By Keith Weiner
Shrinking the Balance Sheet?
The big news last week came from the Fed, which announced two things. One, it hiked the Fed Funds rate another 25 basis points. The target is now 1.00 to 1.25%, and there will be further increases this year. Two, the Fed plans to reduce its balance sheet, its portfolio of bonds.
Assets held by Federal Reserve banks and commercial bank reserves maintained with the Fed – note that while asset purchases and bank reserve creation are connected, the connection is loose (there are other factors influencing movements in reserves as well). [PT] – click to enlarge.
It won’t do this by actually selling, but by not reinvesting some of the principal repaid as the Treasury rolls over each bond at maturity. This is like reducing the workforce by a hiring freeze and attrition, rather than by layoffs.
We are no Fed insiders, but if we were to take an educated guess, we would read the last part as a shuffle between the Fed and the banks. No one can afford rising long-term bond yields, as the banks hold plenty of them and this would be a capital loss. Also, if bond prices drop then all other asset prices would drop too. Banks would take another hit.
Right now, the banks are lending to the Fed at 1.25%. The Fed uses this cash to finance its purchase of long Treasury bonds. The 10-year bond closed on Friday at a yield of 2.16%. If the Fed can arrange for the banks to swap, basically slowly draw down their excess reserves and buy the bonds, then it would not cause the bond market to crash.
At the same time, the Fed can say that it has shrunken its balance sheet. There would be no change in the bond market, but the banks can bypass the Fed, while increasing their net interest by about 0.9%.
This move would have one non-obvious side effect. The duration risk moves from the Fed to the banks. This is the risk of capital loss, if the interest rate should move upwards.
At least the risk moves to the banks nominally. In practice, the Fed will have to bail out the banks should they get hit by this (or assure the banks that the Fed will do everything it can to prevent long bond yields from rising).
We present the issue in these terms, because bank solvency (and the Fed’s own solvency) is the real motivation of the Fed. Price stability — defined to make Orwell proud, as rising prices of 2% per year — is not occurring right now. That is, the Fed has failed to stimulate the price increases that it wishes.
And the Yellen Fed does wish for rising prices. In a key paper she wrote in 1990 with her husband George Ackerlof, Yellen presented her theory of inflation and the labor market. Let’s strip the academic regalia, to see it in plain terms.
Disgruntled employees don’t work hard, and may even sabotage machinery.
So companies must overpay …read more
Source:: Acting Man
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