Monday, May 22, 2017

CNBC - Feds "New Normal" Balance Sheet Could be Huge

CNBC runs this article which explains that the Federal Reserve may just let its balance sheet stay bloated in coming years for a variety of reasons. The article has a couple of points of interest since many have long argued that the enormous size of the Fed balance contributes to instability in the financial system and will lead to the Fed being unable to respond to any new crisis. Below are a few excerpts from the article and then a few added comments.


"While Federal Reserve officials have said they plan to begin a process to normalize their balance sheet, the end result is likely to be a balance sheet that is anything but normal.

Interviews with Fed officials, and public statements they've made suggest the Fed's new normalized balance sheet could end up being three times as large as it was before the financial crisis. And it could be bigger than that."

. . . . .

"In an effort to stimulate the economy in the aftermath of the Great Recession, the Fed cut its benchmark interest rate to zero and began buying up government and mortgage-backed securities to drive down interest rates further. The Fed stopped adding to its balance sheet in 2014 and it now stands at more than $4.4 trillion, compared with around $850 billion before the crisis."

. . . . .

"The biggest reason why there's no going back to the old balance sheet is currency. For a variety of reasons, the amount of currency in circulation has grown 7 percent a year on average over the past five years, or 3 percentage points faster than in the five years before the crisis. People are simply expressing a desire to hold more cash — ironic in a financial world that is growing more digital — and the central bank's job is to simply meet that desire for cash passively.

About $1.5 trillion of cash is currently in circulation and, if current growth rates continue, that level will be north of $2 trillion in the next five years, providing a floor for just how small the balance sheet can get."

. . . . .

Former Fed Chairman Ben Bernanke wrote in a recent blog post: "There are reasonable arguments for keeping the Fed's balance sheet large indefinitely, including improving the transmission of monetary policy to money markets, increasing the supply of safe short-term assets available to market participants, and improving the central bank's ability to provide liquidity during a crisis."

Bernanke added, "It's not unreasonable to argue that the optimal size of the Fed's balance is currently greater than $2.5 trillion and may reach $4 trillion or more over the next decade."

Opponents of a large balance sheet say the Fed should reduce it as much as possible so it doesn't become a victim of politics, where Congress or the executive branch could mandate that the balance sheet be used to buy certain types of securities to solve fiscal problems. They also worry that such a large balance sheet is potentially inflationary."

My added comments: This article lays out the Fed view that the 2008 crisis is past and has been successfully handled to avoid a major deflation event. They clearly are wanting to convey the idea that now that the crisis is past the changes in the world that have taken place mean the Fed should now keep a much larger balance sheet in place. This conveniently provides an excuse to simply do virtually nothing in the next few years and just let the bonds the Fed holds be redeemed. By doing this, the Fed does not have to worry about trying to sell (dump) trillions of US bonds. This would certainly spike interest rates. 

The other note of interest in this article is that the public is holding much more cash and that the Fed expects cash in circulation to increase by $500 billion or more in the next five years. If that is true, what happens to all those headlines we see telling us a "cashless society" is just around the corner? We see headlines and articles about that all the time even as cash in circulation continues to rise.

Fed skeptics will of course not believe any of this is going to happen. They believe the Fed has placed itself between a rock and hard place and is trapped. They do not believe the Fed will be able to simply sit by passively and let its balance sheet slowly shrink over time or that they intend to allow cash in circulation to continue to increase over the next five years.

So far though, the Fed skeptics predictions of massive inflation have not panned out. Most of the huge amount of money created by the Fed never really got into the real economy and boosted the velocity of money. Instead it appears to have boosted stock markets and housing prices again. Now Fed skeptics are predicting that a new recession coming soon will not allow the Fed to just slowly and passively shrink its balance sheet. They see the rising stock markets and house prices as new bubbles that will soon burst forcing the Fed to scramble once again with more massive money creation. So they view the Fed plan detailed in this CNBC article as fantasy.

Who will be right about all this? Only time will tell us. 

What we should watch for is any indication that the Fed is having to reverse course from this plan and start expanding its balance sheet again rather than to gradually shrink it. That is the kind of thing that could shake market confidence and lead to a new major financial crisis. If the Fed succeeds, it means a crisis is likely not on the immediate horizon. 

It will also be interesting to see if cash in circulation does increase by over $500 billion in the next five years. That would hardly be an indication of a "cashless society". What matters is what actually happens, not what the Fed says or what Fed skeptics say will happen.

Added note 5-24-17: Fed will let the balance sheet shrink gradually and keep it much higher per this CNBC article.

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