FORECASTS & TRENDS E-LETTER
by Spencer Wright
January 2, 2024

IN THIS ISSUE:

1. What is the Fed Balance Sheet?

2. How is The Balance Sheet Used?

3. Does the Balance Sheet Matter to Me?

4. Conclusions

What is the Fed Balance Sheet?

I know we have been writing a lot about the Federal Reserve lately. Like it or not, the Fed is the single most influential financial entity on the planet. Period. No other central bank comes close to the sheer scope and global impact of the Fed. What they do and how they do it shapes virtually all global financial markets.

Of the tools the Fed has at its disposal, the most esoteric (and that is saying something) and most stimulative, is the balance sheet. But what is it?

As the name implies it is a statement of debt vs. assets. It is what the Fed owes vs. what it owns at any given time. You can find the most recent Fed balance sheet here or as the Fed calls it, Statistical Release H.4.1. You can’t make this stuff up.

Currently, the Fed’s balance sheet shows net assets of about $7.7 trillion. A staggering sum but well off its recent highs. More on that later. The liabilities on the balance sheet consist mostly of bank reserve deposits and US currency in circulation. The assets consist mostly of directly held treasury securities like bills, notes and bonds of various duration, as well as mortgage-backed securities. The following graph illustrates the evolution of the balance sheet from 2008 to the present.

How is the Balance Sheet used?

The balance sheet is a tool by which the Fed injects or removes liquidity into and from the market in the form of available credit. This can affect longer-term interest rates beyond any direct action the Fed may take regarding the Federal Funds Rate. The Fed either buys assets, known as easing, or sells assets, known as tightening, to achieve this effect.

Considering the above graph, you can see that the level of assets held on the Fed balance sheet in 2008 was approximately $1T. This is only a fraction of the present balance. The balance sheet ballooned to nearly $9T at the peak over the ensuing 15 years. What happened to cause this staggering increase? The short answer is a lot.

The longer answer involves a highly significant change in Fed policy and two “Black Swan” events when the markets dropped dramatically. The events were the 2008 financial crisis and the pandemic of 2020-2021. The policy change was initiated by former Fed Chair Ben Bernanke in 2008 in an effort to combat the financial crisis. The policy changes? The wholesale purchase of assets by the Fed, in quantity and across the board.

These asset purchases formed the backbone of the Fed’s Quantitative Easing (QE) effort. (QE is a media created term. The Fed prefers “large-scale asset purchases.”) The Fed knew that cutting rates to near zero was not enough. A massive expansion of credit to provide liquidity was needed. The measures undertaken by Bernanke were unprecedented in the history of the Fed. Asset purchases were nothing new to the Fed, but never on this scale. The Fed broadened the balance sheet to include many types of agency debt and a much larger percentage of mortgage-backed instruments which comprise about one third of the total balance sheet to this day.

Low interest rates persisted for several years, along with QE. The Fed felt this was needed given the depth of the 2008 crisis. From 2011-2012 the Fed began to “taper” asset purchases, as Bernanke knew that an expansive balance sheet was not desirable. The market reacted poorly and the Fed backed off. Janet Yellen replaced Bernanke in 2014 and QE continued.

Jerome Powell ascended to Fed Chair and in 2018 he sought to normalize interest rates and reduce the Fed balance sheet. This action was again not well received by the market, and in December of 2018 the SPX declined nearly 20%. Once again, the Fed backed off, though Powell reduced the balance sheet going into 2020.

Of course, we all remember what happened in 2020. The FOMC slashed rates to effectively zero and large-scale QE was back on the table in a big way. You can see on the above graph that this was the most massive expansion of the balance sheet ever. This wasn’t a good thing. Perhaps a needed emergency measure but the bill always comes due.

At the end of 2021, 12 years of historically low interest rates and QE came home to roost. Inflation at last. Fearing the stagflation scenario from the late 70s and early 80s the Fed acted. Rates would have to go up, dramatically, and QE would turn into QT (Quantitative Tightening), or as the Fed refers to it, “balance sheet normalization.”

Where QE stimulates markets with ample liquidity, QT removes that liquidity in an effort to cool an overheating economy.

Does the Balance Sheet Matter to Me?

Yes it very much does. A growing balance sheet as a result of QE can promote growth through the expanded use of corporate and personal credit. Usually this is done in response to a crisis and not as a part of normal Fed operations. And as we have recently seen this can bring about serious long-term consequences in the form of price inflation, low savings rates and excessive risk taking in the equity markets. All these things can lead to crises of their own. As good as it may seem, over time there is no free lunch.

When balance sheets are normalized (QT), it makes borrowing more expensive for both the government and businesses. This can result in lower profits for companies, slower economic growth, and eventually, job cuts. To cover increased debt costs, the government may raise taxes. Also, as money supply decreases, consumers may face higher costs for loans and essential goods and services due to increased underlying expenses.

And as we saw in 2022, QT can sink equity markets over the short to intermediate term.

Conclusions

The Fed has given every indication that it plans to continue reducing its balance sheet. Currently they are just allowing positions to mature and roll off as they come due. The Fed is not actively selling positions in quantity. And it is not likely that the Fed would ever be compelled to become an aggressive net seller.

If Fed market operations are kept to those that historically are balance sheet neutral, such as REPO, Reverse REPO, Twist, etc., the balance sheet assets can simply be allowed to run off. It could easily take a decade or more for the Fed to return the balance sheet to pre-2008 levels.

The link below is a very (VERY) dense but very interesting read on the balance sheet unwind and its impact.

The financial market effects of unwinding the Federal Reserve’s balance sheet

Thanks for reading,

[Spencer]

Spencer Wright

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