The Federal Reserve has spent six years and over $3tn buying up bonds to save the economy. Now it has to figure out how to sell it all back without creating a panic

The largest financial stimulus program in the history of the United States has ended. Now the really interesting chapter of the American economy begins.

On Wednesday afternoon, the Federal Reserve announced it would stop its sprawling six-year-old stimulus program, known as quantitative easing. In three rounds of QE, the Fed bought trillions of dollars of mortgage and US treasury bonds from banks and hedge funds to keep interest rates at zero.

The announcement means that the Fed will no longer buy those bonds. Many will focus on whether and when interest rates will rise, but that’s not the big question. Of course interest rates will rise; they’re currently at zero. If you’re a consumer buying anything that needs an incredibly low interest rate, you’ve had plenty of time to lock it in. If you’re a company that needs to refinance your debt, there have been six years to get it done. Anyone else who’s trying to figure out when rates will rise is most likely a speculator, and that grousing can safely be ignored.

The Fed is not filling up the financial hole left by its stimulus. It has only stopped digging itself deeper.

What the Fed isn’t saying is how it plans to get rid of the enormous number of bonds it has bought. The concerns raised by the Fed’s stimulus still exist: has it helped the economy? (Probably, but not enough). Has QE made banks more profitable? (Yes, and that will continue). Has QE created an expectation that the Federal Reserve can now meddle in the markets with trillions of dollars of muscle, complicating things for normal money managers? (Yes, and that expectation, too, will continue). In other words, by ending QE, the Fed is not filling up the financial hole left by its stimulus. It has only stopped digging itself deeper.

This is a big problem, and a historic one. How the Fed manages its exit from quantitative easing will be revealing, exposing the fault lines that underpin the financial system. One of those fault lines, and the one most worth watching, is the resentment that banks have benefited extraordinarily from the Fed’s stimulus. While banks made billions in profits from low interest rates, ordinary Americans lost out.

It has become fashionable, in the past two years, for banks and fund managers to complain that QE was bad for them, that the Fed was vacuuming all the good bonds out of the market and leaving no room to maneuver. Ask Ann Owen, a Hamilton College economics professor and former Fed Board of Governors economist, if these complaints make sense: “No. [Banks] have benefited from it. They’ve benefited from the Fed’s monetary accommodation, because if the economy is stronger, they’re stronger.”



The end of QE won’t hurt banks. The Fed’s exit from QE will benefit banks even more. A large part of unwinding QE involves paying banks high interest rates to behave the way the Fed wants them to behave.



The ransom will be worth it. The exit from QE is perhaps the biggest financial challenge to face the United States in decades. It involves trillions of dollars, the faith of the financial markets, and the ever-present fear of market panic.



Here’s why: the Fed’s balance sheet – a measure of what it holds – was under $1tn when it started buying bonds through QE. Now its balance sheet is over $4tn.

That means that, over the next few years, to get back to normal, the Fed has to find a way to sell over $3tn worth of bonds. The likely buyers? The same group of banks and hedge funds that first sold them to the Fed.

The Fed, of course, cannot just dump $3tn in bonds. It took six years to accumulate that, and it may take as long to dispose of it. So the Fed has to offer incentives to get this to work. Those incentives mainly include paying high interest rates to banks, to keep them happy and profitable.

There are three ways the Fed will continue to pay banks higher interest rates, according to Owen. All of them center around controlling bank “reserves,” or the money they keep parked with the Fed.



The first two have to do with all the money that banks have been parking with the Fed. Banks have not been making loans with that money as they should have been. QE made it too profitable to keep the money sitting at the Fed. The Fed will continue to pay the banks high interest rates to keep the flood of money at bay. It will also offer the banks a higher interest rate to keep those deposits locked up for a certain period of time – like a certificate of deposit, but for major financial institutions.



“They are willing to give banks whatever interest rates necessary. They don’t want all those excess reserves to flood the market at once,” Owen says. “They can go as high as they need to go.”



Another way banks will benefit: what’s called “reverse repos.” The upshot is that the Fed will borrow from banks temporarily, then pay them back with interest the next day. The banks make good money on the interest – and even better money because it’s clear that the Fed plans to do many more of these deals. In September the Fed increased the cap on such deals to $30bn per bank – triple the previous $10bn limit.

This is why quantitative easing is ending with a whimper rather than a bang. The Fed didn’t even hold a press conference at the end of its two-day meeting, a sign that the move to end QE shouldn’t cause much fuss. Perhaps even the Fed knows that the stimulus has worn out its welcome. With the upcoming challenge of its exit, QE is proving a truth of even the most well-intentioned bailouts: getting the financial system out of trouble doesn’t mean ending a crisis for good; it means only delaying the reckoning until the economy is strong enough to take it.

