This morning’s inflation report (September 13) sent the stock and bond markets into a tailspin. The fear is the Federal Reserve’s response to this disappointing report and the effects on the economy if they aggressively raise interest rates and tighten the balance sheet.
Part of this fear results from a chilling statement made by Fed Chairman Jerome Powel in Jackson Hole late last month.
In an eight-minute address on Friday, August 26, 2022, the Fed Chair Jerome Powell reiterated that the U.S. central bank would keep raising interest rates and shrink the Fed’s balance sheet to reduce inflation.
The days after his comment witnessed a declining stock and bond market. While we read and hear news of the Fed balance sheet tightening, how well do you know what the balance sheet entails and what it means when the Fed eases or tightens the balance sheet?
What is the Fed Balance Sheet?
The Fed balance sheet is not much different from your own personal balance sheet, just much larger! Similar to any balance sheet. It consists of assets and liabilities. The assets in the Fed Balance Sheet are primarily treasuries and mortgage-backed securities. Most of these assets the Fed bought during the financial crisis and the COVID shutdown as the Federal Reserve sought to help bolster those two crippled economies.
Nearly two-thirds of the Fed’s Balance Sheet is Treasury securities, including shorter-term Treasury bills, notes, and bonds. Mortgage-backed securities make up almost one-third of the balance sheet.
By law, the Fed can only purchase government-backed debt. However, in severe emergencies, as we saw during the COVID Crisis, the Fed can create a special “lending facility” that it will fund, along with funding from the Treasury Department as a backstop. The Federal Reserve will use that facility to purchase other types of debt, such as corporate bonds, which they add to the balance sheet.
On the liability side, deposits held by commercial banks are the largest line item on the Fed’s Balance Sheet.If you wish to understand the second-largest liability item on the balance sheet, you need only read the front of the dollar bill in your pocket labeled “Federal Reserve Note.” U.S. currency in circulation represents the second largest liability category on the balance sheet. In addition to these two large items, there are other smaller liabilities, like deposits from non-banks and foreign deposits.
Why is the Fed Balance Sheet a topic of discussion?
The Federal Reserve had dramatically expanded its balance sheet to dampen the economic jolts brought on by the financial crisis of 2008 and the recent COVID-19 pandemic. The Fed’s balance sheet expansion is known as Quantitative Easing (QE).
To put the expansion of the balance sheet in perspective, on September 3, 2008, the Fed Balance Sheet stood at $910 billion. The balance sheet would increase to $4.52 trillion by January 14, 2014. On February 26, 2020, the eve of the COVID-19 pandemic, the balance sheet stood at $4.16 trillion, only to balloon to almost $9 trillion by May 17, 2022. As of September 1, 2022, the Fed balance sheet was nearly $8.9 trillion.
How does the Federal Reserve Quantitative easing work?
Quantitative easing is when the Fed begins to make large-scale asset purchases like longer maturity Treasuries and commercial bonds. When the Fed buys these assets, they effectively engage in the so-called printing of money by creating bank reserves on the Fed Balance Sheet. The Fed will use these reserves to purchase long-term Treasuries in the open market from major financial institutions.
These financial institutions now have more cash, which they can hold on their balance sheet or lend to consumers or companies. The Fed’s infusion of money into the economy serves to ease problems in the financial system, such as a credit crunch, when available loans decrease. The Fed’s asset purchase aims to make the financial markets operate normally.
With the Fed buying billions worth of Treasury bonds and fixed income assets, yields will generally go lower because of the greater demand for bonds from the Fed. These lower interest rates make it cheaper to borrow money, encouraging consumers and companies to take out loans to expand their business which could help spur economic activity.
In addition, because bond yields tend to decrease when the Fed expands its balance sheet, investors generally find lower yields on market accounts, bank certificates of deposit, and bonds. These lower yields may turn investors’ attention to higher returning but riskier assets like stocks. This shift to equities could potentially lead to more substantial gains for the stock market, all due to the Fed balance sheet expansion.
The Possible Downside of the Fed’s Quantitative Easing
One danger of the Fed’s quantitative easing is inflation risk. Inflationary pressure may occur if the Fed overestimates the financial crisis. In doing so, the Fed creates too much money in the economy through the balance sheet purchase of assets. Greater monetary supply enables the consumer and businesses to raise their demand for goods and services, which can drive up prices, potentially creating an inflationary environment.
The Fed’s creation of excess cash can also lead to an overheated economy, which puts the Federal Reserve in a position to attempt to cool down inflation and the economy. Here again, the Fed will use the Balance Sheet in what is known as Quantitative Tightening.
What happens to the Fed’s Balance Sheet in Quantitative Tightening?
Currently, the Fed is discussing tightening the balance sheet. The Federal Reserve balance sheet tightening is the mirror image of the Fed’s Quantitative easing. Quantitative tightening is when the Fed sells its assets to reduce the supply of money circulating in the economy. The Federal Reserve’s objective is what is known as balance sheet normalization, which now attempts to reduce the Fed’s inflated balance sheet.
The mirror image aspect of Quantitative Tightening is that now the Fed is attempting to reduce the amount of money in circulation, which could be deflationary. Since the Fed’s balance sheet assets consist primarily of bonds and treasuries, the Fed can reinvest all proceeds from maturing securities or only a portion. In Quantitative Tightening, they will decrease their reinvesting to reduce the balance sheet. The Fed’s assets would decline even faster if it chose not to reinvest any process from matured securities. This tactic is known as “portfolio runoff.”
The Possible Downside of The Fed’s Quantitative Tightening
Like Mansingh Oli Prabhas record of spinning plates, tightening the Fed’s balance sheet through Quantitative Tightening requires the Fed to focus on removing money from the system while not weakening the financial markets and ensuring that plates do not begin to wobble and fall.
The Federal Reserve can see plates crashing to the ground if they remove liquidity in the market too quickly, which can adversely affect the financial markets. We have witnessed this recently with the large swings in both the bond and stock markets.
On a positive note, tightening the Fed’s balance sheet could possibly lead to higher interest rates on bonds, money markets, and bank CDs, which could be a pleasant gift from the Federal Reserve to yield-hungry investors.
The Fed is facing brutal crosswinds, which make its job of curbing inflation more difficult. Supply chain disruptions due to COVID combined with Russia’s invasion of Ukraine have added factors driving up prices.
Federal Reserve Chairman Jerome Powell is trying to navigate a soft landing for the economy, but he has a difficult job ahead of him. To navigate this soft landing, it will take a masterful job to combine interest rate increases with the Fed Balance sheet tightening, blended with factors like the pandemic and the war, both of which are beyond the Federal Reserve’s control.
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