The Fed’s money printing can be traced to the Great Gatsby curve

Since April, the Fed has been shrinking its balance sheet, by gradually sucking out the money that it had printed and pumped into the financial system. The hope was that the Fed’s balance sheet would shrink by a trillion dollars by June. But that won’t be happening now.

As of 8 March, the Fed’s balance sheet size had shrunk to $8.34 trillion. But by 15 March, it had grown by close to $300 billion to $8.64 trillion.

This means that the Fed has started printing money again. Why? Many small-and-mid-sized US banks are in trouble. They have been borrowing money from the Fed. In order to lend money, the Fed creates money out of thin air and lends it against good collateral, which typically tend to be government bonds or other bonds usually deemed to be safe. The Fed has been doing just that. These bonds have ended up as assets on its balance sheet and the size has expanded.

So, how did we end up here? Over the years, the income inequality in the American economy has been increasing. As Martin Wolf writes in The Crisis of Democratic Capitalism: “Over the period of 1993 to 2015, the cumulative real growth in incomes of the top 1 percent was 95 percent, compared with 14 percent for the remaining 99 percent."

Over the years, a lot of manufacturing has moved away from the US, hence, stuff that was produced in the US, is now imported. But that’s not the main reason behind income inequality. As Wolf writes: “Manufacturing industry used to generate a very large number of relatively highly paid and secure jobs for less-educated men… The dominant cause of the decline in the share of industry in employment has been rising productivity, not trade." Fewer factories now produce more than they did in the past, leading to a lower labour force participation rate and hence, a massive increase in economic inequality.

In fact, the economist Alan Kruger termed this as The Great Gatsby curve. He was inspired by F. Scott Fitzgerald’s eponymous novel, which highlighted the prevailing inequality in the US in the 1920s. In countries with high income inequality, children from poor families are less likely to improve their economic status during the course of their lifetime, because wealth is concentrated in fewer hands.

In fact, the financial crisis of 2008 made the situation worse. Further, the political and economic response left much to be desired, with Wall Street being rescued and not much being done to help Main Street. As Wolf writes: “It was this shock, together with the grossly unfair bailouts of the people who caused the crisis, that persuaded so many Americans that Washington was a “swamp," which Donald Trump alone could drain."

In this scenario, when covid broke out, it was important that the political response to the crisis helped people on the Main Street. This time around the American government, indirectly helped by the Fed’s decision to print a massive amount of money, decided to put money directly into the bank accounts of people.

But what the Fed and the government hadn’t bargained for is the rise in inflation. In December 2020, the month before Joe Biden took over as the president, the retail inflation in the US was 1.3%. By June 2022, it had risen to 8.9%. This was due to an increase in purchasing power of people and the supply-chain shock because of the pandemic.

The Fed’s initial reaction was that inflation would be ‘transitory’. This probably stemmed from the fact that the US had seen low-inflation since the early 1980s, after retail inflation had peaked at 14.6% in March 1980. Further, between February 2012 and December 2020, inflation had never crossed 3%.

Now the money that the government had distributed to people along with the money printed by the Fed, ended up in the banking system. Many banks ended up investing a part of this in long-term treasury bonds and mortgage backed securities (MBSs). Treasury bonds are issued by the American government to finance its fiscal deficit. MBSs are financial securities issued to securitize mortgages (or home loans). These banks assumed that interest rates will continue to remain low, like they had since the early 1980s.

The Fed finally acknowledged inflation and started raising interest rates from March 2022 onwards. It has raised rates eight times since. Interest rates and bond prices are inversely proportional. So, as interest rates go up, bond prices fall. Further, the longer the tenure of the bond, the higher the fall. This is precisely what happened with many small and mid-sized US banks which had loaded up on long-term bonds, leading to huge unrealized-losses.

Now the trouble is that banks borrow for the short-term and lend for the long-term. So, as deposits matured, banks had to sell some of these bonds to redeem them and in the process, the losses became real.

This dynamic has led to the failure of a few banks during March. In order to prevent any further trouble, the Fed is ready to lend money against the full face value of such bonds and not just the prevailing market value. And this is why it’s printing money all over again.

Vivek Kaul is the author of ‘Bad Money’