An essay on FED Balance Sheet
Several times in 2016, I shared the idea that the FED would take advantage of the low levels to reduce its balance sheet. Levels of 1.5% were levels in which the FED would not harm, as well as high demand for UST in the market. During the week, the FED renewed its view that its balance sheet would shrink after a significant rate hike in its strategy. Basically the balance sheet will be important for the FED in terms of both the course of monetary policy and its relationship with politics at some point. Banks keep reserves of approximately $ 2.15tr in the FED and the FED pays interest on this amount. There will be no problem at around 0.25 or 0.50%. When interest rates rise to 1 or more, this will be seen as a transfer from the state to the banking system by policy or taxpayers and will become increasingly difficult to defend.
The second point is the relationship between the balance sheet monetary policy. We have discussed in detail that the banking system does not need deposits (as the relationship is actually the opposite) to create credit, as we have read in books or in most comments. So theories like Money Multiplier are already obsolete. The role of reserves is more important than deposits. And at the same time, the system is closed so that, except for some very specific developments (such as increased demand for paper money, the decision of the MB to reduce assets, the government to increase MB deposits), it is not possible to reduce reserves. A bank may reduce the reserve it holds, but a contraction throughout the system can only take place under the conditions set out in the previous sentence. The fact that the reserve amount is too high means that the banking system will be able to lend without any difficulty in case of a boom in loan demand. However, at this point, it is not difficult to control the system through regulations such as capital ratios etc.
Above you can see the proportions of assets in the FED balance sheet. In this table I created using FRED, the highest share was in bonds with maturities between 1-5 years, while the share of maturities of 5-10 years decreased. The share of 91-day-1-year securities is around 6.7%. I started in 2005 to see how the structure changed due to QE. However, the only change was not in the pre-post QE structure. Note that the maturity structure has changed since 2013 and the weight shifted from a 5-10 year package to 1-5 and 91-1y packages. I am one of those who think that the support given to the market should be measured with magnitude, but we should also take into account the maturity structure, because the opinion that the portfolio will shrink faster when the FED redemption policy of redeemed assets ends.
Former FED chairman Ben Bernanke shared an article evaluating the issue in his blog: https://www.brookings.edu/blog/ben-bernanke/2017/01/26/shrinking-the-feds-balance-sheet/
He says that to avoid a tapering panic, the balance sheet should be reduced passively and much later than the interest rate hikes (so that, in addition to the interest discussion, it does not create the uncertainty about how the FED will actively manage its balance sheet). The reason for being after interest rate hikes may be the desire to have the opportunity to intervene in a possible panic rise in returns. When we talk about passive contraction, the maturity structure in the previous paragraph gains importance. However, I think the interesting part of the article is the part where the FED balance sheet discusses how big it should be. Basically, we can say that the liabilities of treasury bonds under the Assets section of a MB balance sheet contain the above mentioned Reserves, money in circulation and public deposits.
Now let’s look at the graph above. In the 2003-2008 period, you see FED assets (yellow) and the amount of cash in circulation. We can say close to one to one. In the appendix #3 I shared the difference between the two items. The spread, which was close to zero before 2008, has now reached $ 3 trillion. And this difference is almost * 2 in the amount of cash reached 1.5 trillion in a period.
In the graph above, I share the difference between the two items. The spread, which was close to zero before 2008, has now reached $ 3 trillion. And this difference is almost * 2 in the amount of cash reached 1.5 trillion in a period.
Bernanke points out that there is no rush to reduce the balance sheet, as the public’s cash demand will at some point capture the balance sheet. At the same time, considering the growing economy, the banking system and the amount of reserves that must be kept in order to maintain the interest base, time solves the problem.
Suppose that the FED will reduce its balance sheet in accordance with pressures and economic reality. If such a step creates a serious shock, there are two basic actions he can take. 1- Restarting the investment strategy, which it announced that it has ended (parallel to the reduction decision) and stopping the shrinking 2- Lower interest rates. Can a passive contraction decision create “shock?? This will probably not be a shock as it will be discussed very often during the year. However, it is important to note the difference between FED purchases and market purchases (Koo also mentions this in his latest article). When US bonds are held in the hands of the core sector, a bond that redeemed is simply replaced by a new issue. So there is no reason for interest rates to go up in this transaction. However, when the redemption of a bond held by the FED comes, money released to the FED, paid to the FED, will not be going to the newly issued bonds. This means that the bonds that will be sold to the private sector mean an increase in the supply this time, which means that the interest rates will increase in itself.
PART 2 COMING SOON
VERIFIED ACCOUNT AND SETUP RESULTS
Subscribe to our premium packages if you would like to get 1000+ instruments analysis and trade signals of Chartreadreadepro.
You can contact us via Skype User Name: Chartreaderpro
DISCLAIMER: This is a technical analysis study, not advice or recommendation to invest money
Information on these pages contains forward-looking statements that involve risks and uncertainties. Markets and instruments profiled on this page are for informational purposes only and should not in any way come across as a recommendation to buy or sell in these securities. You should do your own thorough research before making any investment decisions. Chartreaderpro does not in any way guarantee that this information is free from mistakes, errors, or material misstatements. It also does not guarantee that this information is of a timely nature. Investing in Forex involves a great deal of risk, including the loss of all or a portion of your investment, as well as emotional distress. All risks, losses and costs associated with investing, including total loss of principal, are your responsibility