The Federal Borrowing Implications of a QE Reversal

With inflation surging, the leadership of the Federal Reserve seems ready at last to pull back on the quantitative easing (QE) program it initiated more than a decade ago. If the central bank’s intended downsizing of its asset holdings proceeds as planned (and is not interrupted by another downturn), the effect will be to add to the sums the U.S. Treasury must borrow from non-Fed creditors in the coming years.

QE began in late 2008 as an improvised -- and, presumably, temporary -- response to the financial crash. As private banks and investment firms reeled from the collapse of the housing market, the Fed stepped in and bought hundreds of billions of dollars of mortgage-backed securities (MBS) which had become exceptionally risky investments because of the sub-prime fiasco. The funds for these purchases came from the Fed’s authority to create bank reserves -- the equivalent of printing money.

To further support the economy, which had fallen into a deep recession in early 2009, Fed Chairman Ben Bernanke expanded the purchasing program to include Treasury-issued debt instruments (along with a smaller amount of “agency” securities sponsored by Fannie Mae and Freddie Mac).

When, in the years after the crash, the pace of the economic recovery proved disappointing, the Fed decided to keep QE in place for an extended period, with on-going purchases focused on long-term Treasury debt. The aim was to expand the money supply beyond what was already occurring with short-term interest rates at just above zero.

The Fed’s QE interventions led to a vast expansion of its balance sheet. In 2014, the central bank reported holding financial assets worth $4.2 trillion, or the equivalent of roughly one-fourth of annual GDP, which was an increase of $3.7 trillion over the level recorded in 2008.

By 2017, the Fed believed the recovery was secure enough to begin monetary policy “normalization.” It was decided that some of the funds from maturing securities would not be reinvested in new purchases, which had the effect of modestly shrinking the Fed’s holdings. However, just as this policy was starting to take hold, the COVID-19 pandemic cut it short. The Fed responded to this new crisis as it had to the previous one, by implementing an aggressive QE program. By the end of 2021, the central bank’s balance sheet had swelled to $8.4 trillion, the equivalent of nearly 40 percent of annual GDP. The largest share of holdings -- $5.7 trillion -- was in Treasury-issued debt instruments.

QE has made the Federal Reserve a major financier of the government’s annual budget deficits, which is a sharp departure from previous practice. From 2008 to 2021, the federal government borrowed $16.5 trillion, while the Fed’s holdings of Treasury securities grew by nearly $5.0 trillion. In other words, just about 30 cents of every dollar the federal government borrowed during this period was made available to it through the Fed’s QE program. This was the monetization of government debt on a very large scale.

In its January 2022 meeting, the Federal Open Market Committee (FOMC) of the Fed announced its intention to begin a “significant reduction” in the size of its balance sheet. Similar to the approach taken in 2017, the plan is to not reinvest some of the payments received from the Treasury for maturing securities.

This policy will have roughly the opposite effect to that of QE on the Treasury’s debt management operations. Instead of the Fed financing much of the government’s borrowing needs, reversing QE will mean the Treasury has to borrow enough from non-Fed creditors to cover both the entirety of its current fiscal deficits and a debt drawdown at the Fed.

The sums involved are not trivial. The Congressional Budget Office’s new budget forecast projects a cumulative federal deficit over the four-year period 2022 to 2025 of $4.4 trillion. That’s the total that the Treasury will need to borrow to cover its costs without the assistance of the Fed’s QE program.

In addition, economists at the regional Federal Reserve Bank in Richmond, Virginia have provided a simulation of the implications of QE’s reversal on Treasury securities held by the Fed. Using assumptions that track with the Fed’s public statements (which, as usual, leave some room for interpretation), the Richmond Fed analysts project a reduction in Treasury debt held by the Fed of roughly $2.5 trillion over the coming four years (they simulate three scenarios that differ only marginally in their cumulative effects).

Thus, instead of the Fed financing 30 percent of the government’s annual deficit, as it has done since 2008, QE reversal means the Treasury will need to borrow an additional 60 cents for every dollar of deficit spending. In total, Treasury will need to borrow $6.9 trillion over four years, or more than $1.7 trillion annually. That is equivalent to roughly 6 percent of annual GDP.

Treasury-issued debt remains in high demand globally because of its low risk and the relative stability of the U.S. dollar. It is likely there will be plenty of buyers for the $6.9 trillion of T-bills, notes, and bonds the federal government will sell in auctions through 2025 to cover its obligations.

Even so, the impending QE pullback by the Fed should be seen as another signal that the federal government needs to get its fiscal house in order. Printing money to finance routine government activity should be seen for what it is: an exceptional step that should be used only in extreme emergencies, and then phased out quickly when the crisis has passed.

James C. Capretta is a Contributor at RealClearPolicy and is a senior fellow at the American Enterprise Institute.