The Federal Reserve balance sheet is not a commonly discussed topic at your local dinner party but in the world of economics it’s definitely a subject that gets a lot of attention.
When one hears the word balance sheet, it tends to conjure up a vision of long rows of numbers on a paper that, when added up, leans the mind’s eye to picture mountains of green cash sitting in a vault somewhere, or something like that.
Although it’s likely most if not all of us would probably prefer to imagine a hefty balance sheet to reflect our own financial condition, in the case of the Federal Reserve’s balance sheet, the opposite tends to be true.
Although many would think a balance sheet details how much money one has, the legal term is it’s actually as a statement of the assets, liabilities, and capital of a business or other organization at a particular point in time. In simplistic terms, it’s what you own, owe and it correlates the two.
In the case of the Federal Reserve, a hefty balance sheet might sound like a good thing, but some might argue it is anything but. The Feds balance sheet is actually a list of what it owns and it’s not just piles of green cash. Again some might argue it’s another type of pile the Feds balance sheet reflects. One might get a better picture of whether that statement is true or not by knowing the pile was commonly about a trillion dollars prior to 2008 and now it sits at over four trillion. There is a reason for the massive increase.
Four trillion sounds like a pile of cash but actually there is little cash there. What is there is about one trillion in what it had historically held prior to 08, which is mostly U.S. government debt and now there is about three trillion of what it bought to pull us out of the global monetary implosion that was the crisis.
So what did the Feds buy and from whom did they buy it?
The balance sheet contains what is called U.S. debt (treasuries which our IOU’s from the Uncle Sam), agency debt (U.S. debt that might be from other government institutions or offshoots) and mortgage backed securities (MBS) to name a few.
It buys the U.S. debt instruments from the government (no the Federal Reserve is technically not a government entity) and buys the MBS from, among other places, the banking system.
These purchases are known as “asset purchases’ and are a part of their “open market operations (OMO).
OMO can be thought of as a gas pedal to throttle the economy. The Feds can buy stuff from the banks, which puts more money into the system, pushing down on the economic pedal to stimulate, or sells back this stuff to the banks, easing up on the pedal to cool an economy off. These buys and sells either put money into the economic system (when it buys) or takes money out of the system (when it sells).
During 2008/9 the banks were saturated in mortgages that were going bad. The Federal Reserve, whose balance sheet up until that time held mostly U.S. debt to the tune of one trillion, printed up another 3.5 trillion and bought mortgages and “other assets” from the banking system as well as from other public and private enterprises.
This mechanism is thought to have stabilized the banking system which was under severe strain at the time due to trillions in mortgages that were defaulting due to the housing blow up. There are opponents of this mechanism and its use but that’s a story for another day.
The Feds, having increased their balance sheet (holdings) from one trillion to 4.5 trillion during crisis, is now attempting to decrease (sell off) some of its holdings.
You won’t hear much about this on the evening news as it’s not something they want to advertise. The reason being anytime large amounts of money are withdrawn from an economy, the economy tends to want to stall out or slow.
As the Fed attempts to unwind (reduce by selling assets it previously bought) money is taken out of the system as the buyers (banking system among others) give their money back to the Fed for these assets.
If you recall, when the Feds sell, like they are doing now, the “pedal’ is lifted and the economy slows. Since the crisis, the Feds have tried to unwind before, only to back off when economic conditions slowed.
Only time will tell if they will be more successful this time around.
This article expresses the opinions of Marc Cuniberti and are opinions only and should not be construed or acted upon as individual investment advice. Mr. Cuniberti is an Investment Advisor Representative through Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Marc can be contacted at SMC Wealth Management, 164 Maple St #1, Auburn, CA 95603 (530) 559-1214. SMC and Cambridge are not affiliated. His website is www.moneymanagementradio.com. California Insurance License # OL34249