THE KING WAS LOOKING DOWN
This has made the Fed cautious. At his November Brookings Institution speech, Fed Chair Jerome Powell was asked when he will end QT. After noting we were “not close to reserve scarcity”, he warned that “the demand for reserves is not stable and can move up and down very substantially” – a direct reference to March 2020’s hiccup.
The biting point of reserves is a known unknown, and Powell doesn’t want to test it too hard, because the wiring of the financial system has severely undermined his ability to calibrate policy appropriately to secure a smooth landing.
Think of central banks’ problem as like using a stick to slow a bicycle that’s careering down a hill. The Fed realises the only way to brake without putting the stick in the spokes and causing an accident is to rub the stick hard against the spokes. But even placing the stick close to the spokes has become dangerous because the axel of the bike (the treasury market) becomes unstable just as the stick starts to twang against the spokes.
So the Fed has to hope the road ahead changes from downhill to sufficiently uphill. But, because of our hyper-financial system, if it stops braking too soon, the hill may become less steep and not slow the bike enough. Braking both slows the bike and reduces the gradient of the road ahead. Who wants to ride that bike?
CAN MUSIC SAVE YOUR MORTAL SOUL?
Can the Fed do anything to help liquidity in the treasury market when it gets stressed?
Yes. If forced to, the Fed and the US Treasury have options to ease stresses without having to stop QT.
The two most prominent
- Exempting treasuries from the calculation of leverage in SLR calculations. In effect, this would allow banks to expand their balance sheets to buy treasuries without having to put up more capital. This would undoubtedly supply a lot of liquidity to the treasury market, but it would probably be seen as helping the banks.
- Issuing short duration T-bills in order to buy back longer duration treasury bonds. By removing duration from the markets, this would probably be viewed as monetary easing, which runs counter to the Fed’s stated ambition of vanquishing inflation.
The effect: a treasury market put.