Yesterday brought news that I have been predicting for some time. You may not have seen any mention of it because it is about an area that Federal Reserve Chair Jerome Powell described like this.
A colleague recently compared this topic to a trip to the dentist, but that comparison may be unfair—to dentists.1
Actually as I shall explain later he wants it to be like that as for example it means that the issue of buying bonds at all-time highs and then building large losses remains in the shadows. But he was talking about this.
With that in mind, I hope to enhance understanding of one of the more arcane and technical aspects of monetary policy:
What size is it?
We were given a breakdown.
. On the Fed’s balance sheet, the liability side of the ledger totaled $6.5 trillion as of October 8, and three categories account for roughly 95 percent of that total.2 First, Federal Reserve notes—that is, physical currency—totaled $2.4 trillion. Second, reserves—funds held by depository institutions at the Federal Reserve Banks—totaled $3.0 trillion…….Third is the Treasury General Account (TGA), currently at about $800 billion, which essentially is the checking account for the federal government.
You nay note that he is telling us first about the other or for those less kind the wrong side of the balance sheet and he is doing it so he can out this into listeners minds.
Reserves are the safest and most liquid asset in the financial system, and only the Fed can create them. The adequate provision of reserves is essential to the safety and soundness of our banking system, the resilience and efficiency of our payments system, and ultimately the stability of our economy.
He wants you to think those nice friendly reserves and that the Federal Reserve is doing vital work oiling the wheels of the monetary system. But he then has to admit after a barrage of numbers that he and his colleagues changed the monetary system with all their QE bond purchases. The emphasis is mine.
The asset side of our ledger consists almost entirely of securities, including $4.2 trillion of U.S. Treasury securities and $2.1 trillion of government-guaranteed agency mortgage-backed securities (MBS).When we add reserves to the system, we generally do so by purchasing Treasury securities in the open market and crediting the reserve accounts of the banks involved in the transaction with the seller.
I doubt many listeners will be able to properly follow this. This is added to by the way such a significant speech is being ignored. For example in my home country the economics editors of the BBC ( Faisal Islam) and Sky News ( Ed Conway) have not mentioned it at all on X (Twitter) whereas there was plenty of time apparently to discuss the forecasts of the ( consistently wrong) IMF.
One way this really matters is to do a back of the envelope style calculation. The interest-rate on reserve balances or IORB is 4.15% and that is a lot on balances of the order of US $3 trillion. There will be income from the Bonds held against this. Let me be generous and say it is 1.65% ( remember they deliberately drove yields and hence their income as low as possible).So we get a net cost per year of the order of US $750 billion. Or at least it would be if they had only bought Treasury Bonds but they also bought Mortgage-Backed Securities with a higher yield so that actual annual loss is more like US $250 billion.That is why such losses are called “Deferred Assets” as we see another attempt to mislead and confuse the unwary.
Oh and the ownership of all those MBS bonds is yet another reason why they only want house prices to rise as capital losses would be a nightmare for them.
The issue of IORB is a very important one and has arisen in the other QE operating countries. Recently in the UK the Reform party has suggested scrapping it which would end the ability of the Bank of England to set interest-rates and would risk interest-rate cuts for savers/depositors. The essential problem here is that another flaw in the QE era was that it changed the plumbing of the monetary system and we need more reserves than before.
It may be occurring to you that QE was always going to have a phase where it lost lots of money and maybe to wonder why more did not join me in pointing that out. But for today’s purpose let us stay with central bank balance sheets and profit and loss accounts being under pressure
If you have any doubts about this being a source of large losses then the words below should convince you.
Turning to my second topic, our ample reserves regime has proven highly effective, delivering good control of our policy rate across a wide range of challenging economic conditions, while promoting financial stability and supporting a resilient payments system.
Actually one of the reasons they delayed interest-rate rises whilst claiming that inflation would be “Transitory” was that they were suddenly faced with the prospect that their “free lunch” of cheaper bond yields for governments was about to face a backwash of costs because they were funding themselves using the interest-rates they would have to raise. Switching to my home country the UK this is why the Bank of England in the past suggested an interest-rate of 1% was relevant for the future of QE and more generally other central bankers were affected by a similar type of mind virus. Higher interest-rates were just too painful to contemplate. And after all such a mistake could not be made by people who consider themselves to be so frightfully clever right?
To put it another way they made a bet on fixed interest-rates at all time lows for bond yields and funded it via variable ones. This ignored the basic banking precept of do not borrow short and lend long.
The Quantitative Tightening Problem
Quantitative Tightening or QT was to reduce the problems above but it has two catches,
- The monetary system was changed such that it needs more reserves now.
- Politicians and in this instance we also have the very public utterances of US President Donald Trump have spotted that QT has raised bond yields. Mostly the utterances of President Trump look at official interest-rates but to paraphrase The Spice Girls what he “really, really wants” is lower bond yields.
The Announcement
Here it is as a result of the above. The emphasis is mine.
Our long-stated plan is to stop balance sheet runoff when reserves are somewhat above the level we judge consistent with ample reserve conditions. We may approach that point in coming months, and we are closely monitoring a wide range of indicators to inform this decision.
At that point QT is over. This with its implications for future bond yields is really significant but it is hard to quantify because it is likely to come with this.
The US labour market is showing further signs of distress, Jay Powell has warned, as the Federal Reserve chair signalled that he could be ready to support another interest rate cut later this month.
That was always likely and those who follow my work will be aware of this. Stopping QT was always likely to come with a way of reducing its cost which is done by reducing interest-rates.Sorry to anyone who is fooled by the claims it is really about lower inflation prospects. They can support the labor market as they would spell it and reduce their own losses and put inflation control on a back burner.
Comment
This is a deeply significant move and whilst this is at this stage for the Federal Reserve only remember that central bankers are pack animals. Few things frighten them more than being outside the pack. This means that the central bank of my home country the Bank of England will now be very nervous about this.
At this meeting, the MPC had voted to reduce the stock of UK government bond purchases held for monetary policy purposes by £70 billion over the 12-month period from October 2025 to September 2026. The details of the first quarter of the associated gilt sales programme, covering 2025 Q4, were set out in a Market Notice accompanying these minutes.
I mean in their own terms as I always thought it was a bad idea. They will now think it is a bad idea because they will be acting differently to the Federal Reserve via the pre-commitment that they thought was so clever.
Let me finish off by giving you a couple of examples of how language is twisted by these people. Here is Federal Reserve Chair Jerome Powell telling us that normal is in fact not normal.
Normalizing the size of our balance sheet does not mean going back to the balance sheet we had before the pandemic.
Also those who know my views on official denials will note this one.
In the longer run, the size of our balance sheet is determined by the public’s demand for our liabilities rather than our pandemic-related asset purchases.
Notice how this conveniently shifts the blame for their actions and indeed losses onto the public.This reminds me of the lyrics Paul Weller wrote for The Jam where.
And the public gets what the public wants
Later becomes.
And the public wants what the public gets
