The Fed is set to grow its balance sheet. What does this mean?
The Fed is concerned that the economy is operating below its potential. During the first half of the year, the Congressional Budget Office estimated that the economy could have produced an annualized GDP of $14.1 trillion. Instead, the economy actually produced $13.2 trillion—a $900 billion gap. What’s a central banker to do?
During normal times, this would call for a rate cut. Lower short-term rates would cut the rates on prime business loans, increase corporate profitability and lead to more hiring. Also, rates on consumer loans and mortgages would fall, allowing people to refinance at lower rates and have more money to spend.
Lower rates help stimulate the economy. But short-term rates are almost zero, so the Fed has begun “quantitative easing.” In this strategy they will use bank reserves to purchase Treasury bonds, lowering long-term interest rates. The Fed currently has about $2 trillion on its balance sheet; that’s up from $500 billion at the beginning of 2009. By some measures, the Fed needs to grow its balance sheet by another $2 trillion.
All these reserves have some scared that the dollar will collapse and inflation will soar. It’s true that the dollar has fallen about 10% since QE was first floated. But that’s hardly a collapse. The real issue is how lower interest rates will help the economy. We’re already close to a liquidity trap where companies won’t spend their excess cash because of uncertainty. A weak financial system aggravates this mess.
If normal Fed policy is three yards and a cloud of dust, this is a long bomb. But these are extraordinary times, and they call for extraordinary measures. Let’s hope they work.
Douglas R. Tengdin, CFA
Chief Investment Officer
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