The Federal Reserve is sitting on a massively bloated balance sheet, and all major asset markets—stocks, bonds, alternative offerings, and real estate—are long overdue for a massive correction. That was the thinking of many in early 2020, when the size of the Federal Reserve’s balance sheet stood at $4.3 trillion. Prior to the financial crisis of 2008, its balance sheet never breached the $1 trillion mark. But over a decade after the crisis began, the Fed’s balance sheet has been nowhere near pre-crisis levels. Then, on March 9th, 2020, all three major stock indices recorded historically large percentage losses as investors digested the news that COVID-19 illnesses were surging around the globe. The news led to even more government intervention. Today the Fed’s balance sheet sits at a staggering $8.1 trillion and yet many indices are near all-time highs. So, does the size of the Fed’s balance sheet really matter, and what is the Fed’s balance sheet anyway?
The Treasury and the FedThe Fed essentially sets the cost of money through a variety of activities including balance sheet purchasing. The Fed’s balance sheet purchasing, sometimes referred to as “quantitative easing,” impacts all interest rates, which materially affects things like cap rates and rates of return for alternative investment programs.
To explore more fully, let’s imagine a person named Trey, and his cool guy alter ego who we’ll call the “the Fred.” Trey is an artist who paints pictures and sells them at auctions. Whenever bidding for Trey’s paintings is slow, the Fred steps in to keep the bidding going with magic money that only he has. Occasionally Fred gets stuck owning a few. Trey is very cautious of selling too many of his paintings to the Fred because there have been many such Trey/Fred relationships around the globe in the past, and every one of them has soured because the painter abused the friendship of their buying alter-ego. The Fred realizes that if he keeps throwing his magic money around all kinds of strange things may happen and not just to the price of art. Maybe art in general will be so expensive that people will look at all other asset classes as being “better buys.” Starting in late 2008, their relationship changed, because the market for Trey’s paintings turned south; and before either of them knew it, Fred’s inventory of paintings, which for years had been minimal, all the sudden ballooned to trillions of paintings. In 2013 Fred started to feel he was being taken advantage of by Trey and started letting everyone know that he was going to scale back his purchases and he was giving Trey time to adjust before he stopped buying all together. Well, people threw a tantrum over the suggested tapering. “How dare you” they said, “if you start tapering now, we’ll never speak to you again.” The threat worked, and the Fred said, “I take it back.” Sad to say the Fred never was able to sell any of Trey’s paintings and only ended up buying more, lots more, and today has around 8 trillion of them laying around. Not only that, at some point along the way, Trey started asking the Fred to buy the paintings of some of his friends, including a huge producer of art who we’ll call Mort G.
Now back to the questions at hand—the Fed’s balance sheet assets include holdings of U.S. Treasury, agency, and mortgage-backed securities (debt securities). When our government (the Treasury) needs money it doesn’t have, it borrows either from the investing public or the Fed by issuing U.S. Treasuries. When the public buys Treasuries investors give up cash; when the Fed buys Treasuries, the Treasury gets credited with new cash and the Fed, rather than giving up the fruits of labor, simply makes an accounting entry for Treasuries on its own balance sheet. The newly created Treasuries are assets on the Fed’s balance sheet. The Fed owns a promise of repayment from the Treasury. Similar to the fictitious story above (where when the Fred buys paintings, he bids prices up, a good thing for Trey), when the Fed purchases treasuries, it bids cost down, a good thing for the Treasury. If you’re selling something, high prices are good, if you are issuing debt, low costs are good (as interest is a cost to the Treasury). If you flip selling paintings with issuing debt, the Fed’s balance sheet is a little like the Fred’s garage.
Ok, ok, I know this is getting confusing, but all you need to know is that whenever the Fed purchases debt securities new money is created. So, when the Fed’s balance sheet is growing by the trillions the investing public becomes concerned with, have you guessed it yet? inflation. So why has inflation, up until very recently, been so tame in light of all this Fed spending?
It's a Wonderful Life and the velocity of moneyWell, we haven’t even gotten to the fractional reserve banking system yet. Who can forget the most heartwarming scene from the holiday classic It’s a Wonderful Life (The rest of the movie is pretty good too, especially when watched around the holidays in a warm house under a blanket.) In that scene, George Bailey explains the fractional reserve banking system to the good people of Bedford Falls by saying “You're thinking of this place all wrong, as if I had the money back in a safe. The money's not here. Your money's in Joe's house...right next to yours, and in the Kennedy house, and Mrs. Macklin's house, and a hundred others. Why, you're lending them the money to build, and then, they're going to pay it back to you as best they can.” Once a dollar goes into the banking system (imagine the government deposits the dollar into the bank account of government worker Sally Smith), through Federal Reserve purchasing, only a portion of it must be kept by the bank and the remainder may be lent again and so on and so on. If, for example, the reserve requirement ratio is 10%, of the first dollar deposited, 10 cents must be reserved by the bank and the remaining 90 cents may be lent out. When those 90 cents are deposited, 9 cents must be reserved, and 81 cents may be lent out and so on. I’ll save you the math; every one dollar that goes into the system has the potential to create $10 worth of money supply. In this example, Fed balance sheet purchasing only adds one dollar to the system, but bank lending adds $9 to the system (I wonder what the actual reserve requirement ratio is as of today, but anyway…). Fed injections are only a piece of the whole. If banks aren’t lending, you can see the impact of Fed purchasing is muted. It’s when banks start lending that the effects of additional funds in the system get rolling and inflation has the potential to heat up.
The "I" word
Inflation has clearly become relevant for the investing public and investors are now experiencing what some are calling financial repression. Financial repression is the erosion of the investing public’s wealth through the Fed’s policies because the government is dependent on low interest rates to refinance its own debt, and inflation increases government tax revenues, which mitigates it need to borrow in the first place. The investing public is repressed with low yielding investments not keeping pace with Inflation.
Fed purchasing has been credited with helping the economy recover and the Fed has been buying $120 billion of debt per month; but, whether it be transitory or permanent, inflation is clearly heating up. According to the Fed’s favorite inflation gauge, the PCE, inflation is at 5%. The Fed began tapering debt purchases in November and is expected to raise interest rates at least once before the end of 2022. We have an indication from the Fed as to what a tapering will look like, but, in my opinion, there is no historical precedent and we do not know how this will all play out. George Bailey was right, if all borrowers withdraw at once there aren’t enough dollars available to satisfy the investing public. The “multiplier effect” works in reverse just as well. Money cannot simply be withdrawn en masse from the system without devastating impact.
Crystal ballsAs many of us try to predict where interest rates are headed in effort to better navigate the alternative investment landscape (from real estate to alternative credit), our inclination is to think logically about the historical correlations of asset classes and leverage our academic understanding of the relationships of risk-free assets, stock and other equity offerings, bonds, and commodities. One investing paradigm has been that zero or near zero interest rates could not persist for long periods of time, much less negative interest rates witnessed in the global economy. After all, who wants return-free risk? Perhaps our “thinking of this place is all wrong.” Real world asset prices may be better understood by understanding global central banking policies, including the policies of the most influential central banking system in the world, the U.S. Federal Reserve banking system. At least one paradigm of investing still holds, “Don’t fight the Fed.” The tail is wagging the dog and it has been for some time now.
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