In its first meeting of 2019, the Federal Reserve held interest rates steady and struck a more passive tone moving into the new year. “Patience” and “wait and see” were evoked often by Fed Chairman Jerome Powell; the central bank even dropped any allusions to “further gradual increases” to interest rates from its monthly statement.

The economy, Powell said, remains on steady footing (despite a few crosswinds) and the Fed would act with, what you might call, a “velvet touch” regarding its policy – just as Northwestern Mutual Chief Investment Officer Brent Schutte wrote back in July 2018.

Though Powell provided clarity on interest rates in January, the markets were also keen to learn about the Fed’s approach to unwinding its balance sheet – details were sparse. Some argue that the Fed could disrupt economic growth and spark a recession if it handles this aspect of its policy incorrectly. But notes from that January meeting, released in February, indicate Fed officials may seek to halt the balance sheet unwinding process by the end of the year – an announcement on this front could come soon.

“Such an announcement would provide more certainty about the process for completing the normalization of the size of the Federal Reserve’s balance sheet,” Fed officials said, according to minutes from their January meeting.

So, what exactly is the Fed’s “balance sheet”, and why has it garnered so much attention lately?

THE BALANCE SHEET

To understand how the balance sheet works, it’s important to first understand how the Fed works. The Federal Reserve is the bank for banks. A traditional bank has assets (stocks it holds, loans it makes or other assets that will bring money in) and liabilities (money you deposit – and may want to in the future – or loans the bank takes and will have to pay back). The Fed also has assets and liabilities; however, they are a little different than what you’d find at a traditional bank because the Fed controls the supply of U.S. dollars.

On the Fed’s liabilities side is reserve funds that banks hold (just as you make a deposit at a bank, a bank makes a deposit at the Fed). The Fed also has assets in the form of securities it may buy or loans it makes (typically by buying bonds like US treasuries).

The Fed also has this little trick every CEO in the world envies: When it wants to expand its balance sheet, it simply “creates” more money. It does this by buying assets on the full faith and credit of the United States government. To pay for the Treasury bills, for example, the Fed credits funds to the reserves of banks. Every central bank has this unique ability, and it can have a profound impact on the economy and prevailing interest rates.

HOW THE FED USES ITS BALANCE SHEET

The financial collapse of 2007 provides a vivid example of how the Fed deploys the balance sheet to affect the economy.

With the mortgage crisis in full tilt, the Fed cut short-term interest rates to zero, but that still wasn’t enough to stimulate the economy. The Fed needed a way to lower long-term interest rates, as well. So, it pulled out its little trick and put more money into circulation by buying a bunch of Treasury bonds and mortgage-backed securities (high demand drives bond prices up and yields, or interest rates, lower). This move, known as quantitative easing, had the effect of driving interest rates lower and putting more money into the economy. More money and low rates encouraged people and businesses to take out loans and buy things. That, in turn, helped drive the economy.

Some economists estimate that interest rates are about 1 percent lower today than they otherwise would have been without quantitative easing; however, jumpstarting the economy didn’t come cheap. The Fed’s balance sheet ballooned from a pre-crisis level of $925 billion and hit a peak of $4.5 trillion in 2015. The highest in its history.

WHY INVESTORS CARE NOW

As you can see, when the Fed goes on a buying spree (expanding the balance sheet) it’s increasing the money supply and keeping interest rates lower to boost the economy. But in June 2017, the Fed announced it would begin shrinking its post-crisis, bloated balance sheet. Unwinding the balance sheet is stimulus in reverse: the money supply shrinks, interest rates may rise, and economic activity might fall.

The Fed can unwind the balance sheet in one of two ways: Let the securities fully mature and simply dissolve or sell them on the open market. Since 2017 the Fed has let more securities mature than it has purchased, reducing the size of the balance sheet to $4 trillion – shrinking no more than $50 billion a month.

Here’s why investors worry about the Fed’s balance sheet: If it unwinds too quickly and overly constrains the money supply, higher borrowing costs could grind the economy into a recession. However, if there’s too much money sloshing around it could lead to higher inflation. As with all things, the Fed is looking to strike a balance to keep inflation low and employment levels high.

For now, given what we’ve heard from Powell, the Fed will let the economy shape its views regarding the balance sheet and interest rates, rather than stick to a predetermined schedule or plan. Given the S&P 500 posted its best January since 1987, investors seem to be OK with the Fed’s position to start the year.

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