If you pay any attention to the Federal Reserve, you probably watch whether the central bank is lowering interest rates (an attempt to boost the economy) or raising interest rates (an attempt to tap the brakes on the economy).
But the Fed has another key tool it can use to steer the economy: the balance sheet. And it’s getting a lot of attention right now.
The Fed announced Wednesday it does not plan to raise interest rates at all in 2019. With interest rates on hold, President Trump and Wall Street are focused on the balance sheet, the $4 trillion in assets that the Fed currently has in its coffers. Trump and many on Wall Street want the Fed to keep the balance sheet big because that should help stimulate markets and the economy by keeping a lot of money in the banking system.
They see it kind of like loose-fitting jeans, a comfortably large pool of money that helps keep operations flowing easily in the financial sector. Basically, they don’t want the Fed to trade in comfy jeans for tight ones, which might constrict the economy.
The central bank announced Wednesday it is basically keeping the comfy jeans. It will slow the “slimming” of the balance sheet starting in May and finalize it by the end of September.
Before the financial crisis, the Fed held less than $1 trillion in assets. The Fed bought a ton of assets — mostly Treasury bonds and mortgage-backed securities (MBS) — shortly after the crisis in an effort to pump more money into the banking system and lower interest rates, a process known as “quantitative easing” or “QE.”
The Fed’s balance sheet peaked at about $4.5 trillion in 2017 when the central bank announced it would slowly and gradually try to bring its assets down a bit.
Wall Street wanted the balance sheet to end up being around $3.5 trillion and that’s where it’s going to end up. Many on Wall Street like Kevin Logan, chief U.S. economist at HSBC Bank, also expected the Fed would stop shrinking the balance sheet by the end of September and that is exactly what the Fed announced Wednesday.
Why does President Trump care about the Fed balance sheet?
Trump cares about this because it impacts the stock market, and the president likes the market to go up. Wall Street freaked out a bit in December when Fed Chair Jerome H. Powell said the slimming down of the balance sheet was on “autopilot” and would keep going. Stocks sold off sharply after that comment, which implied there was no end in sight for how low the balance sheet would go.
Trump tweeted at the Fed in December urging the central bank to “feel the market” and “don’t let the market become any more illiquid than it already is.”
How does the balance sheet really impact the market?
What this really boils down to is a debate over how much money banks should hold at the Fed, the so-called “bank reserves” level. The reason Powell and just about anybody else connected to banking says the U.S. financial system is a lot safer now is because banks have to hold more cash on hand to ensure they will have money to pay their bills, even in hard times. Big banks keep some of that cash at the Fed (because they get a pretty good interest rate on it).
As the Fed slims down its balance sheet, it has the side effect of lowering the level of bank reserves held at the central bank. That worries some people because the reserves held at the Fed are the easiest to access and safest money in the banking system, so there’s good reason to keep that level high. That’s why Trump tweeted about wanting to keep as much “liquidity” as possible.
The Fed, however, argues that it has surveyed banks many times about how much they need in reserves and they keep hearing that banks want to keep about $1 trillion in reserves at the Fed (versus more than $1.6 trillion now). So Powell and other Fed leaders have implied they want to get bank reserves to a level around $1.2 trillion (the $1 trillion plus a “buffer”). If bank reserves are at that amount, the overall balance sheet would end up around $3.5 trillion, since it also includes other assets and liabilities beyond bank reserves (things like the amount of currency in the economy).
Should Americans who don’t work on Wall Street care about this?
You probably don’t need to know all the details, but the reality is what the Fed did by running up the balance sheet to more than $4 trillion is unprecedented, and so it faces an unprecedented challenge in figuring out how to bring it back down. No one really knows what the appropriate level is or what type of bonds the Fed should hold.
“Average investors don’t have to care about the specifics of how the Fed drives its car. But they do need to care about the direction,” said Michael Farr, chief executive of Farr, Miller & Washington, an investment firm.
If the Fed gets this wrong — or if the central bank communicates its plans poorly — it will likely spook the market. Even more importantly, if the Fed gets this wrong, it will make this tool less effective when the next recession hits. The Fed wants to be able to use this tool to pump more liquidity into the system in a downturn, if need be. But that tool will be less effective if the size and mix of assets isn’t correctly calibrated before the recession hits.
“You get your firepower ready early,” said Kathy Bostjancic, director of U.S. Marco Investor Services at Oxford Economics. “That means the Fed needs to start buying more Treasury bills and short-term Treasury notes so they can reload for the next downturn.”