The Big Test: The Fed’s Securities Portfolio

The Federal Reserve Raised its Policy Rate of Interest

Big deal.

Was it 75 basis points or something else?

I really don’t care.

I’m happy that the Fed did raise its policy rate of interest today, but I am really more interested in seeing what it is going to do about reducing its securities portfolio.

As of September 14, 2022, the Fed held $8,407.9 trillion in securities purchased outright.

On December 25, 2019, just before the spread of the Covid-19 pandemic really hit the United States and the Federal Reserve reacted to protect the U.S. economy from falling into a major economic and financial disaster, the Fed held $3,751.2 billion in securities purchased outright.

And, on September 30, 2007, just before the start of the Great Recession, the Fed held $3.0m trillion$779.6 billion in securities purchased outright.

The securities portfolio rose through the Great Recession and into the following economic recovery as the Federal Reserve not only acted to end the recession in 2009 but also conducted two periods of quantitative easing during the recovery period to drive the longest period of economic expansion in the post-World War II period.

In 2020 and 2021, the Federal Reserve carried on another period of “quantitative easing” making sure that the economy did not “accidentally” face into another “great” recession or something more.

Government Debt Levels

As I described in my post on September 20, 2022, the federal government issued huge amounts of debt as it also tried to combat potential economic disasters.

In retrospect, the policymakers did well in both cases but left the economy with lots and lots of public debt to deal with. This amount, of course, includes the amount of public debt that the Federal Reserve acquired and held on its balance sheet.

But, as I showed in my recent post, injecting all this public debt into the economy changed the behavior of investors. The data show a very different set of outcomes after the beginning of the Great Recession when compared with relationships from before the Great Recession.

The increase in the public debt held by the Federal Reserve was consistent with what was going on elsewhere in the U.S. economy.

The Big Test

The big test, to me, is going to be how the Federal Reserve performs this planned reduction in its securities portfolio.

The Fed is not planning to sell securities, but it is going to let securities mature off the Fed’s balance sheet, without being replaced.

The initial plans are for the Fed to allow about $95 billion in securities to run off each month going through 2023 and into 2024. If this plan is achieved, the securities portfolio will be about $2.4 trillion smaller in the middle of 2024 than it is right now.

Thus, the Fed will have given up about one-half of the $4.7 trillion in securities it added to its securities portfolio during the 2020-2021 period.

I have two questions here.

The first is, will the Federal Reserve actually stick to its guns and carry out this extended program of portfolio reduction?

My second question is whether or not this $2.4 trillion will be enough.

That is, the Fed acted, in an emergency fashion, to protect the economy against an unusual disruption. But, to get the economy back to a more normal setting, the Fed may have to reduce its portfolio by more than $2.4 billion.

And, this question can be extended. Was the $3.0 trillion in securities added to the Fed’s portfolio from the start of the Great Recession to December 2019 really needed, and might the Fed need to consider moving some of these securities off of its portfolio?

The Two Reasons

There are two reasons why the United States might want to reduce the amount of Treasury securities carried on the Fed’s balance sheet and the amount of public debt that is outstanding.

First, the United States appears to be battling China as China tries to become the number one economy in the world with the number one reserve currency in the world.

The rising strength of the U.S. dollar in foreign exchange markets has put the United States in a very strong position.

The Euro costs only about $0.99. The British pound costs a little more than $1.1300. And it takes more than 7.00 Chinese Yuan to purchase one U.S. Dollar.

The value of the U.S. dollar has not been this strong for a long time.

Maintaining this strength is very important to the United States, and it would seem that U.S. policymakers would want to do what they need to do in order to keep the U.S. dollar at “the top of the hill.”

U.S. monetary policy has brought us to this point. The federal government now needs to bring its debt under control so as to cement the dollar’s strength in the global economy.

Second, the world is on the brink of going digital. A digital world is going to become the foundation of the globalized world.

United States policymakers need to get their act together so that they can take advantage of the strong U.S. dollar, of a disciplined fiscal budget, and American leadership in digital finance to lead the world into this new era.

This digital world is the future. Therefore, the United States cannot afford to fall short of taking a leadership position in this future.

And, the timing seems ripe because of the strength of the dollar.

So, the U.S. needs to keep hold of the leadership of the U.S. dollar in the world, and it needs to take charge of the leadership in the technological evolution of finance.

The United States has the chance. The United States must act.

So, the United States needs to get its budget in order, and it needs to step up with the plans for a digital system.