Chatter has it that the Fed is going to raise the funds rate this week; the first hike in almost a decade and the first move of any kind in the fed funds in seven years. Oh, well, this isn’t about that. This is about the Fed’s balance sheet.The funds rate may be the best known Fed policy tool, but adjustments to their balance sheet has been the tool policymakers turned to when they had concern that the zero bound funds rate was just not low enough to get the economy back on track. And it is a policy that will persist for some time – even after the funds rate begins to rise; a journey it is expected to begin this week
The Fed balance sheet is enormous; the latest reading puts the size at $4.48 trillion. For reference sake, the balance sheet totaled $891 billion on the eve of the recession back in December 2007.
The balance sheet grows when the Fed buys assets; in recent years the growth of the balance sheet is the result of quantitative easing (QE). The Fed creates money and uses it to buy things such as Treasuries and mortgage-backed securities. This strategy forces money out into the system, which should help to make broader financial conditions more accommodative; below and beyond the zero funds rate.
It is also supportive of the longer term assets, keeping those interest rates low. Or at least, that’s the theory. On the other side of the ledger, the Fed’s balance sheet increases since the purchased securities are held by the Fed.
Treasury Buying did the Trick...
The Fed started buying mortgage-backed securities in the fall of 2008, but the big splash was in March of 2009, when the Treasury buying began. This initial quantitative easing program continued until the end of March 2010; QE2 began in November 2010 and continued through June 2011; and the Treasury component of QE3 was introduced in December 2012 and it persisted until it was finally tapered to nil in late October 2014. So it was during these periods when the Fed balance sheet grew, and in between those times, the balance sheet was essentially flat. The size of the balance sheet was maintained during the non-QE periods because the Fed reinvests the mortgage securities principle payments and they roll over maturing Treasuries.
The October 2015 FOMC statement reiterated the Fed’s commitment to this strategy, thus maintaining the size of the balance sheet at or about its current level of $4.48 trillion. This was in contrast to the comment in that statement about “determining whether it will be appropriate to raise the target range at its next meeting.
“The differentiation of the balance sheet from the funds rate is the right way to think about these strategies,” said the monetary policy expert Professor Michael Woodford and San Francisco Fed economist Vasco Curdia in a paper a couple of years ago called, The Central Bank Balance Sheet as an Instrument of Monetary Policy; “Thus in considering an appropriate strategy for ‘exit’ from the current unconventional posture of the Federal Reserve, it is important to recognize that, according to our model, there is no reason that the timing of the Fed’s reduction in its holdings of assets other than short-term Treasuries must be tied in some mechanical way to the timing of a decision to raise the federal funds rate above its current historically low level. These are independent dimensions of policy, not only in the sense that they can be varied independently in practice, but in that they have different effects as well, and are appropriately adjusted on the basis of conditions that are fairly different.”
So there you have it. The Fed can go ahead with increases in the funds rate and not do a darn thing about the size of their balance sheet. According to experts on the matter, the strategies are distinct from one another. Both are accommodative strategies, but importantly, the growing of the balance sheet through quantitative easing is, according to former Fed Chairman Ben Bernanke, intertwined with stock market success.
The day after the FOMC announced QE2 in early November 2010, the Fed chairman wrote about the Fed’s reasoning for again doing the strategy in the Washington Post: “And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.”
The Fed not only figured that stocks would benefit during the QE process, but also that there would be a continuing benefit as long as the balance sheet was maintained at a high level. As it turns out, this perception was only half right.
Since March 2009, the SP rallied whenever QE was ongoing and the balance sheet was growing; the effect was unfailing. Additionally, the SP also went bid when the Fed clearly suggested more QE was on the way.
A Brief History of the Market Tanking without QE
But in the last six years when QE programs were not in operation, and the Fed balance sheet was essentially steady and not growing, the stock market has been unable to sustain a rally and it has been vulnerable to repeated sell-offs.
- The SP bottomed in March 2009, just a few days before the Fed formally announced QE1. That program continued on through March 2010 and the SP rallied the entire time. But, absent the QE the market had trouble, by early July 2010, the SP was seventeen percent off the high. Sure, you can blame the Greek debt trouble for the US stock weakness, but that doesn’t explain why the market ignored European debt woes whenever QE was underway.
- Bernanke strongly hinted at QE2 during the Jackson Hole Fed Fest in late August 2010, and the SP responded. The rally was well underway on November 3, 2010, when the FOMC presented the program. The SP continued to rise until the end of June 2011. The market peaked in early July but it was twenty percent down from there by October.
- The Fed did not do QE3 at that point; instead they chose a maturity extension program known as “operation twist”. But this did not expand their balance sheet, it just changed the mix of securities in it. Interestingly, this did not help the stock market. In early July 2011, the Fed’s balance sheet totaled about $2.87 trillion and the SP high that month was 1356. Sixteen months later, on November 16, 2012, with the Fed balance sheet still at about $2.87 trillion, the low of the day for the SP was 1343. The SP made no progress without the assistance of a growing Fed balance sheet.
On November 20, 2012, Bernanke used a speech at the Economic Club of New York to foreshadow QE3; a program the FOMC would formally announce at the December 2012 policy meeting. The SP rallied unimpeded for the next two years; the Fed balance sheet expanded by about sixty percent during that time.
Not until September 2014 did the SP stumble. That’s when the FOMC stated that QE3 was set to conclude the following month. The market fell by almost 10% in just a next few weeks; it was only rescued by a chattering Fed bank president who said the Fed could QE again if it proved necessary.
There hasn’t been additional QE since then, so therefore the balance sheet has been steady as she goes, at about $4.48 trillion. And what has the stock market done while the balance sheet sat still? The SP settlement at the end of October 2014, which is the last month during which there was QE, was 2018.05. The SP settlement on Friday December 11, 2015 was 2012.37. At its best since the end of QE, the SP was up six percent, but the gain was not sustained.
Since the low in March 2009, the stock market has rallied during QE and has had trouble without it. That is an observation not an opinion; it is an observation made obvious in the chart below. (The SP is in blue; the Fed balance sheet is in pale green.)
The Fed is not yet ready to shrink their balance sheet. Recent history suggests it might be a tricky thing to do.
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