In the midst of the Federal Reserve’s creative but controversial quantitative easing program — the five-year plan of buying billions of dollars in debt securities each month and forcing down interest rates to historically low levels — the central bank’s balance sheet has ballooned to nearly $4.3 trillion in assets from $800 billion, leaving one large unanswered question hanging over the marketplace: What does the Fed intend to do with all those bonds?
Will it hold them to maturity? Will it sell them back into the market? Will the Fed’s balance sheet ever return to its pre-quantitative easing size? When interest rates inevitably rise after the Fed stops manipulating them, will the Fed take the mark-to-market losses on its huge portfolio, as, say, Goldman Sachs would if it owned the same securities? And if the Fed takes losses on its portfolio, does it matter? Can the Fed’s equity capital of $56 billion — yes, the Fed is leveraged 77 to 1 — be wiped out? A mere 1.3 percent change in the value of those $4.3 trillion in bonds would theoretically wipe out the Fed’s equity. Can the Fed go down the tubes, in the same way that Bear Stearns, Lehman Brothers and Merrill Lynch did?
To be clear, I am not suggesting that the assets on the Fed’s balance sheet are impaired or are in any danger of becoming impaired. And a bond held to maturity will pay off at par as long as there is no default. But as we all know from the events of 2008, the market value of bonds can swing drastically and quickly, and with devastating effect, at least for big securities firms in the private sector. Do the same rules of impaired valuation and acute loss of confidence apply to the Fed, which before the crisis had a balance sheet made up mostly of Treasuries but no longer does?
The Fed isn’t saying what its precise intentions are for its balance sheet. But it has offered a few hints. In an August 2012 speech in Jackson Hole, Wyo., Ben Bernanke, the Fed chairman at the time and the architect of quantitative easing, conceded that some people believe that “substantial further expansions of the balance sheet could reduce public confidence in the Fed’s ability to exit smoothly from its accommodative policies at the appropriate time.” He seemed to reject that concern, however.
He also raised the question of whether the Fed’s balance sheet would be impaired if interest rates were to rise “to an unexpected extent.” He dismissed that, too, as a likely possibility and noted, in a footnote, that the Fed had actually paid the Treasury $200 billion since 2009, “well above historical averages.”
At her news conference last week, after two days of Federal Open Market Committee meetings, Janet Yellen, the Fed chairwoman, said the Fed’s balance sheet would remain “very large” “for some time” and that the Fed had no plans to sell its large stash of mortgage-backed securities. On the other hand, she did say, in response to a question, that she expected the Fed’s balance sheet “to shrink considerably over time back toward normal levels” and that she would have a “revised set of exit principles” — Fed code for shrinking its balance sheet — sometime in the fall.
Into this information vacuum has strolled none other than Stephen A. Schwarzman, first at an off-the-record discussion at the Council on Foreign Relations and then in a conversation with me. Mr. Schwarzman is the co-founder and chief executive of the Blackstone Group, the monumentally successful private equity, asset-management and advisory firm. Like other private equity firms, Blackstone has benefited immeasurably from the Fed’s low-interest rate policies, not only by being able to borrow money cheaply for its buyouts, refinancing and other deals but also because quantitative easing has raised the value of financial assets in general, allowing private equity firms to profit handsomely on many of their investments by selling them into a rising market, either through an initial public offering or an outright sale.
Mr. Schwarzman had been thinking about the Fed’s balance sheet and whether it needed to be unwound and shrunk to precrisis levels. For at least a generation, the Fed’s balance sheet has averaged about 5 percent of nominal gross domestic product and is now more than 20 percent, in line with both the Bank of England and the European Central Bank. The Bank of Japan’s balance sheet, meanwhile, is an outlier, at nearly 45 percent of nominal G.D.P. (During the Great Depression, the Fed’s balance sheet was 23 percent of nominal G.D.P.) Although Mr. Schwarzman concedes he’s no Fed expert or an economist, he concluded the Fed’s bigger balance sheet was a good thing. The Fed’s smaller balance sheet should not be the norm, he figured, when a single systemically important bank has trillions of dollars in assets.
“There’s no reason for your central bank to be a very, very small part of the total banking system,” he said. “I always thought it was underscale,” he added, “particularly as the Fed needed to undertake a variety of actions to stabilize the economy.”
So when Blackstone invited Mr. Bernanke to the firm recently to give a speech, Mr. Schwarzman decided to test his theory. To his surprise and delight, Mr. Bernanke told Mr. Schwarzman that he agreed that the Fed’s balance sheet should stay large.
“I don’t think it needs to be reversed,” he said. “The scale of the U.S. central bank is in line with many central banks around the world.” Mr. Schwarzman told me, “The fact that Bernanke saw the world the same just gave me the reassurance that someone else was looking at it in a similar fashion. And he’s important — I’m not.”
That the nation’s former central banker and one of its most powerful businessmen agree that the Fed’s huge balance sheet expansion poses no immediate risk to the economy drives James Grant nuts. Mr. Grant, the publisher of the highly respected Grant’s Interest Rate Observer, is a longtime Fed watcher. In an interview, Mr. Grant said the Fed’s vastly expanded balance sheet was “in service to an idea that the Fed ought to control and manipulate the structure of interest rates in this financial economy.” He said central bankers around the world had surrendered to the idea of “price administration” — efforts to manipulate interest rates — as opposed to “price discovery” — letting the market set price of money, which is what interest rates are, of course.
In this “collision of worldviews,” Mr. Grant wrote in the latest issue of his newsletter, he saw “risk and opportunity,” using the logic that “price control is futile. Interest rates are prices. Attempts to control, suppress or otherwise manipulate interest rates are therefore futile.” He says that for the first time in its history, the Fed has undertaken a propaganda campaign “to induce American savers and investors” into riskier assets like stocks and speculative debt. Like other “Credit Cassandras,” he sees this experiment ending badly: “Low volatility, deep complacency, perverse financial incentives, collapsing credit spreads, unslaked thirst for yield — the basic preconditions for a financial accident are already in place.”
The outcome of the Fed’s unprecedented effort to manipulate interest rates and whether it will unwind its balance sheet remain two of the greatest, underappreciated questions lingering in the corridor of power between Washington and Wall Street. One thing is certain: How they are answered will affect us all for years to come.