Should We Really Not Worry About The Fed’s Balance Sheet?

Bill Dudley, who is now a senior research scholar at Princeton University’s Center for Economic Policy Studies and previously served as president of the New York Fed and was vice-chairman of the Federal Open Market Committee, recently penned an interesting piece from Bloomberg stating:

“Financial types have long had a preoccupation: What will the Federal Reserve do with all the fixed income securities it purchased to help the U.S. economy recover from the last recession? The Fed’s efforts to shrink its holdings have been blamed for various ills, including December’s stock-market swoon. And any new nuance of policy — such as last week’s statement on “balance sheet normalization” — is seen as a really big deal.

I’m amazed and baffled by this. It gets much more attention than it deserves.”

I find this interesting.

A quick look a the chart below will explain why “financial types” have a preoccupation with the balance sheet.

The preoccupation came to light in 2010 when Ben Bernanke added the “third mandate” to the Fed – the creation of the “wealth effect.”

“This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate this additional action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”

– Ben Bernanke, Washington Post Op-Ed, November, 2010.

In his opening paragraph, Bill attempts to dismiss the linkage between the balance sheet and the financial markets.

“Yes, it’s true that stock prices declined at a time when the Fed was allowing its holdings of Treasury and mortgage-backed securities to run off at a rate of up to $50 billion a month. But the balance sheet contraction had been underway for more than a year, without any modifications or mid-course corrections. Thus, this should have been fully discounted.”

While this is a true statement, what Bill forgot to mention was that Global Central banks had stepped in to flood the system with liquidity. As you can see in the chart below, while the Fed had stopped expanding their balance sheet, everyone else went into over-drive.

The chart below shows the ECB’s balance sheet and trajectory. Yes, they are slowing “QE” but it is still growing currently.

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Moon Kil Woong 2 months ago Contributor's comment

The limited reversal of a fraction of QE is a good thing. The rise in rates was more the Federal Reserve echoing the higher rates in the market than the Federal Reserve dictating interest rates. The simple fact is tariffs and tax cuts more than systemic demand caused inflation.

The Federal Reserve was right to raise rates and the US is much safer in a downturn for doing so. That said, they can let off the wheel if the trade war ends. If not, they will likely have to raise again because they are not dictating rates, merely following higher rates as lenders deal with inflationary pressures.

As for QE, they should keep cutting it until it shows some adverse effect in the market. Cutting QE is more important than raising rates in my book. It should have never happened in the first place.