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In his Tuesday, February 26, 2019 semiannual testimony on the state of monetary policy, Federal Reserve Chairman Jerome Powell told a Senate committee that the Fed was prepared to “adjust” the balance sheet unwind. This seemed to ease the market’s concern.
Two months earlier Chairman Powell rattled the markets when he described the balance sheet unwind as being on “autopilot”.
What do these seemingly disparate terms mean and how might they affect investors?
What is the Fed’s Balance Sheet?
The Fed's balance sheet is not much different from your own personal balance sheet, just much larger! It consists of assets and liabilities. The assets are primarily treasuries and mortgage-backed securities, the majority of which the Fed bought during the financial crisis in its effort to lower long-term interest rates and stimulate growth. The Fed’s balance sheet was under $1 Trillion in 2008, expanded to $4.4 trillion by October of 2017, and sat at $4 trillion at the start of 2019. (1)
On the liability side, deposits held by commercial banks are the largest line item, representing about 45% of its liabilities. (2) To understand the second largest liability item, you need only read the front of the dollar bill in your pocket labeled "Federal Reserve Note." U.S. currency in circulation is the second largest liability category representing $1.67 trillion or 40% of the Fed’s balance sheet liabilities. (3) In addition to these two large items, there are other, smaller liabilities, like deposits from non-banks and foreign deposits.
How Does the Fed Unwind its Balance Sheet?
The balance sheet unwinding process is simply the Central Bank deciding not to reinvest the proceeds from maturing Treasuries and government-sponsored mortgage bonds. In effect, the Fed is increasing the supply on the market of U.S. Treasuries, which is simply another way of trying to influence rates to trend higher. As a result, the Fed’s current $4 trillion portfolio has shrunk from its October 2017 high.
What is the Debate and How Might it Affect Investors?
At the core of the debate over the positive or negative sides of this practice is the Fed policymakers' need to give themselves options in the event the U.S. falls into a recession. If interest rates remain low, and if the Fed’s bond holdings are historically large, this may mean that the Fed has very few options at their disposal if the economy needs help in the next financial downturn.
On the other hand, the opposition feels that if rates rise, either by raising the Fed Fund Rate or unwinding the balance, it may slide the economy into a recession as the cost of borrowing increases. This increase of borrowing could not only potentially hurt corporate America, but Main Street as well, as it could result in higher mortgages, consumer loans, and credit card interest rates. All of these could potentially lead to sluggish economic growth.
Based on Chairman Powell’s testimony, it appears the Fed has moved from its previous position that the balance sheet unwinding was on autopilot. It would appear they are adopting a more pragmatic approach of accessing the economic environment as they make these decisions. As for the potential effects on the economy as a whole, only time will reveal the true long-term results.