Nearly four months into its $60 billion-a-month Treasury bill-buying program, the Federal Reserve is battling a perception among some investors that its asset purchases are equivalent to the central bank's postcrisis quantitative easing program.
Those investors' views could cause a communications headache for the Fed in the coming months, when the central bank is expected to begin slowing the pace of its purchases as it builds banking system reserves back up to an "ample" level.
The Fed's current purchases of short-term Treasury bills are different from its postcrisis QE programs, through which the Fed bought longer-term Treasurys and mortgage-backed securities in an effort to lower long-term borrowing costs and encourage spending. This time, the Fed's purchases consist only of T-bills maturing in one year or less and are intended to restore liquidity after a shortage of cash in mid-September 2019 led to a spike in short-term borrowing rates.
But investors are not "buying into the idea" that the Fed's purchases are simply an attempt to alleviate liquidity issues, setting up a challenge for the Fed when it tries to gradually pull back from its current program, said Danielle DiMartino Booth, who advised former Dallas Fed President Richard Fisher and is now CEO and chief strategist at Quill Intelligence.
If enough investors believe the Fed's current asset purchases are akin to QE and have piled into riskier assets as a result, the thinking goes, their giddiness could turn into disappointment when the Fed looks to ease its Treasury purchases, sparking market volatility and potentially prompting a change of course at the Fed.
"If the market thinks that this is a new round of stimulus and a new round of quantitative easing, then the market is going to construe that a certain way and behave a certain way," said Gregory Faranello, head of U.S. rates at AmeriVet Securities. "So the behavior [of] the market matters for the Fed."
Stock market prices and valuations have generally risen since the Fed announced in October 2019 that it would buy $60 billion in T-bills per month. That period has also included two other significant news items: an easing of trade tensions between the U.S. and China, and comments from Fed Chairman Jerome Powell suggesting interest rates were unlikely to go up until the Fed sees a "persistent" and "significant" upturn in inflation.
One Fed official has raised concerns that the Fed's purchases have played a role in encouraging greater risk-taking from investors. The purchases are "contributing to elevated risk-asset valuations," as are low interest rates and investors' belief that the bar is high for a future Fed rate hike, Dallas Fed President Robert Kaplan told Bloomberg Television on Jan. 15.
"I think we've done what we've had to do, but I'm very sensitive from here that we need to be finding ways to limit and temper the growth in the Fed balance sheet," Kaplan said, calling the current program a "derivative" of QE.
Asked at a Jan. 29 news conference about whether he worried investors were perceiving the Fed purchases as QE, Powell pointed to his past comments differentiating the two efforts and said it is "very hard to say with any precision at any time what is affecting markets."
Powell and other Fed officials have billed the Fed's T-bill purchase program as a technical operation meant to ensure there is ample liquidity in the banking system again.
"This is what the Fed does; they provide liquidity," said Collin Martin, fixed income strategist at the Schwab Center for Financial Research. "We tend to lean towards, 'This is not QE,' but any way you slice it, we think it's a positive in that it helps keep the markets going and the economy going."
Fed expects 'gradual reduction' in purchases in second quarter
The Fed's efforts have increased the assets on its balance sheet to roughly $4.15 trillion, up from roughly $3.8 trillion on Sept. 11, 2019. That number includes the Fed's repo operations, which temporarily inject reserves into the banking system, as well as the $60 billion in Treasury bill purchases a month that boost bank reserves more permanently.
The Fed's plan is to keep buying T-bills until bank reserves are "ample" enough to limit the need for temporary repo operations, the role of which will "naturally recede," Powell told reporters.
The central bank currently expects to conduct repo operations "at least through April," when the income tax return season is likely to drain some bank reserves. The Fed is also currently projecting reserves will reach the desired "ample" level sometime in the second quarter, and reserves will be $1.5 trillion at the very least going forward. Officials plan on reducing the pace of purchases as they approach that point and transition to a smaller purchase program, Powell said.
"We're committed to completing the transition to our longer-run ample reserves regime smoothly and predictably," Powell said. "Of course, we will continue to closely monitor conditions in money markets and we will adjust these plans as conditions warrant."
Michael Feroli, chief U.S. economist at J.P. Morgan, predicted there would be no economic impact from the Fed's gradual move away from its T-bill purchases. The Fed's program has restored calm to funding markets but has had "no other effect on the real economy or asset pricing fundamentals," he wrote in a Jan. 24 research note.
"When the increase in reserve creation slows in coming months — due to satiation of the financial system's demand for reserves — this will have no effect on the economy," Feroli wrote.
Still, the Fed will "tread lightly" as it looks to slow its purchases, said Faranello, of AmeriVet Securities. Fed officials are considering some broader questions on the issue, such as whether to make regulatory changes that reduce banks' demand for reserves, which are assets that are viewed as even more liquid than nearly risk-free Treasury securities and therefore can be a preferred method for banks to meet post-crisis regulatory rules.
But policymakers cannot make regulatory changes "with a snap of their fingers," Faranello said, so the Fed will likely "err on the side of [adding] more reserves, not less" to ensure the system has more than enough liquidity available.
"They can't afford another hiccup like they had in September," he said.