Will the Fed Keep Tightening as Banks Fail?

In order to minimize disruption, the Fed is paring some securities when they mature, not selling them rapidly. If even this ponderous pace continues — a questionable assumption in today’s parlous markets — it will take two years to reach the $6 trillion range. That’s still an unfathomable fortune — about $2 trillion more than before the pandemic.

The Fed bought up these assets with its unique powers to create money. This was deliberately inflationary. U.S. government debt is $31.5 trillion, and the Fed financed a big chunk of it.

Now, it is reversing itself. The probable effects — in terms of slowing growth, increasing unemployment and reducing inflation — are hard to calculate, but Solomon Tadesse has tried. He heads North American Quantitative Equity Strategies for Société Générale. In an interview, he estimated that a $2 trillion reduction would be roughly equivalent to 2.4 percentage points of additional increases in the Fed funds rate. “It would have a serious impact,” he said.

Will the Fed ever get there?

It has capped monthly asset reductions at $95 billion, divided between Treasuries, at $60 billion, and mortgage-backed securities, at $35 billion. But it hasn’t hit those targets, especially for mortgage-backed securities.

By raising rates, the Fed made it imprudently expensive for homeowners to refinance mortgages, and relatively few people have taken out new mortgages to buy homes. As a result, 98 percent of the mortgage-backed securities on the Fed’s books won’t mature for at least a decade, by my calculations. Unless rates drop, mortgages won’t turn over.

If the Fed keeps tightening, it will have to remain a behind-the-scenes giant in the mortgage market for many years — or sell large quantities of securities at a loss. Such sales would risk a new market debacle that could make mortgage rates soar further, adding to the damage in the housing and construction and real estate industries.

Of course, the Fed could abandon rate increases and quantitative tightening. That would mean an end to the Fed’s inflation fighting, and was unthinkable a short time ago. But it could happen if banking problems escalate and a recession is evident.

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