Is the Federal Reserve Sitting on a $4.3 Trillion Time Bomb?

Money

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When the U.S economy tripped into recession after the 2007 financial crisis, the Federal Reserve responded by buying assets in the open market in order to increase the supply of money.

The objective of the Fed’s large-scale asset purchase (LSAP) program, under which it conducted bond purchases, was to resuscitate a deteriorating economy and support consumption. The Fed bought long-term Treasuries to push down benchmark market interest rates so that credit could be more easily available for investments and consumption. Under this program, the Fed also bought mortgage-backed securities (MBS) for the first time in order to channel credit to the housing sector.

As a result of these bond purchases, the Fed’s balance sheet has grown to $4.3 trillion, an increase of about $3 trillion since December 2007. Currently, the Fed continues to buy bonds on a monthly basis under its LSAP program, though the purchases are being reduced steadily each month. As it stands, the Fed is purchasing $20 billion worth of MBS and $25 billion worth of longer term securities each month.

To give you a sense of the timeline, in 2009, the Fed bought $1.25 trillion in MBS, $200 billion in federal agency debt (debt issued by Fannie Mae, Freddie Mac, and Ginnie Mae), and $300 billion in long-term Treasury securities. In the second round of quantitative easing (QE) — the name given to the monthly asset purchase program — which lasted from 2010 to 2011, the Fed added a total of $600 billion in bonds. Between September 2011 and June 2012, the Fed bought, sold, and redeemed securities worth $667 billion.

After September 2013, under the third round of QE, the Fed bought mortgage backed securities and treasuries worth $85 billion each month. It started cutting down on these purchases by $10 billion each month starting in December 2013. Buying these assets from the market expanded the Fed’s balance sheet from 6 percent of the gross domestic product (GDP) in 2007 to 22.3 percent of the GDP in 2013.

The tricky part about this whole situation is that at some point the Fed will either have to start winding down its balance sheet, or it will have to sit on the bonds until they mature. Selling the bonds risks flooding the market and pushing up the interest rates. It will also squeeze the excess liquidity (supply of money) out. So now the discomforting questions facing the Fed are: is there a good time to start unwinding, and if so, at what pace? And how long must it keep buying assets?

The first sign of the Fed getting back in the mode of monetary tightening will be when it decides to let the bonds on its books mature instead of reinvesting the proceeds. The markets have already discounted the reduction of bond purchases every month, which currently stands at $45 billion per month and is expected to taper off by 2015.

According to Bloomberg, the Fed may refrain from actively winding down its positions in the near future on fears that flooding the market with treasuries may jolt the financial markets and stall the economic recovery.

Bond prices move in the opposite direction of interest rates or yields, so if the Fed sells off bonds, supply-demand mismatch will cause prices to go down and yields to go up. If long-term interest rates go up, it may increase the cost of credit for borrowers, slow consumption on credit, and discourage investment.

On the flip side, central bankers like Richard Fisher, President of the Federal Reserve Bank of Dallas, express fears that if the Fed does not aggressively reduce its bond buying program, it may lead to the creation of asset bubbles in the economy due to a temporary increase in prices of stocks, bonds, and other tradable assets. When the huge reserves held by Fed institutions start flowing into the real economy, it may have an inflationary impact led by rise in asset prices.

“I’ll continue to vote for a reduction [in the stimulus program],” Mr. Fisher said, who is a voting member in the Federal Open Market Committee. “There is enormous liquidity in the system.”

On another occasion earlier this year, Mr. Fisher, taking from analyst Peter Boockvar, had said that QE had put beer goggles on investors. “Things often look better when one is under the influence of free-flowing liquidity,” Fisher said. Fisher and many others believe that longer they delay the more difficult it would get for the Fed to exit its easy money policy.

But one thing to keep in mind is is that each central bank’s balance sheet is perhaps best measured relative to the size of its nation’s economy. Japan’s balance sheet size is 44 percent of its GDP and the size of Swiss central bank’s balance sheet bloated up to 83 percent during the European debt crisis, according to data provided by Federal Reserve Bank of St. Louis. As we pointed out earlier, the Fed’s balance sheet is about 22.3 percent the size of U.S. GDP.

Historically, whenever U.S has had an economic or financial crisis, it has seen a similar expansion in the size of the Fed’s balance sheet. For example, in 1940 during the Great Depression, the balance sheet touched 23 percent of nominal GDP. In 1946, following World War II, the balance sheet fell to 20.2 percent, and in the following years the Fed was able to unwind its position without hurting the economy.

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