As my colleague Bill Lierman mentioned last Monday, we will know on Wednesday of this week whether the Federal Open Market Committee (FOMC) changed their target overnight interest rate or perhaps gave the markets some indication as to when they might. So, this week I thought we could look at how the Federal Reserve might begin to normalize interest rates and how it could impact their balance sheet which has quintupled since the financial crisis from about $900 billion in 2007 to about $4.5 trillion today. Most all of the increase came as the result of the Fed’s asset purchases (quantitative easing) to reduce interest rates and aid the economy.
We know that an increase in the Fed’s balance sheet was not just a result of purchasing securities, as there had to be an offsetting increase in their liabilities to fund the purchases. This was done by the Fed beginning to pay interest on deposits banks had with them beginning in October 2008 (Interest on Excess Reserves or IOER). This gave banks the option to lend to other bank by selling ‘Fed Funds’ or a risk-free option of keeping the funds on deposit with the Fed and having immediate liquidity. The banks chose the latter and bank reserves at the Fed now total about $2.4 trillion compared to about 20 billion pre-crisis in 2007. So, essentially the Fed financed the purchases of securities from the private sector by writing checks on itself.
Although they stopped purchasing securities in late 2014, the Fed still holds about $2.5 trillion of U.S. Treasury and Agency securities as well as $1.7 trillion of government-guaranteed mortgage-backed securities and maturities that are currently being reinvested.
Since the financial crisis we have lived in what Bill Gross, now with Janus, began to refer to as the ‘New Normal’ with regard to the environment of record low interest rates for a much longer period than anyone anticipated. So, one question is when the Fed begins ‘normalizing interest rates’, what happens to the Fed’s now enormous balance sheet? As you can see from the chart below, one way would be to simply allow the current securities to mature adjusting the rates paid for bank deposits to ‘encourage’ member banks to withdraw their deposits. A shrinking balance sheet would likely put upward pressure on interest rates.
Expect significant debate, however, as to the appropriate size of the Fed’s balance sheet because its size is closely tied to its methods for influencing short-term interest rates. There are strong arguments to allow for the Fed’s balance sheet to ‘shrink naturally,’ allowing current securities to mature and have the markets return to pre-crisis funding. Others will argue that the new roles of central banks require out-sized balance sheets to be able to effectively impact markets and the economy and meet their mandates thru monetary policies.
What does APCM think? We think central banks are in uncharted territory and it may be difficult for them to return to pre-crisis models without uncertainty and increased volatility. The Fed’s balance sheet will ultimately reflect their current monetary policy and what they view as their role in preventing and responding to future financial crises If history can teach us anything, it’s not a question of if, but when. Now more than ever, professional management of your money matters.
Senior Vice President, Investments