The Fed has had ample time to reduce its massive $4.5 trillion balance sheet.
At the very minimum, the Fed long ago could have stopped reinvesting interest.
Instead, the Fed is just now coming to term with a balance sheet strategy.
Federal Reserve officials are zeroing in on a strategy to begin winding down their $4.5 trillion portfolio of mortgage and Treasury securities, possibly later this year, as part of their broader effort to drain reservoirs of stimulus out of the financial system.
Under the emerging strategy, the central bank would raise short-term interest rates two more times in 2017 and then potentially pause rate increases, perhaps late in the year. That would allow Fed officials to start winding down their portfolio of securities in a gradual and measured way to assess how markets handle the moves before resuming additional rate increases in 2018, according to interviews and recent public statements from officials.
The strategy depends on whether the economy keeps performing as expected, and it depends on whether Fed Chairwoman Janet Yellen can build a consensus among policy makers about how to proceed. No decisions have yet been made.
I said years ago that the Fed had no plan, and it’s clear they didn’t, and in fact still don’t.
The market threw a “taper tantrum” in 2013 when the Fed hinted they would gradually reduce the amount of money it was feeding into the economy.
Why the Fed thinks it needs to hike before it stops reinvestment is a mystery. But that at long last appears to be the start of a plan. However, I seriously doubt the Fed hikes twice more this year. Perhaps it believes the Nowcast and not GDPNow. For discussion, please see Discrepancy Between GDPNow and Nowcast is Two Percentage Points Once Again.
Mike “Mish” Shedlock
Rate hikes before reducing the balance sheet would be preferred because that would enable the Fed to have the ability to cut rates when the next recession comes.
But rate hikes expose the balance sheet to massive losses, particularly on longer-term securities.
1. Modest rate hikes should not be a problem assuming we don’t have a recession.
2. Inflation, esp. the perception that inflation will accelerate, will decrease the value of longer term securities even more.
3. Why does the Fed have to care about losses? Keep in mind the securities were purchased with money created by the Fed to begin with. Booking a loss simply means the Fed has less ability to pull money out of the economy by selling off securities.
Bone Fish said:
Prepare to enjoy 2 year CD’s yielding 6% and an opportunity to acquire an average resale house in America for the same price as a shiny new BAIG SUV.
Medex Man said:
The idiot Bernanke said it would be easy for anyone to undo the damage….um, balance sheet explosion… caused by his dim-witted quantitative easing.
Is Mish suggesting that Bernanke lied? That the Fed has no plan?!?!?! I for one am shocked, just shocked, to learn that Bernanke is a lying idiot
Central economic planning fails again (still)
I believe they prefer to TRY to steepen the yield curve first, and then see what happens before reducing the size of the balance sheet.
Steepening the curve (if it actually happens – and it hasn’t, so far) benefits the TBTF banks (of course!) and would give the Fed an idea as to how well the economy and stock market can handle the even higher rates that a balance sheet reduction would likely cause.
Curve steepening, particularly by letting the long end of the curve move up, damages the TBTFs as they’re loaded up with longer-term securities that will suffer huge MTM losses. This is inevitable, and no, it won’t help the TBTFs one bit.
Steepening only helps if the short end of the curve is suppressed through rate cuts. Not if the long end blows out as you’d expect in a long-term rising rate environment (ie: opposite of the past 35 years!).
Thank you for making it so clear that you obviously have no clue what you are talking about.
Any securities on a bank balance sheet that are categorized as “Held to Maturity” DO NOT get marked-to-market.
There is very little NOT being held to maturity right now. That was the whole point of QE – to give the banks the opportunity to unload (at full, face value) any securities they would not be comfortable holding to maturity. Where do you think the $2 TRILLION in excess reserves came from?
MTM isn’t just accounting fiction, its real. Losses are not avoided simply by holding something to maturity. If long-term interest rates rise, a good chunk of the Fed’s (and the TBTF’s) long-term securities portfolio is going to be underwater. The victim of depreciation at a rate faster than the interest coupons can roll in. This is very simple mathematics involving duration.
If the TBTFs are viewed on a MTM basis to be insolvent by the market their funding costs will rise dramatically, burning away their net equity position further than just the MTM losses. If the Fed is viewed to be insolvent, there will be a significant systemic problem.
So no, the person who obviously doesn’t have a clue certainly isn’t me. It most likely is you. The monetary heroin that the Fed injected into the banking system is going to be awfully hard to withdrawal from, especially since it has created massive malinvestment in the economy.
If I am holding a MBS that pays a 5+% dividend and the Fed raises interest rates tomorrow and then lowers them next year (or the year after), and I have NOT SOLD, please tell me how I have incurred a loss.
@Bam_Man, if the MBS has a duration of 10 years, and the Fed unloads a bunch of securities which pushes the rate on that MBS from 5% to 7%, the MBS loses 20%.
You still collect your 5% dividend, but your asset is worth 20% less. For a net of a 15% loss YoY.
If you’re a highly leveraged institution, like the Fed, or like a TBTF, that 15% loss, with 10X leverage, is enough to wipe out the entirety of equity in the institution.
Even a loss half of that will escalate the cost of capital to said TBTF dramatically.
CzarChasm Reigns said:
Ah, “how to proceed…”
● Reply hazy try again
● Ask again later
● Better not tell you now
● Cannot predict now
● Concentrate and ask again
and so “No decisions have yet been made.”
chris m said:
you seriously doubt the Fed hikes twice more this year.
but what if you’re wrong.
surely, it would make more sense,politically speaking, to do as and hike rates
as quickly as possible, as Fed suggests.
that way Trump gets to force economy into recession asap.
then blame subsequent recession all on Obama.
then the general idea would then be for economy to come out of recession in the period
leading up to next presidential election.
That way Trump comes up smelling of Roses and gets reelected.
Couldn’t agree more. He can’t pass much of anything before the market corrects.
Assimilate This said:
The concept of a balance sheet is completely irrelevant for entities that can create unlimited amounts of currency at will.
Medex Man said:
You are either another socialist troll…
…or one of those idiots that thinks Zimbabwe and Argentina have globally dominant economies (both after printing unlimited currency)
Please stop commenting in the US, and move to one of those places you think are a currency printing utopia. Suffer there until you develop a brain cell.
Raising interest rates is familiar. They have long experience with it. The balance sheet has never been at this level before, so they are going slow.
Mish, I think you’re wrong. They had a plan and that was to buy the completely fraudulent mortgage backed securities created by their owners, the big banks to make sure that the scumbag executives of those scumbag institutions didn’t end up and jail where they belong. That was half the plan of their purchases, keep our owners out of jail for the crimes they’ve committed.
Bingo! That’s how it works.
Bob Wolf said:
Why would the fed hike rates instead of reducing the size of their balance sheet?
Two reasons. First, the Fed does what is best for the banks, not the economy. If they reduced the size of the balance sheet, the fiscally responsible solution, it doesn’t benefit the member banks. Instead, raising rates allows them to donate 1% interest on all excess reserves. With over $2.4 trillion in excess reserves, this means the relatively new policy of IORR sends 24 Billion plus (and possibly rising) directly to these banks from the fed. How nice for them. Not to leave anyone out, the latest Repo numbers from Friday were $346 billion. All of these “non member” and non US institutional dollars received a healthy 0.75% for their overnight agreement. Another crony bonus to a different level of institutions. The huge repo market is a direct result of this method of raising rates.
Second, in order to affect the interest rate, the Fed would need to undo QE. In order to accomplish that, they would need to unload nearly $2 Billion in bonds, almost half the current balance sheet, to move the rates by even 0.25 basis points. Such a glut of sales would not only risk crashing the bond market, but it would severely undermine the “crowding out” philosophy that created this highly overvalued stock market. Bernanke flat out said that the reason for QE was to make other assets less desirable in order to foster higher stock prices and the wealth effect (making the rich richer and punishing savers). Providing a healthy supply of a safe alternative investment would very likely pop the stock market bubble.
The real question should be, why would the fed do what is “right” when it can enrich its primary constituents instead?
Bob Wolf said:
*$2 Trillion in bonds… not billion.
An extra little bit paid on excess reserves is nothing compared to the losses accumulating on the securities held by the banks and the Fed itself, on a MTM basis.
Trust me, its no windfall. As rates rise, the banks become increasingly insolvent, and performance of the underlying collateral, of course, diminishes. The ‘miracle’ of falling interest rates and rising asset values over the past 35 years or so will be quite the nightmare for the next few decades as such is unwound.
Bob Wolf said:
As a percentage, a few billion is relatively small compared to overall corporate profits, but prior to QE there existed no such thing as interest on excess reserves. This is free money. Remember, the question is whether to hike rates by running off the balance sheet, or giving banks free money. The fed picked the latter. They are stalling.
Are we in serious trouble as this unwinds? You know it. Check the Nikkei, Bernanke’s first experimental economy. After the QE comes decades of economic malaise. Unless our economy gets an influx of population (with Trump as president??) or our productivity increases (with Obamacare laws and government regulation stifling business creation, and QE crowding out all sensible investment ideas?), long term GDP growth is destined to continue its multiyear decline.
One day, valuation will matter, as we all realize. It’s like a gigantic “deadpool” game. Whoever shorts on just the right date, wins a whole lot of everyone else’s money. Problem is, the Fed is picking a date far in the future, and they have a lot of capital to manipulate! Meanwhile, if you picked any date prior to April 2017, you lost. Game on!! 😉
“Government debt” is corporate welfare. The money called government debt is deposits by investors who bought Treasuries. Why would they do that? Banks etc are sitting on a lot of unspent money, fuelled by QE etc. Banks can’t find, they say, enough credit worthy customers, so they get interest from the Fed and it’s the safest place to put their money. They don’t need QE money to lend, but they have it anyway.. Treasury decides to sell securities as a monetary operation, control the money supply. Fed does their bidding.
Whatever, government debt is a sign of WEALTH. All that loose money sitting in the Fed, doing FA. is actually a sign of a stagnant economy. The Fed never spends the money.It has no need for it. It’s the Fed. The Fed spends new money created debt free.
I doubt they can ever reduce their balance sheet, it’s supporting the debt levels. The only way I can see to do it would be a drastic reduction in government debt, really drastic reduction.
Again,,,all eyes on the Fed,,,and they won’t disappoint. They will pump out cheap credit until the law of diminishing returns hits them smack between the eyes. But, before that happens, these central planners will likely remain irrational longer than most Fed watchers will remain solvent. In other words, the Fed is the last to go down.