this new money has leaked into the government's manipulated CPI calculation. Therefore, our government can no longer promulgate the lie that inflation is some elusive goal that it cannot achieve. And, the argument that stronger economic growth is around the corner in a context of low inflation has been fully debunked. That is why the market sold off last week. In a word, it is inflation. The Employment Cost Index (ECI) component in the GDP data put the Keynesians on "high wage inflation alert".
But, most will be blindsided by the temporary period of deflation that will result from the end of the Fed's massive asset purchases, as the monetary spigot for the primary beneficiary of the Fed's credit--namely stocks and bonds-gets turned off.
Similar to the housing market in the mid-2000's, we are about to relearn the lesson that many equity investors (especially those on margin) can only afford to hold on to an asset when prices are rising.
However, on the other end of this cyclical period of deflation, lies a period of inflation that will make the '70s seem like an era of hard money. The reason for this is in order to fight inflation the Fed will have to bring home trillions of those "money troops" it sent into the economy. Calling the money back is going to be far more difficult than it was deploying it.
When the Fed buys Treasury debt, most of the interest payments made go back into the government's coffers. In fact, by law the Treasury has claim to all income derived from the Federal Reserve; less expenses. So the Treasury pays the Federal Reserve an interest payment and in return receives most of that payment back. This is a pretty good deal for the Treasury, considering the Fed's profit is in the neighborhood of $91 billion a year. This means the Treasury not only didn't have to find a real buyer for the newly issued debt but it also did not have to worry about paying interest on that debt.
But, it gets even better--as the bonds mature, the Fed has been rolling over the principal. Therefore, it is as if the $2.4 trillion of newly issued Treasury bonds sold to the Fed since 2008 don't even exist. The Treasury gets reimbursed on its interest payments and never even had to worry about what the cost would be for the private market to purchase that debt. To further sweeten the pot, the Fed has pushed rates down to unprecedented lows, leading to relatively-modest debt service payments on all of its record-breaking $17.6 trillion of outstanding debt.
However, if the Fed wants to genuinely fight inflation, it will have to eventually raise interest rates. Ending QE will only provide temporary relief from a weakening currency. To accomplish this in sustainable fashion it will have to shrink its balance sheet back to around the same level it was prior to the Great Recession.
How does the Fed shrink its Balance Sheet? As we discussed, when the Fed purchases a bond from a bank it creates a credit that can be taken back at the Fed's discretion. Taking the credits back on a short-term basis is called a reverse repo-the Fed sells the assets back to the banking system and takes back the cash for a very limited period of time.
But, it just cannot conduct reverse repos to the tune of trillions of dollars without putting extreme pressure on the market for private short-term loans. This means the government is not only going to have to permanently sell the over $2 trillion in bonds into the market, it will have to start paying real interest on that debt as well. And, the private market will also have to finance all the new annual deficits, which will no longer have the luxury of a trillion dollar plus annual QE program from our central bank.
The net effect of all this would be surging interest rates and a complete economic collapse. This is why I do not expect the Fed's balance sheet to significantly contract for many years, if at all. And predict inflation will become a huge and growing problem--especially after the central bank launches another massive QE program in 2015 to re-inflate falling stock prices.
Our government is in a horrific trap because of the record amount of debt it has issued and allowed the central bank to monetize. This is why every time the Fed tries to fight asset bubbles and bring inflation under control it will result in the creation of a monetary depression. And is also why nearly every central bank on the planet has decided the only real long-term objective is to fight against deflation and ensure inflation will always prevail.
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. The author has no business relationship with any company whose stock is mentioned in this article.