Federal Reserve Announces Balance Sheet Reduction

By Michael Larkin & Mack Wilowski

National News Writer; Editor – National News

Years in the aftermath of the financial crisis, the Federal Reserve is finally pulling away its support of the financial system – in the form of large-scale asset purchases and record-low interest rates – and initiating procedures to shrink its massive balance sheet. With over $4.5 trillion in its portfolio of mortgage-backed securities and Treasury bonds, the Fed will have a long road ahead of itself.

Along with keeping interest rates low, the Federal Reserve’s strategy of purchasing bonds and similar debt instruments in the years following the financial crisis has ensured that the American economy could stabilize and recover smoothly. From early 2009 until the end of its quantitative-easing program in the autumn of 2014, the size of the Federal Reserve’s balance sheet increased dramatically from a pre-crisis level of $800 billion to over $4 trillion by early 2015. From early 2015 onward, the level of the balance sheet has remained stable at an all-time record, given the fact that the Fed has reinvested all bonds due to mature during that period – preventing a preemptive reduction of the balance sheet.

To see how the portfolio is going to unwind, it should be noted how the balance sheet was expanded and inflated in response to the 2008 financial crisis. In essence, The Federal Reserve would purchase securities from bondholders during the late stages of the crisis and rather than printing currency, the bondholder would receive funds electronically for the same amount as the bond principal. Through bond purchases, the Fed would create wealth for the holder and thus eliminate liabilities; along with low interest, it would spur growth so that the economy could recover to a stable level.

Presently, instead of buying up additional securities, the Fed is going to allow a set amount of its outstanding bonds to mature every month. Starting in October, the Federal Reserve will allow up to $10 billion worth of assets to slowly mature every month without reinvestment, essentially “rolling them off” the balance sheet. Federal Reserve officials will permit $6 billion worth of Treasuries and $4 billion worth of mortgage bonds to mature every quarter. It will then incrementally increase this amount to $50 billion per month with each successive quarter, ensuring the process runs smoothly in the background of Fed operations and preventing a major shock to financial markets. Eventually, the balance sheet will level off to an amount between $2 billion and $3 billion by the end of 2020. Essentially, these electronic funds are going to be erased from the system. The plan is in place, but the future is still in a fog. As former head of the White House Council of Economic Advisers Austin Goolsbee mentions, “The final exam, with the grade yet to be determined – is can the Fed actually get out of this stuff?”

The Federal Reserve is fully aware of potential upsets to financial and equity markets, as similarly unprecedented moves by the central bank have uneased investors in the recent past. On a positive note, markets in the current year have shown little volatility, appearing to be unaffected, but this has rarely been the case in past years. In 2013, when the plan of reducing the balance sheet was first mentioned under then-chairman Ben Bernanke, the result was a market reaction known as the “taper tantrum”, which led to a sharp decrease in bond prices over the course of several months. Current Fed Chairwoman Janet Yellen is currently conducting policy in a way that does not generate uncertainty in the markets while at the same time normalizing the balance sheet. Low volatility could also be due to the fact that while the Fed is going through this process gradually; there is no action being made that does not constitute a major surprise to the market. In addition, since other central banks such as the European Central Bank and the Bank of Japan are still continuing asset purchases, there is not much of a change across waters either.

Another incentive for the Fed slowly decreasing its debt is to show that the experimental crisis solution was a success. Other central banks, as mentioned before, are watching closely as they may follow suit and decrease their own asset purchases. This effect, however, could have its downsides. CEO James Dimon of JP Morgan Chase & Company states that the Fed’s actions “could be a little more disruptive than people believe.” If other central banks do decide to unwind as well, it could lead to less economic influence on a global scale.

While the Fed is taking steps that may appear uneasy, these are necessary steps in order to get the U.S. banking system and the American economy back to a pre-crisis norm. No one knows for sure if this gradual process is going to work as the Fed hopes, but if successful, it could put a decisive end to the final chapter of the financial crisis, as well as the extraordinary measures put in place to combat its effects.

A version of this article appeared in the Tuesday, September 26th print edition.

 

Contact Michael & Mack at

michael.larkin@student.shu.edu,

maciej.wilowski@student.shu.edu

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