In the U.S. monetary and fiscal policy have become intertwined
In May 2022 the New York Federal Reserve Bank published its report of open market operations, which showed that, as of December 2021, the Fed owned 38% of 10-30 year Treasury bonds. In total, Fed’s holdings of federal debt reached 24.3% of GDP as of the latest 2021 data. In this commentary, Calcagno and Lopez argue that very high Fed holdings of public debt could compromise the central bank’s independence while risking inflation:
[A]fter holding down interest rates for nearly a generation, the shift to quantitative tightening combined with rising yields will squeeze the federal budget. As we recently showed, net interest is projected to exceed 10% of the budget within the next five years. The financial pain of winding down from 24.3% of GDP might be too much to bear, prompting fiscal policymakers to again pressure the Fed.
The Fed’s Share of Public Debt: Worsening Withdrawal Symptoms?
By: Peter Calcagno, Edward J. Lopez – College of Charleston, Western Carolina University
Central bank balance-sheet expansion and the liquidity claims on the banking system
In this paper, Acharaya et al. ask whether the system is better placed today to sustain a shrinkage of the Fed’s balance sheet? The last two times the Fed initiated quantitative tightening (QT), in September 2019 and March 2020, financial markets in the United States experienced an episode of significant liquidity stress.
In their theoretical framework commercial banks finance the reserves they hold at the central bank with demandable deposits. Banks also issue other claims on liquidity such as lines of credit and as a result, the reserve holdings become a backstop for commercial banks to issue claims on liquidity that may not all materialize at the same time in the normal course. This allows commercial banks to generate higher fees. In reality, this leads to far less “spare” liquidity in the system for stressed times than might be suggested by the increase in commercial bank holdings of reserves.
From their empirical investigation they find that, in September 2019 and March 2020, the system became vulnerable and eventually dependent on further liquidity provision mostly because QT took place without a commensurate decline in aggregate claims on liquidity by the commercial banking sector.
We document that banking deposits increase, and become more demandable when QE expands reserves. Importantly, the maturity-shortening of banking sector liabilities when the stock of reserves rises is evidenced not just at the aggregate level in time-series data but also at an individual bank level in the cross-section. Banks also originate more corporate lines of credit. We observe little reversal of all this during quantitative tightening. We argue that this asymmetric behavior can explain tightening liquidity conditions and occasional stress episodes when quantitative tightening is underway, despite the central bank balance-sheet being large relative to historical standards. Furthermore, such behavior can make the banking system dependent on the central bank for ever larger liquidity infusions during stress.
Liquidity Dependence: Why Shrinking Central Bank Balance Sheets is an Uphill Task
Authors: Viral V Acharya, Rahul S Chauhan, Raghuram Rajan, Sascha Steffen
From: NYU Stern School of Business, University of Chicago Booth School of Business, Frankfurt School of Finance & Management
