By: Financial Advisor Tim Hayes - posted in: Economy, Markets, and Interest Rates - Last updated Nov 15, 2019

About Financial Advisor Tim Hayes

Tim Hayes AIF®, CRPS®, AWMA®, CFS®, APMA®

Registered with Cambridge Investment Research, Inc., a broker-dealer with over 3,000 Registered Representatives nationwide. Investment Adviser Representative at Cambridge Investment Research Advisors, Inc., a $94B RIA based in Fairfield, IA. I've held an industry securities registration for 26 years and am subject to SEC and FINRA oversight.

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Is the Reduction of the Fed’s Balance Sheet a Ticking Time Bomb? Two Financial Heavyweights Weigh In

by | Last updated Nov 15, 2019 | Economy, Markets, and Interest Rates

A dispute is brewing in the financial press between two financial heavyweights: Paul Sheard, Executive Vice President and Chief Economist of S&P Global, and Urjit Patel, Governor of the Reserve Bank of India.

Gov. Patel warns us that the combination of President Trump’s tax cuts and the Federal Reserve’s reduction of its $4.3 trillion balance sheet will require the issuance of a massive amount of new U.S. government debt at a time when the economy has less money to buy it.[1]

Read more: Is It a Smart Idea to Reduce Taxes If a Big Buyer of Your Debt Stops Buying?

Watch the Fed’s Balance Sheet, Not Interest Rates

Mr. Sheard, however, believes Gov. Patel’s fears are overblown. Mr. Sheard contends that the money in the form of banks reserves that banks received from selling treasuries to the Fed during QE is available to buy new bonds.

One may ask: Isn’t that money needed to pay the Treasury for the bonds the Fed is redeeming?[2] Also, the Fed pays banks interest on their reserves, similar to what new government bonds are paying, and reserves have less market risk. So there is no guarantee that banks will want to use their reserves to buy and hold the new bonds.

Regarding treasuries, Mr. Sheard is right: there is no reduction in the money supply when the Fed allows any of its $2.4 trillion of treasuries to roll off its balance sheet. The Fed merely debits the government’s checking account by the amount of any maturing bonds.

If, however, government spending stays the same or goes up (which it is doing), the Treasury must issue new bonds to compensate for the drop in its checking account. Moreover, with all of those bonds for sale, their interest rates will have to increase to entice buyers.

Higher rates make Treasury bonds attractive relative to other obligations as well, such as emerging market bonds. This could cause a squeeze in demand for emerging market bonds and trigger another financial crisis.

Read more: The Risks of Quantative Tightening

Mortgage-Backed Securities

Reducing the holding of mortgage-backed securities (MBS) is, however, a different story: this action will cut the money supply. The process for the Fed’s reduction of its $1.7 trillion of MBS starts when someone makes a monthly mortgage payment, most likely from the homeowner’s checking account. That account is a bank liability, matched up with a corresponding asset of bank reserves, namely money that a bank has with its bank—the Federal Reserve.[3]

The mortgage payer’s checking account is reduced by the payment amount, which in turn is deducted from the bank’s account at the Fed, thereby reducing the Fed’s liabilities to that bank. Simultaneously, the Fed lowers the value of its $1.7 trillion of MBS assets on its balance sheet.

Thus the balance sheets of the Fed is reduced by the amount of the mortgage payment, which deletes that same amount of cash from

Which brings us back to Gov. Patel’s fear of a massive amount of new U.S. government bonds for sale at a time when there is less money in the economy to buy them, causing a reduction in demand for more risky bonds such as emerging market bonds.

Read more: The Fed Balance Sheet Reduction Schedule


[1]   Tett, Gillian. “Watch the Fed’s Balance Sheet, Not Interest Rates.” The Financial Times, June 7, 2018.

[2]   Sheard, Paul. “Clearing Up Some Misconceptions About The Fed’s Balance Sheet Unwind.” PDF, June 10, 2018.

[3]   Ihrig, Jane, Lawrence Mize, and Gretchen C. Weinbach. “How Does the Fed Adjust its Securities Holdings and Who is Affected?” Finance and Economics Discussion Series 2017-099. Washington, D.C.: Board of Governors of the Federal Reserve System, 2017.

These are the opinions of 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.

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