Federal Reserve Quantitative Tightening Could Spur the Next Financial Crisis

Federal Reserve Quantitative Tightening Could Spur the Next Financial Crisis

In an unsurprising development, the Federal Reserve decided at this week’s Federal Open Market Committee (FOMC) meeting that it would begin implementing the program of drawing down its balance sheet that it had begun to develop earlier this year. But while ending aggressively expansive monetary policy is a good thing, actively tightening monetary policy does bring up some cause for concern. If the Fed actually tightens policy to the extent that it claims it wants to, it could hasten the bursting of the many bubbles it has created throughout the economy and bring on the next financial crisis much faster than anyone is prepared for.

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The first inklings of the last financial crisis began in June of 2007 when two large funds at Bear Stearns began to show signs of distress. While the company claimed that their problems were mostly contained, hindsight showed those problems to be the first developments in a long slide towards financial meltdown.

At the beginning of June 2007, the Federal Reserve’s total assets were $876 billion, a sizable sum that was around 6% of GDP. Of that, $790 billion, or 90%, consisted of Treasury securities. That equaled about 16% of the debt held by the public, or 9% of the total national debt.

By late September of 2008, the economic situation had gotten far worse. Stock markets were panicking, as was Congress. Major banks were experiencing shadow bank runs and the fear in Washington was that the entire financial system was on the brink of collapse. Congress reacted by passing the Troubled Asset Relief Program (TARP), the $700 billion bank bailout program.

Unbeknownst to most people, the Federal Reserve had already engaged in quantitative easing, albeit without using that term openly. By the beginning of October 2008, the Fed’s assets had swelled to $1.498 trillion, a 90% increase from 15 months before. Most surprising was that the Fed’s Treasury holdings had decreased to $476 billion, while nearly half of its assets were not openly declared, comprising $409 billion in “other loans” and $318 billion in “other assets.” This was a stealth bailout of the financial system, with the Fed swapping its Treasury securities with banks in exchange for taking their worthless assets off their books.

The Fed announced in November of 2008 that it would begin purchasing mortgage-backed securities (MBS), a program of quantitative easing retroactively named QE1. Along with the other bailout programs the Fed had enacted, its balance sheet swelled to $1.9 trillion by March of 2009, and $2.08 trillion by June of 2009, the official end of the recession. By that time, Treasury security holdings were $606 billion, MBS holdings were $427 billion, and the Fed’s total assets were nearly 15% of GDP.

By June of 2010, the Fed’s balance sheet was at $2.34 trillion, with $776 billion in Treasury holdings and $1.113 trillion in MBS holdings. As the economy still was judged to be weak, the Fed introduced its QE2 program of quantitative easing in November of 2010, planning to purchase $600 billion in Treasury securities.

Between November of 2010 and the end of 2011, the Fed’s balance sheet increased from $2.3 trillion to $2.93 trillion, with its Treasury holdings nearly doubling from $842 billion to $1.672 trillion and its MBS holdings declining from $1.05 trillion to $837 billion. The total debt held by the public had increased by $1.305 trillion, meaning that the Fed had purchased 64% of all the federal government’s debt issued during that period, a massive subsidy to unbalanced federal spending. Its holdings of Treasury debt comprised 16% of the debt held by the public and 11% of the overall national debt.

Not content with all of that easing, the Fed embarked on further MBS purchases in its QE3 program, finally ending its asset purchases in late 2014. At the beginning of November 2014, the Fed’s assets were close to $4.5 trillion, with $2.461 trillion in Treasury holdings and $1.717 trillion in MBS. Treasury holdings were 19% of the debt held by the public and nearly 14% of the total national debt, and the Fed’s total assets were 25% of GDP.

Those figures are roughly the same for the Fed’s balance sheet today, and the Fed has now announced that it will begin to unwind its balance sheet. The plan is to begin reducing the balance sheet by $10 billion per month this year, increase it to $20 billion a month at the beginning of next year, and eventually draw down the balance sheet by $50 billion per month.

For most people, this process is naturally worrying. Should the Federal Reserve have engaged in quantitative easing? No, most definitely it shouldn’t have. The Fed more than quintupled the size of its balance sheet in dollars and quadrupled its size relative to GDP. Its balance sheet is still equal to 23% of GDP, an incredibly high percentage. But unwinding a position that large is fraught with danger.

Because the Fed’s purchases of securities were done willy-nilly, without thought of an eventual unwinding, the maturity dates of those securities are all over the place. Some years could see hundreds of billions of dollars of securities maturing, others very little. That’s why the Fed is pursuing its program in the way that it is, to provide a steady and ordered decrease to its balance sheet.

It all sounds good in theory, but in practice, the Fed, just like all other central banks that engaged in quantitative easing, is traveling into uncharted territory. The history of the Fed’s balance sheet is one of slow and gradual expansion. A decrease of 10, 20, or 30% would have been unheard of in the past, yet that is exactly what the Fed says it is trying to do right now.

Because financial markets have been so addicted to monetary stimulus, the effects of the Fed’s tightening could exacerbate underlying tensions in financial markets. Stopping quantitative easing policies already will have an effect on markets, as the flow of easy money coming to a halt will result in higher interest rates and an increased number of defaults. That makes it likely that we’ll see a repeat of 2007-08, where a handful of funds in difficulty quickly turned into a systemic crisis.

Remember that the financial crisis was fueled by interest rates remaining too low too long, with the underlying malinvestments exposed once the Fed began to raise interest rates. But while the Fed raised interest rates from 2003 to 2006, it continued to expand its balance sheet by 14%. This time around the Fed is both raising interest rates and decreasing the size of its balance sheet. That will hasten the development of the next financial crisis, which will make 2008 look like child’s play. Not surprisingly, investors are already nervous about their cheap money coming to an end.

Some of the questions that arise relate to the Fed’s reaction when the economy inevitably falls back into recession. Will the Fed continue unwinding its balance sheet? Will it continue raising interest rates? Or will it fall back to zero rates and more quantitative easing? There’s a great deal of uncertainty about the future.

That’s why the outlook for gold is better than ever. Gold’s performance during the last financial crisis showed just how powerful it is as a safe haven. The Fed’s actions will definitely push the economy into another financial crisis, and gold will see huge gains yet again when stock markets crash and investors seek to trade their paper assets for gold.

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The best time to get into gold, though, is right now, before markets begin to crash. Waiting until after you’ve already lost money in stock markets will result in painful financial losses. With the development of gold IRAs, investing in gold is easier than ever. You can even roll over existing retirement accounts into a gold IRA, benefiting from both the safety and security that gold offer and the same tax advantages as a traditional IRA. Investors who are serious about protecting their assets should start looking at gold today.