Is the Reduction of the Fed’s Balance Sheet a Ticking Time Bomb?
Summary: 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.
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.
Massive Bond Sales
Gov. Patel warns us that the combination of President Trump’s tax cuts and the Federal Reserve’s reduction of its .3 trillion balance sheet will require issuance of a massive amount of new U.S. government debt at a time when the economy contains less money to buy it.[i]
Bank Reserves
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.
Federal Reserve Pays Interest on Reserves
One may ask: Isn’t that money needed to pay the Treasury for the bonds the Fed is redeeming?[ii] 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 purchase and hold the new bonds.
The Money Supply
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.
The Impact of Rising Interest Rates
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.
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 bank has with its own bank—the Federal Reserve.[iii]
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, the bank, and the mortgage payer are all reduced by the amount of the mortgage payment, which deletes that same amount of cash from the economy. So the amount the Fed cuts from its $1.7 trillion of MBS determines how much money is taken out of the economy.
Shrinking Supply of Money
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.
References
[i] Tett, Gillian. “Watch the Fed’s Balance Sheet, Not Interest Rates.” The Financial Times, June 7, 2018. https://www.ft.com/content/a072a4b0-697b-11e8-8cf3-0c230fa67aec
[ii] Sheard, Paul. “Clearing Up Some Misconceptions About The Fed’s Balance Sheet Unwind.” PDF, June 10, 2018.
[iii] 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. https://www.federalreserve.gov/econres/feds/files/2017099pap.pdf
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.
Please share
Financial Advisor Tim Hayes
What Is My Financial Advisor Experience
I’ve held an industry securities registration for 30+ years and am subject to SEC and FINRA oversight.
How Much Do I Charge?
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.
Do We Need to Meet in Person?
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.
Contact Tim
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.
