The Federal Reserve at its October 28-29 meeting announced that it would stop reducing the size of its balance sheet and instead begin a renewed “quantitative easing” buying bonds from the market. In other words, the central bank will once again finance the government’s budget deficit, a flagrant violation of Monetary Policy 101. As I will show below, this will have immensely damaging long-term economic effects, further agglomerating and bureaucratizing the corporate sector. It will also allow the central bank to “Liz Truss” the government, forcing a market meltdown, every time the government tries to implement better policies. President Trump needs to find new Fed leadership that will reverse this nonsense.

There are three factors that come into a Fed monetary policy, relating as it does to today’s dollar, a fiat currency with no established basis of value. The first and most obvious is the interest rate. The Fed’s new target for the Federal Funds rate of 3.75-4% is too low, since inflation is currently running at 3%. Indeed, the target may be sufficiently slack, below 1% in real terms, as to encourage a resurgence in inflation, especially as fiscal policy remains excessively loose and the Fed is promising to accommodate at least part of future budget deficits by buying Treasuries. However, the interest rate is at least closer to the optimal level of around 6% (a real rate of 3% net of inflation, mildly restrictive to bring inflation down further) than it was in the disgraceful and damaging years of 2010-21.

The second factor in Fed monetary policy is the inflation target. This has been set at 2% since 2012, because Fed chairman Ben Bernanke was paranoid about the possibility of deflation. As I have discussed previously, the Fed’s inflation target should be zero, because that is the only target consistent with its statutory policy mandate of stable prices. Over time, a zero inflation target, once it had been achieved, would produce lower nominal interest rates, perhaps at the 2.5-3% level on 30-year Treasuries. That would produce considerably cheaper home mortgages, a key objective for President Trump and for many of his supporters.

The third factor in Fed monetary policy, whose importance is often underestimated, is the extent to which it engages in “Quantitative Easing” or tightening, buying government and Agency bonds in the market or selling them to the market to reduce its balance sheet. In principle, through QE the Fed is financing the government by printing money. Every economic textbook since Adam Smith (and a couple such as Sir Dudley North (1641-91) and Richard Cantillon (1680s-1734) before him) has decried this practice, pointing to the Continentals, the French Assignats and the 1923 Weimar inflation and innumerable Third World disasters, notably the experience of Argentina since 1945, as reasons why it is wrong in principle and disastrous in practice.

Fed Chairman Ben Bernanke, a master of obfuscatory flim-flam, introduced QE in 2010, having seduced the unfortunate Bank of Japan into the practice on a visit in 1998. The result has been gigantic budget deficits, in Japan, the U.S. and Europe (except for Germany, which had a very sensible anti-deficit constitutional provision, now alas repealed). In Japan, the sheer size of the resulting government debt at 270% of GDP is beginning to restore sanity; in Europe and the U.S., government debt is still only around 120% of GDP so the market is not yet exerting sufficient pressure to provide a wake-up call. The first order effect of QE is thus to make it easier for the Left to grow government, a pernicious outcome that is likely to lead to debt default and financial collapse in a couple of decades.

There are other more immediate ill effects of QE that relate to its financing. If the Fed simply dropped money from helicopters, as Bernanke suggested at a notorious 2001 meeting that I attended, its effect would be inflationary but not especially distorting. Consumers would spend their money on whatever they spent it on, the economy would rev faster, and tax payments would increase, reducing the budget deficit. However, that is not what the Fed does; effectively it has devised a system whereby its helicopters hover only over Wall Street. The Fed finances its bond purchases by deposits from the major banks, on which it not only pays interest but pays interest at the full Federal Funds rate, currently 3.9%. The total of these Reserve Balances, while down from the peak, is currently $2.9 trillion, in addition there is another $1.2 trillion of deposits with the Fed which are not technically “Reserve Balances.” (The latter figure has been increasing in the last year almost as quickly as the Fed has been lowering Reserve Balances, so about half the announced figure of “Quantitative tightening” over the last year has been fictitious.)

The Reserve Balances and the Fed’s bond portfolio have led the Fed to make huge losses, all of which accrue to taxpayers and none of which have led to any recriminations or resignations at the Fed itself. The operating loss reported for 2024 was $77.8 billion, as the Fed paid out more to banks than it received from its investments; in addition, the value of its portfolio was underwater by $1.06 trillion at the end of 2024, approximately 600 times the $1.8 billion bond portfolio loss that bankrupted Silicon Valley Bank in 2023. Of course, unlike other financial institutions, the Fed has a special accounting dispensation by which it does not have to “mark to market” the underwater bond rubbish held in its portfolio. But still, $1.6 trillion is real money; it could today buy you a third of Nvidia.

The Reserve Balances, which can be expected to resume their inexorable long-term rise once QE starts again in the New Year, have a highly pernicious effect on the banking system while interest rates are even at their current levels, let alone where they should be. The big banks get much of their funding from deposits that pay very little interest, and they have the ability to leverage themselves by 10 to 1 even while retaining an image of sober conservatism. With Reserve Balances yielding 3.9% as at present, they can thus earn a return of more than 30% on their capital without lifting a finger.

Naturally, this risk and trouble-free return is much more tempting to banks than small business lending, the most difficult and time-consuming portion of their portfolio (even with the write-offs, consumer lending at extortionate interest rates is far more profitable). Hence, bank lending to small business has continued to decline sharply in real terms since 2010 – in the second quarter of 2025, an expansionary year, total outstanding small business loans increased only 1.5%, a 1.2% decline in real terms and an even larger decline in relation to GDP.

A resumption of QE, bloating the amount of “Reserve Balances” on bank balance sheets, can be expected to constrict small business lending still further, reducing the economic usefulness of the banking sector as a whole and increasing economic concentration in the largest companies. With the biggest banks devoting more of their effort to fee-earning businesses such as mergers and acquisitions, the overall effect of more QE will thus be negative on output and productivity in the short term, as well as being inflationary and causing long-term devastation to the Federal Budget.

President Trump, when he picks a new Fed chairman, must ensure a near-total reversal of current policies. First, the chairman must set an inflation target of zero, allowing long term interest rates to be brought down over the next 12-24 months as that target comes closer to being achieved – that will ensure cheaper home mortgages for 2028, the time of the next Presidential election. Second, and almost equally important, he must reverse the decision to resume QE and continue quantitative tightening until the $4 trillion of dreck Fed “Reserve Balances” are removed from the banks’ balance sheets, forcing the banks to do something more useful with their capital, such as lending to small business. Since this cannot be done overnight, he should reduce the rate paid on “Reserve Balances” not to zero, because that would force banks into a loss, but to somewhere around half the Federal Funds rate, or 2% at present. Trump likes low interest rates; that reduction will lower them within the banking system, as well as pushing the money market back onto the Federal Funds rate as a barometer, not the rate spuriously paid to banks on their idle Reserve Balances.

Trump’s other policies on deregulation and stimulus and removal of illegal aliens are all designed to get economic growth returning at a rapid clip, with spectacular productivity growth. Only by forcing banks to lend to small businesses can we ensure that the increased economic activity does not flow into the sluggish bellies of the corporate behemoths.

The big banks may not only whine; they may as in Britain in 2022, attempt to stage a “flash crash” money market crisis that can be used to deter the Trump administration from its anti-behemoth policies. Liz Truss was brought down by this; her foolish Chancellor of the Exchequer failed to point out the Bank of England scam that had produced an artificial crisis. President Trump and Treasury Secretary Bessent are, one hopes, made of sterner stuff.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)