The Incredibly Shrinking Fed

Do you remember getting your height checked?

Photo: Sgt Alesia Gusic. Source: US Navy

I do. And it was a shock to me, recently, when I realized that I was shorter than before. It shouldn’t be, though. As we get older, the discs in our spine dehydrate and compress. Our spines can also become more curved. Most people lose about a half inch every 10 years or so after they turn 40.

Getting smaller isn’t something we usually celebrate, though. Everything we do is oriented around growth. This is true in economics, too. It’s rare that we celebrate when economies or companies shrink. The population in Japan has been declining for decades, and that’s been a problem for them.

But sometimes shrinking is prudent. That’s the case with the Federal Reserve right now. During the Financial Crisis the Fed expanded its balance sheet from less than $900 billion to about $4.5 trillion. The Fed stopped growing in 2014, and recently has begun to allow its balance sheet to shrink

Source: St. Louis Fed

The Fed bought US Treasury Notes and Mortgage Backed Securities because interest rates were at zero and they couldn’t cut rates any more to stimulate the economy. Managing monetary policy via the Fed’s balance sheet presents challenges, though. When Ben Bernanke announce in mid-2013 that they would begin to taper their purchases, the market responded with a “taper tantrum,” pushing longer rates and market volatility higher. And this was understandable: we were in uncharted waters, and a $4 trillion balance sheet is pretty big.

As a result, the Fed currently makes its expected actions and adjustments as transparent and predictable as possible. Notably, as they shrink, they’re not selling assets, they’re just allowing a some of their holdings to mature without replacing all of them. It took some trial and error to get to this point, and any changes need to be gradual. An actively managed bond portfolio this big would be pretty disruptive. Imagine buying a bond and finding out a day or so later that the Fed will be selling $10 billion of the issue you just purchased. That might affect the price!

Where is all this going? Ten years ago, the public held about $800 billion in currency, roughly equal to the size of the Fed’s balance sheet. Now we hold almost $1.7 trillion in greenbacks. This should grow to almost $3 trillion over the next decade, unless we all start paying our bills in Bitcoin. In addition to currency, the Fed owes $1.7 trillion to the commercial banks for their excess reserves, which are kind of like deposits. As a result, the Fed’s balance sheet isn’t much bigger than normal right now.

Sometimes getting smaller is natural and even helpful. I can fit into smaller spaces more easily now that I’m shorter, and I’m less likely to bang my head. The Fed’s balance sheet is slowly adjusting to its normal place in our financial landscape. Let’s hope this process continues in a healthy way.

Douglas R. Tengdin, CFA

Charter Trust Company

“The Best Trust Company in New England”

By |2018-10-19T16:42:35+00:00October 19th, 2018|Global Market Update|0 Comments

About the Author:

Mr. Tengdin is the Chief Investment Officer at Charter Trust Company and author of “The Global Market Update”. The audio version of each post can be heard on radio stations throughout New England every weekday. Mr. Tengdin graduated from Dartmouth College, Magna Cum Laude. He received his Master of Arts from Trinity Divinity School, Magna Cum Laude and received his Chartered Financial Analyst (CFA) designation in 1992. Mr. Tengdin has been managing investment portfolios for over 30 years, working for Bank of Boston, State Street Global Advisors, Citibank – Tunisia, and Banknorth Group. Throughout his career, Mr. Tengdin has emphasized helping clients manage their financial risks in difficult environments where they can profit from investing in diverse assets in diverse settings. - Leave a comment if you have any questions—I read them all! - And Follow me on Twitter @GlobalMarketUpd

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