Reforming the Federal Reserve, Part 4: Restoring Sensible Asset Purchases

While QE was marketed as a necessary step to support economic recovery, the Fed’s foray into large-scale asset buying raises serious concerns about fiscal independence and financial stability. To maintain a clear demarcation between monetary and fiscal policy, as well as minimize its footprint on financial markets, the Fed must revert to trading only US Treasury securities and revert its asset-purchase program to its pre-2008 regime.

QE was introduced as an unconventional monetary policy tool when the federal funds rate approached its effective lower bound (i.e., the fed funds rate was effectively zero percent) and, as a result, traditional monetary policy could no longer provide additional stimulus by targeting short-term interest rates. Through QE, the Fed purchased large quantities of longer-term Treasury securities and agency MBS to influence broader financial conditions and support economic activity.²

The primary theoretical justification for QE lies in its ability to reduce long-term interest rates by altering the composition of assets held by the public. By absorbing large volumes of long-duration securities, the Fed aimed to compress term premiums (i.e., lower the additional compensation for holding longer-term assets versus short-term assets), thereby encouraging greater borrowing and investment.³ In addition, rising asset prices were expected to boost household wealth and stimulate consumption—a transmission channel often referred to as the wealth effect.

QE was also intended to serve a signaling function. By undertaking large-scale purchases, the Fed sought to reinforce its commitment to accommodative policy for an extended period, helping anchor market expectations of low future short-term rates. Finally, during periods of financial distress, QE was thought to inject liquidity into key markets, stabilize asset prices, and restore investor confidence.

There is wide debate as to whether QE worked as intended and helped the recovery from the recession.⁴ Regardless, QE has undoubtedly bloated the Fed’s balance sheet and led to undesired interactions with financial markets and fiscal policy beyond the Fed’s traditional role.

The multiple rounds of QE following the 2008 recession and again following the COVID-19 pandemic have drastically increased the size of the Fed and fundamentally changed its relationship with the financial sector. Figure 1 shows the Fed’s asset holdings as a percentage of all the assets held by US commercial banks. Prior to the 2008 financial crisis, the Fed’s balance sheet rarely exceeded 10 percent of the commercial banking sector, with the trend exhibiting a gentle decline. After the financial crisis, however, the Fed entered a new era, with this number frequently exceeding 20 percent. The QE operations during the pandemic led to another structural jump, with the Fed reaching 40 percent of the size of all commercial banking.

Such a large shift in central banking has effects on the financial system. The primary effect of the Fed’s interference in asset markets is the massive reduction in reserves trading between private banks through the federal funds market. In return for the Treasurys and MBS the Fed purchased, those funds drastically increased the reserves of financial institutions, moving from a scarce-reserves regime prior to 2008 to an abundant-reserves regime. Under the new framework, banks were so flush with reserves that they no longer needed to borrow them from other banks. As a result of the policy framework switch, daily trading volume in the fed funds market fell from its pre-2008 level of $150–$175 billion to just $60–$80 billion in the mid-2010s.⁵ Consequently, the fed funds rate, the Fed’s key policy rate, has become much less correlated with other borrowing rates.⁶

This shift in framework has also had serious repercussions for financial markets.⁷ Before the 2008 financial crisis, increases in the Fed’s balance sheet typically led to minor reductions in market volatility; after the crisis, balance sheet increases are accompanied by large increases in market volatility. Research from the Cato Institute shows that since 2008, a 1 percent increase in assets may cause a 6 percent increase in financial market volatility.⁸ Market participants may now view Fed asset changes as a signal of weakening economic conditions due to the scale and frequency of QE measures. Conversely, before 2008, balance sheet expansions were less common and typically viewed as a routine adjustment or a response to relatively minor financial disruptions.

The nature of the assets being purchased also changed post-2008, when the Fed, for the first time, expanded its asset purchases to include a large quantity of MBS. Figure 2 shows the breakdown of the securities held by the Fed. As the figure shows, until 2008, the Fed purchased Treasurys, largely of a relatively short duration.⁹ At their peak in 2010, MBS comprised over half the Fed’s assets. Presently, one-third of its assets are MBS, with Treasury securities comprising the remaining two-thirds. Consequently, the Fed has drastically increased its footprint by preferentially allocating credit to the housing sector and distorting it away from its market-based equilibrium.¹⁰

The QE program’s focus on long-term Treasury securities is also concerning because it exposes the Fed to heightened interest rate risk.¹¹ Put differently, these long-term asset purchases mean that the Fed, to a much greater extent than in the past, now borrows short while lending long. This operation exposes the Fed to financial losses when short-term rates rise, because the Fed must pay higher rates than the rates it will receive. The Fed’s “borrowing” comes in the form of bank reserves and reverse repurchase agreements—both of which have associated interest payments and are very short-term liabilities. That is, the Fed’s profitability rests on an upward-sloping yield curve (where long-term rates are higher than short-term rates) and it faces losses if the yield curve inverts.¹² The yield curve usually slopes upward, but this relationship is not guaranteed, as demonstrated by the downward-sloping yield curve experienced for much of the past few years. The Fed did not face interest rate risks of this kind, or the resulting financial losses, when it focused on short-term Treasurys in a low-rate environment.

The new abundant-reserves system divorces the Fed’s monetary policy stance from the size of its balance sheet by allowing it to purchase as many assets as it would like, all while paying firms to hold on to the excess cash that these purchases create. This framework can allow the Fed to be a pawn of the US Treasury for the simple reason that its asset purchases no longer directly threaten its price-stability mandate—the Fed’s operating framework is designed to pay interest on reserves for the express purpose of preventing asset purchases from funding broader money creation. Ultimately, the Fed’s current operating system increases the risk that its QE powers will be used in the funding of backdoor government spending.

Federal spending is supposed to go through the congressional appropriations process, but the Fed’s new abundant-reserves regime provides a path for bypassing that process. That is, the new regime enhances the Fed’s ability to fund government programs—such as a Green New Deal, energy subsidies, or an industrial development bank—independent of the appropriations process to a much greater degree than before. Federal agencies could, for example, increase their funding by selling securities to the Fed, thus making it less likely that Congress will control government spending. Because the new regime is built upon “containing” newly created reserves, the Fed would no longer be able to stave off such backdoor funding by appealing to its congressional price-stability mandate.¹³

Arguably, QE could have been an effective emergency program in some circumstances. The Fed’s implementation of QE, however, has proven that such “emergency” programs are nearly impossible to contain and eliminate. Prolonged QE of this kind—it has become an all but permanent fixture at the Fed—blurs the lines between monetary and fiscal policy. Such a scenario can trigger fiscal dominance, a situation where the central bank’s ability to conduct independent monetary policy is constrained by the government’s fiscal position. The central bank is pressured, explicitly or implicitly, to help finance government debt. In such a regime, fiscal needs drive monetary policy, risking macro-instability and loss of central bank credibility—problems more typically inherent in politically unstable countries.¹⁴

When the QE program launched, it came with a commitment to restore asset holdings to pre-2008 levels.¹⁵ This restoration has not yet happened, nor is it likely to happen soon. At the very least, the Fed should deflate its balance sheet until it is commensurate with its size relative to the private sector before the 2008 recession. This change would mitigate QE’s effects on financial markets as well as return the Fed’s framework to a scarce-reserves regime. This would in turn strengthen the private borrowing market for reserves once again, allowing the federal funds rate to send a correct signal of borrowing conditions. The return to the scarce-reserves framework would have the added benefit of shielding the Fed’s independence from wanton government spending. Since monetary surpluses do have macroeconomic effects, particularly inflation, when reserves are scarce, Congress would no longer be able to use the Fed as a backdoor spending mechanism.

To be fair, as Figure 1 shows, the Fed has attempted to reduce its asset holdings during periods of economic calm. However, the Fed has little incentive to wind up the QE purchases quickly for fear of inducing tighter credit conditions. Predictably, any additional economic disturbance further slowed the Fed’s pace for shrinking its balance sheet, and the temptation to implement new QE-style purchases has proven too great to resist. Consequently, the Fed should commit to not engaging in QE, even if there is external pressure to do so from financial market participants or elected officials.

The Fed’s operations in the wake of the 2008 financial crisis gave rise to an experimental policy framework that replaced traditional market activity with bureaucratically administered interest rates. To shrink the Fed’s currently outsized footprint, thus restoring the market forces that the Fed has displaced, the Fed should shrink its balance sheet and end these experimental programs. To ensure that the Fed can no longer implement these types of lending programs in the future, Congress should restrict the Fed to purchasing only short-term US Treasury bonds. Additionally, Congress should limit the size of the Fed’s balance sheet. For example, Congress could cap the Fed’s total assets at no more than 10 percent of the commercial banking sector’s total assets, the approximate share held by the Fed prior to the 2008 financial crisis.¹⁶ These restrictions would make it harder for Congress to use the Fed for backdoor fiscal expenditures, and for the Fed to allocate credit beyond the banking sector.

The Federal Reserve has vastly expanded its footprint in financial markets through massive asset purchases. The size of the Fed’s balance sheet raises serious concerns about fiscal independence and financial stability. To maintain a clear demarcation between monetary and fiscal policy, as well as minimize the Fed’s footprint on financial markets, the Fed must trade only short-term US Treasury securities and revert to its pre-2008 policy framework. Congress should also limit the size of the Fed’s total assets relative to the size of the financial sector or outstanding federal debt.