The Big Risk Awaiting the New Federal Reserve Chair
Summary: But the biggest risk is not a spike in interest rates. It is: when the public buys the bonds the Fed sells, money is removed from the economy. In a normal transaction, a bond’s seller would deposit that sale’s proceeds into the seller’s commercial bank. That deposit would remain in the economy and could be used for additional spending. But when the Fed sells a bond, it doesn’t deposit the money; it extinguishes it.
If your bank account dropped from $100,000 to $80,000, would you be inclined to spend more, or less? Would it matter if the drop happened all at once, or over 16 months? This is the predicament in which Federal Reserve Chairman front-runner candidate Jerome Powell finds himself: keeping the economy growing when less money is in it.
The Fed has three options with its $4.3 trillion balance sheet
(Pre-2008 financial crisis, its balance sheet was around $900 billion) 
- Do what former Federal Reserve Chairman Ben Bernanke recommends: Don’t worry about it. Don’t sell the trillions of dollars of bonds the Fed bought during QE, and continue reinvesting maturing bonds’ into new bonds.
Bernanke, the architect of QE, might have some self-interest in this recommendation, as it poses the least amount of risk to the economy, hence less reputational risk to him personally. It, however, remains an unpopular choice; my guess is, some worry that the Fed would have to enlarge the balance sheet even more to try to stimulate the economy if it turned sour.
- Lower the balance sheet by selling bonds, preferably to banks. Selling bonds to banks is the only way to reduce their \$2.4 trillion of excess reserves. (By comparison, banks had just $20 billion of excess reserves in 2007.) The amount of reserves banks have has little impact on the amount of spending that takes place in the economy, so bond sales to banks are probably the safest way for the Fed to shrink its balance sheet.
Reserves are the monies banks received from the Fed during QE, when they sold bonds to the Fed. However, commercial banks that are not interested in reducing their reserves by buying bonds from the Fed seems like a good bet, for each time the Fed raises the fed funds rate—which, in December, they will probably do for the third time this year—they are forced to pay banks a higher rate of interest on those reserves. And banks wouldn’t have those reserves were they to buy bonds.
Paying banks interest on their reserves is therefore the only way the Fed can increase the rate it charges banks to borrow reserves (the fed funds rate). Today, that rate is around 1%. In December, the Fed will probably up it to 1.25%, which must be the minimum interest rate the Fed pays banks in order to dissuade them from lending their excess reserves to other commercial banks. If it isn’t, a bank will lend their extra reserves to other banks, causing the fed funds rate to drop, thus reversing the Fed’s goal of raising rates in the economy.
What happens if banks don’t buy bonds?
If banks don’t buy bonds, then the Fed is forced to sell bonds to the public—that is, to pension funds, mutual funds, and other large investors. Selling to the public increases the supply of bonds for sale, which could cause interest rates to spike and push the U.S. into a recession, something the Fed is obviously hoping to avoid.
But the biggest risk is not a spike in interest rates. It is: when the public buys the bonds the Fed sells, money is removed from the economy. In a normal transaction, a bond’s seller would deposit that sale’s proceeds into the seller’s commercial bank. That deposit would remain in the economy and could be used for additional spending. But when the Fed sells a bond, it doesn’t deposit the money; it extinguishes it.
- Stop reinvesting the proceeds the Fed receives when a bond matures. Consistent with current Federal Reserve Chair Janet Yellen’s gradualist approach, this is the option that, in September 2017, she told the public the Fed was going to implement.
Not reinvesting also takes money out of the economy, but gradually, and without adding more bonds for sale. The issuer of the bond pays the bond’s owner—in this case, the Fed—the face value of the maturing bond. The Fed then eliminates the asset, the bond, and the liability—the cash—thus reducing its balance sheet.
What types of bonds does the Fed own?
The Fed owns Treasury securities and mortgage-backed securities. Beginning in October 2017, it slowly stopped reinvesting both. For example, in October it did not reinvest $6 billion of any maturing treasury bonds. So, if $30 billion of treasury bonds matured in October, only $24 billion were reinvested.
This process will continue with increasing amounts taken out of the economy until the Fed stops it. And that will depend on how big or small it wants its balance sheet to remain.
The Federal Reserve Balance Sheet Reduction Schedule
From Oct. 2018 on
 Bernanke, Ben. “Should the Fed keep its balance sheet large?” Brookings Institution, Sept. 2, 2016, https://www.brookings.edu/blog/ben-bernanke/2016/09/02/should-the-fed-keep-its-balance-sheet-large/
 Federal Reserve Bank of New York, Statement Regarding Reinvestment in Treasury Securities and Agency Mortgage-Backed Securities, Sept. 20, 2017, https://www.newyorkfed.org/markets/opolicy/operating_policy_170920
These are the opinions of Financial Advisor Tim Hayes and not necessarily those of Cambridge Investment Research. They are for informational purposes only and should not be construed or acted upon as individualized investment advice. Content provided via links to third party sites should not be considered an endorsement of content, which we cannot verify completeness or accuracy of.
Financial Advisor Tim Hayes
I’ve held an industry securities registration for 30+ years and am subject to SEC and FINRA oversight.
Most clients pay fee-only or an hourly rate. The size and complexity of the client’s wealth management and financial and retirement planning determine that fee.
Some clients pay a commission, mainly those with smaller accounts, i.e., Roth IRAs, some public-school teachers with 403b retirement accounts, or parents or grandparents who set up a 529 college savings plan.
The first introductory and fact-finding appointment can be in-person or by phone. The next meeting where I provide my recommendations should be in-person. (For the time being, telephone, Zoom, and email are replacing some in-person meetings.)
Subsequent meetings during which we monitor your progress and investments can be done in-person or by phone, email, Zoom, or Skype – or, more likely, a combination of these meeting types.
Tim has offices in Boston and South Dartmouth, Massachusetts. He’s licensed to handle securities in 8 states: Massachusetts, Rhode Island, New Hampshire, New York, New Jersey, Connecticut, Maine, and Florida.