The Emerging Balance Sheet Plan

By: C.Jay Engel
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Now that the Fed has tinkered the Fed Funds target range to the upside on a handful of occasions over the last year, they are slowly turning more focus to the Fed's balance sheet. Before the financial crises, the balance sheet stood below $1 trillion. Now, just 8 years later, it sits above $4.5 trillion. That's a lot of purchased assets and interest rate manipulations. Since they are claiming to have saved the global economy, it is time to prove it by unwinding all these positions.

Their emerging plan is to complete two more rate hikes this year and then address the balance sheet, likely starting by slowing or halting the reinvestment of their proceeds from their current assets. Of course, they don't want to go too fast, lest the markets panic. The Wall Street Journal observes:

How it proceeds is of great importance to market participants. In 2013, when the Fed signaled it would stop adding to the portfolio, stocks fell, interest rates rose and emerging stock and bond markets sank—an event known as a “taper tantrum” on Wall Street, driven by investor worries about the implications of a less accommodative Fed.

The implications are obvious: Wall Street is a mighty influence on the Fed and Wall Street's anticipated reaction to the Fed actually influences monetary policy, whether they admit it or not. Of course, this is nothing new. As David Stockman explains in The Great Deformation, as the Fed becomes more involved in interest rate targets and asset-purchases, market speculators begin to play the game and bet on the Fed's moves. He writes:

For instance, if traders believed there was an 80 percent chance that the federal funds rate would be increased by 50 basis points in four months, the futures contract for that month would exceed the spot rate by a corresponding amount.

The market-pricing signals that [Arthur] Burns mused about thus eventually became something very different than honest assessment of financial market conditions. In effect, they became Wall Street’s marching orders to the Fed. The message was that if Wall Street “expectations” of continuous accommodation by means of low and even lower interest rates were “disappointed,” then an economically threatening market sell-off or even panic was likely to ensue.

And here we are 40 years later, with the Fed having traveled the road of monetary expansion and interest rate manipulation, to the benefit of Wall Street (among others). The Fed still has at the forefront of its mind the "tantrum" that may ensue if historically unprecedented "accommodation" is slightly taken away. The Fed is stuck, and refuses to admit it. The question remains to be seen: how far on the road to balance sheet "normalization" can they go?