IWM - Federal Reserve Watch: The Fitch Downgrade

2023-08-04 18:47:07 ET

Summary

• The Federal Reserve needs to understand and accept the seriousness of the recent downgrade of U.S. debt by Fitch Ratings.
• The Federal Reserve has its role to play in the upcoming deluge of federal debt that is forecast and must move to play a role in this future.
• The Federal Reserve continues its program of quantitative tightening but faces a future where the amount of government debt issued will be huge.
• How will the Fed handle the market conditions that accompany a massive amount of new government debt?
• Maybe it is time for the Fed to "Wake Up!"

Fitch Ratings reduced the grade of U.S. debt from AAA to AA+.

The justification: "a steady deterioration in standards of governance over the last 20 years" along with the country's mounting debt load.

Through this downgrade and the recent battle over the government's debt ceiling, the Federal Reserve has been silent.

David Malpass, former president of the World Bank, 2019-2023, and undersecretary of the U.S. Treasury, 2017-2019, is calling out for Federal Reserve attention in a Wall Street Journal article .

The Federal Reserve has been complicit in the actions of the U.S. government, cries Mr. Malpass.

The Fed's "more than $7.0 trillion in bonds support Washington's deficit spending by holding down bond yields, blurring the line between fiscal and monetary policy."

"The downgrade is a clarion call to rethink fiscal, monetary and regulatory policies."

In other words, the government, the Federal Reserve, and other policy makers need to change their approach to what they have responsibility for because what the government, the Federal Reserve, and other policy makers have done is culminating in a very bad way.

"The Congressional Budget Office's June 28 report on the long-term deficit shows that the federal government expects to spend $160 trillion between 2024 and 2040, doubling the public debt."

"Fiscal deficits would average more than 6 percent of GDP during that period, well above the historical panic button of 3 percent...."

The Federal Reserve is now engaging in quantitative tightening, reducing the size of its securities portfolio on a regular basis.

With all of this projected debt coming to market, can the Fed continue to this policy to fight inflation?

"The New York Fed's April Open Market Operations report describes a plan to buy trillions more in U.S. government bonds, apparently without regard to the issuer's fiscal policies or bond rating."

Sounds like the Federal Reserve System is becoming the "lackey" of the federal government.

So much for central bank independence.

Question: When will quantitative easing begin again?

Quantitative Tightening Still Going On

In the meantime, quantitative tightening is still going on.

In the latest banking week, the week ending August 2, the Fed's securities portfolio declined by $33.0 billion.

Since the end of June, the securities portfolio has fallen by $117.7 trillion.

And, since the quantitative tightening began on March 216, 2023, the securities portfolio has declined by $922.6 billion.

Given the accounting adjustments associated with bond discounts and bond premiums have resulted in the assets connected with the securities portfolio also contributing to the Fed's portfolio, we see that the Federal Reserve "portfolio" has fallen by $982.5 billion...almost $1.0 trillion.

However, the declining securities portfolio has not been the only thing going on over this time.

Member commercial banks have been allowed to borrow $262.1 billion from the Federal Reserve. Most of these borrowings have been associated with the problem bank situation which came to our attention early in March 2023.

As a consequence, Reserve Balances with Federal Reserve Banks, a proxy for commercial bank excess reserves, have fallen by only $676.0 billion since March 16, 2022.

Note two things in this chart.

First, it looks as if Reserve Balances leveled out beginning in early October 2022. That is, the reduction in the Fed's securities portfolio did not contribute to a further "tightening" of "excess reserves" beginning in the fall of 2022.

Second, the amount of "excess reserves" in the banking system actually rose beginning in early March 2021.

This was the time that the trouble at Silicon Valley Bank was identified and the time that the Federal Reserve responded to the problems in SVB and other troubled banks by opening up the Fed's loan window.

The point of this discussion is that since the fall of 2022, the liquidity available to the banking system did not decline further. And, this liquidity level remained relatively constant throughout the time the Fed was continuing to let securities leave the Fed's securities portfolio.

Quantitative tightening continued.

Bank excess reserve levels remained constant.

Further Issue

There still remains the question about whether or not the "tightening" plans of the Federal Reserve really went far enough.

Quantitative tightening is now in its 17th month. The reduction in the securities portfolio has amounted to almost $1.0 trillion.

But, $1.0 trillion is only a minor part of the securities that the Federal Reserve added to its securities portfolio in the 2019-2021 period.

After sixteen months, the Federal Reserve still has over $7.5 trillion on its balance sheet.

And, the amount of cash that is in the financial system. I have just written a post examining all the cash that is "lying" around in the financial system.

So, how long is the Federal Reserve going to stick with its quantitative tightening?

This is one of the questions being asked by David Malpass in the Wall Street Journal cited above.

"Wake Up" Mr. Malpass cries.

The situation is becoming more and more serious.

Mr. Malpass is crying out that the "governance" of the national debt includes more than just the federal government.

The Federal Reserve, he contends, must be included in this failure of governance.

And, the failure of governance goes back a long way...at least 20 years.

I, personally, believe that this " failure of governance " goes back further than that.

But, as we see within a historical setting, a lack of fiscal responsibility tends to extend over a substantial period of time. And, usually the time extends long enough that the period of irresponsibility cannot be overcome...problems accumulate as the problems grow.

"Wake Up" Mr Malpass cries.

But, we need some leadership for this to happen.

Where is the leadership going to come from?

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