Quantitative easing (QE) implemented by the Federal Reserve, which involved buying trillions of dollars in bonds, essentially pushed trillions in deposits into the banking system, backed by newly created reserves. Despite this massive monetary expansion, the growth rate of U.S. commercial bank loans between 2008 and 2022 averaged a mere 3.4% annually, the slowest since 1947. This created a situation where at the end of 2022, the U.S. banking system held $18 trillion in domestic deposits, with an estimated $8 trillion exceeding the FDIC insurance limit, indicating a significant amount of destabilizing excess deposits.
The excess liquidity meant that banks and other investors, desperate for yield in a zero-interest-rate environment, drove long-term securities, including Treasury bonds, to record valuations. This created a toxic mix of abundant bank deposits and speculative investments seeking higher returns. The Federal Reserve's actions, by creating $8 trillion in base money, ensured that someone in the economy would ultimately hold this indirectly as bank deposits or money market funds, or directly as physical currency.
The recent failure of Silicon Valley Bank (SVB) exemplified these problems, combining excess deposits with losses on assets, even in normally safe investments like Treasury bonds. SVB's collapse was not due to a system-wide lack of liquidity, but rather an abundance of it, which contributed to an unwinding bubble and highlighted that issues like sudden banking strains, the British pension crisis, and equity market losses are mere symptoms of this larger instability. The article argues that the Fed itself would be technically insolvent if its assets were marked to market value.
While central banks were initially hesitant to unwind these holdings, fearing negative impacts on financial markets, current quantitative tightening (QT) programs have been more muted in their effects than QE. QT has caused only a modest increase in yields, between 0.04 to 0.08 percentage points, for government bonds with maturities of one year or longer. However, the unique nature of QE, particularly its impact on bank deposits and the valuation of assets, makes the process of QT potentially dangerous, as emphasized by banking experts who warn that it might not be a simple reversal and could pose financial stability risks for weaker banks if deposits are withdrawn and asset values decline.
