As the Federal Reserve prepares to shrink its nearly $9 trillion balance sheet to cool US inflation, which is at 40-year highs, tricky questions may arise about what’s happening in the system besides money.
Is some of the money disappearing, effectively shrinking the money supply? Or is it going somewhere else?
MarketWatch asked a handful of industry experts to help explain the financial assets that connect one of the world’s most powerful economic institutions to the financial markets, the economy and the government purse.
Here’s a rundown of what happens when the Fed stops creating “money out of thin air,” as Luke Tilley, chief economist at Wilmington Trust, described it in an interview with MarketWatch, and starts “expanding the money supply in the economy to reduce”.
where the money comes from
To stabilize markets during the pandemic, the Fed started paying $120bn monthly back in 2020, via BofA Securities BAC, +3.13%,
Citigroup Global Markets C, +3.07%,
JP Morgan Securities JPM, +4.47% and other primary dealers or the 24 major banks and brokers now authorized to deal directly with the central bank.
As central bank holdings increased (see chart), this provided the financial markets with liquidity and confidence to keep credit flowing. It also helped initiate a rapid economic recovery from early pandemic shocks. More recently, it has also been blamed for creating too much exuberance in some asset markets, which could fizzle out and lead to painful losses.
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As Wilmington Trust’s Tilley, a former Fed official, put it, the Fed buys securities and adds money to dealer accounts with the aim of making money in the economy.
One way to track the “oceans of cash” piling up at banks under the easy money policy is bank reserves (see chart below), or the amount sitting in the Federal Reserve earning 0.15% .
Importantly, bank reserves are part of the monetary base, but contribute to the money supply only when they are deployed and circulating in the economy, Tilley said.
Ideally, some reserves will flow out of banks to businesses and households in the form of loans to fuel economic growth, but without incurring too much debt that could backfire in the form of defaults.
Another way to track cash in search of a home is to note the spate of funds parked overnight in the Fed’s reverse repo facility, which was almost idle a year ago but is of late time to about $1.5 trillion daily.
“That’s a bunch of cash worth about $5.5 trillion,” said Mark Cabana, head of US rates strategy at BofA Global.
Fed Chair Jerome Powell now faces the difficult task of tightening financial conditions to combat inflation, which was fixed at 7.5% in January, or well above its 2% target for the year amid high fuel -, food and housing costs threaten to trigger a slowdown or recession.
Powell said on Wednesday that the balance sheet rundown could begin in May after the central bank pulled the trigger for a quarter-point hike in interest rates, the first hike since 2018.
Read: The Fed is raising interest rates for the first time in four years and is planning a series of rate hikes to fight inflation
troubled markets
The market’s nervousness about the Fed’s next steps can already be found in falling stocks this year SPX, +2.24% DJIA, +1.55%,
but also in US high-yield HYG, +1.40% JNK, +1.44%,
or the “junk bond” market, where debt issuance has been largely halted since Russia’s invasion of Ukraine sent oil and commodity prices soaring.
High yield bond issuance so far in 2022 is about 70% lower than a year ago, Bill Zox, high yield portfolio manager at Brandywine Global Investment Management, said in a phone call.
“Look, there’s no question that the new issue market could close,” Zox said of the deeper turmoil that could unfold if the Fed plans to hike rates and sell off assets for the first time since 2018. “That’s not my base case right now, but it’s a lot more likely today than it was a month ago.”
Read: Four things to consider as we wrap up Wednesday’s Fed meeting
where money goes
The Fed transfers profits accumulated on its holdings to the U.S. Treasury once a year, which equated to nearly $90 billion in 2020, to help cover government bills.
As the Fed seeks to reduce the money supply in the economy, it can do so in a variety of ways, including passively paying maturing bonds.
BofA Global estimates that approx $1 trillion in bonds held by the Fed mature this year, with roughly the same amount maturing in 2023, which would affect a sizeable portion of its balance sheet.
“They bought bonds with the idea that in the next two to four years a lot would expire, so they wouldn’t have to sell anything,” Jim Vogel, interest rate strategist at FHN Financial, said over the phone.
Sounds simple enough, but Cabana, also a former Fed official, argues that passive balance sheet shrinking still requires the Treasury to issue more debt to the public to bolster the Fed’s maturing inventory, “destroying” bank reserves. The Fed’s reverse repo program shrinks and keeps the cash ready.
And if the Fed no longer acts as the primary buyer of its debt, others would have to step forward when the Treasury lays out its expected quarterly funding needs in the coming months.
“The big risk here is that there is too much outstanding debt for the market to just unwind,” Cabana said. “The question is how this affects financial conditions and risk appetite.”
A more measured approach could be for the Fed to reinvest some of the proceeds from maturing bonds to buy more, thereby regulating the pace of its balance sheet rundown, as it did after the 2008 financial crisis. However, unlike earlier in the pandemic, the Fed would now buy bonds directly from the Treasury, bypassing primary dealers.
A third, perhaps more disruptive, path would be for the Fed to sell bonds on its books directly to the market.
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“If it sells bonds, the market would have to buy them,” Vogel said. “The simplest words: The Fed will stop throwing stones in the pond. But even after it stops, there’s a whole series of ripples.”
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