The Federal Reserve Balance Sheet is Shrinking – Why That Matters

The Federal Reserve balance sheet is shrinking.  Why does this matter? The Federal Reserve’s balance sheet is one of the tools that provides power to the economy.  Shrinking the balance sheet would have the effect of lowering decreasing economic activity by taking liquidity out of the economy.  But, the Federal Reserve is simultaneously raising interest rates which.  This also has the intended consequence of lowering economic activity.  The combination has pundits wondering how the Federal Reserve will be able to shrink its balance sheet and raise interest rates without choking the economy from lack of liquidity.

There are some that believe the Fed is taking on these measures under duress and, a soft landing nearly impossible.^[1]MarketWatch: The Federal Reserve is shrinking its balance sheet under duress, which makes a soft landing nearly impossible

First, having a look at the Federal Reserve balance sheet and answering the question what does it do and why it is where it is would lay the foundation for understanding the potential future.

The Federal Reserve Balance Sheet

In any normal economic environment, the rate of growth of the Federal Reserve balance sheet increases fairly smoothly and continuously.  However, there were two very disorderly periods which forced the Federal Reserve to resort to extraordinary measures: The Financial Crisis in 2008 and COVID pandemic in 2020.  The extraordinary measures played out in the chart above with massive increases in the Federal Reserve’s balance sheet.

The above two charts show the Federal Reserve balance sheet over a 20-year period and the more recent 2-year period.  The Federal Reserve balance sheet has grown significantly with what is known as Quantitative Easing, whereupon the Fed adds a tremendous amount of liquidity into the system in order to support economic activity.  In both instances, the US economy had been facing a near-collapse of economic activity and, in order to support economic growth, the Federal Reserve began expanding its balance sheet as well as dropping interest rates near zero.

Mostly, the economy passed through these economic conundrums and the programs worked.  However, the expanding of the balance sheet has taken the economy to a new level.  And, the fear is that taking away the extra liquidity will push the economy into a recession.  The risk is that there is currently extreme inflation.  And, the fear is that the Federal Reserve shrinks its balance sheet at a rate they would rather not have to undertake.

The Current Economic Environment

The most recent economic data showed very high levels of inflation and employment.  Conventional wisdom is that both can only go lower from here.  And, the only way that could occur is with a recession.

Inflation rates are at 40-year highs.  Unemployment rates are near all-time lows with moves from these levels upward always preceding a recession.

The question becomes, can the Federal Reserve shrink its balance sheet, control inflation, and avoid a recession?

Inflation & Supply Chain Breakdown

One of the major factors with the high level of inflation is the stimulus checks that individuals received from the federal government in response to the COVID shutdown.  These measures were taken to blunt the effects of many people losing their jobs.

Personal Incomes surged from the stimulus checks.^[2]Personal Incomes & Personal Consumption Expenditures  And, Americans, stuck at home in  lockdown mode, shopped online.  But, the lockdown was worldwide and supply chains were disrupted significantly.  So, with Americans shopping in large quantity, this put a strain on a broken down supply chain.  Having to restock the supply chain has pushed prices upward.

Then, the war in Ukraine began.  This, also, affected the supply chain with the flow of food and oil from Ukraine and Russia, respectively.

But, it would appear that the high rate of inflation may have peaked and the rate of growth is slowing.

The Federal Reserve Creates Money Out of Thin Air

The Federal Reserve has a super-power that trumps all others: The ability to create money from nothing.  Fractional banking requires banks to maintain reserves while they lend out money.  This process increase the money supply.  But, the Federal Reserve has another power at its disposal that no other bank has and that is to instantly create new money.

One of the steps the Federal Reserve took during the COVID economic collapse was to add significant new money to the money supply simply by inventing it with a proverbial keystroke.  A perfect example of this was the US Federal Government issues debt.  The Federal Reserve “bought” some of that debt by creating new money.  By doing this, other investors & institutions did not buy US Treasury debt and sought out new ways to buy debt.  This had the effect of freeing up that money and demand for corporate, mortgage, and business debt moved higher.

Price & Yield Inverse Relationship

There is an inverse relationship with interest rates and the price of debt that would be driven by the demand for debt.  If demand increases, price moves higher.  Interest rates would move lower.  So, if the Federal Reserve all of a sudden created new money and bought up US Treasury debt, there would be new demand for debt across the board.  Demand for US Treasury debt would be consumed by the Federal Reserve in large quantities.

Any institution that would have been looking for US Treasury debt before would have to invest elsewhere and this would have had the effect of driving demand higher for that debt. This drives down interest rates.

But, the Federal Reserve also took on 30-year mortgages and corporate debt.  This artificially pushed all of the demand for this debt upward, pushing price higher, and interest rates lower.

Now, everything is about to be reversed.

Federal Reserve Balance Sheet is Shrinking: The Real Risk Ahead

The real risk to all of this is that economic activity gets choked out.  The fear is that interest rates move higher in the long end and liquidity drops significantly.

With inflation as high as it is, the economy is already seeing demand destruction in some cases.  We are seeing demand for gasoline drop significantly because price is simply too high for some consumers.  And, increases in food costs are having the same effect of restraining consumption as people level down in what they spend on food.  It is also possible that because of high rates of inflation economic activity slows on its own as consumers are unable to keep up with higher prices.  And, the economy could move lower from this.

The Federal Reserve is very likely to slow the pace of interest rate increases as the economy absorbs the ripple effects of shrinking balance sheet.  If the Fed can maintain a balance between an economy that expands at a modest pace, and inflation pressures start to abate as the supply chain mends itself, very possibly the economy can progress forward without many hangups.

The stock market may take a very cautious approach in the months ahead as more information is needed to determine how well the Federal Reserve balances the economy moving forward.