The Federal Reserve’s Balancing Act


Kevin Gale, Managing Director, Head of Fixed Income

We know that since the 2008 financial crisis, the Federal Reserve (FED) has significantly expanded its balance sheet to ensure the financial system functions in an efficient manner and has access to liquidity. From 2008-2015, the FED’s balance sheet expanded by approximately $3 trillion to a total of $4 trillion. In just several months during the mass shutdown of the U.S. economy earlier this year due to COVID, the FED expanded its balance sheet by an unprecedented $3 trillion to a total of over $7 trillion, as you can see in this J.P. Morgan illustration. This number sounds staggering, but what does it mean and why is it important to investors?

JP Morgan illustration

Let’s start by looking at the Federal Government, a large and complex entity primarily funded through various taxes. However, as is the case in most years, the government may spend more than it receives in tax receipts, resulting in a deficit. When deficits occur, the government will borrow money to cover the costs. The U.S. Department of Treasury is responsible for ensuring the government is funded and, in conjunction with the Federal Reserve, will sell treasury securities to fund any deficit spending.

Acting as the Central Bank of the United States, the Federal Reserve is arguably the most influential bank in the world. One of the biggest responsibilities instilled upon the Federal Reserve is the management of the total outstanding supply of U.S. dollars, creating or eliminating billions of dollars every day if needed. By adding dollars to the economic system, the money supply increases, resulting in lower interest rates and increased demand for loans due to the cheaper borrowing rates.

The Federal Reserve does not literally create paper dollars to accomplish this as the job of printing paper money belongs to the U.S. Treasury. Instead, the FED turns to banks as a conduit to electronically add money into the economic system by conducting large asset purchases from banks through open market operations. The FED receives the asset on its balance sheet, the bank receives the cash and the economy remains liquid. The Federal Reserve Act specifically prohibits the Federal Reserve from purchasing treasury securities at issuance to ensure the agency maintains its independence.

The addition of the new money helps drive down interest rates, keeping borrowing costs low for those that need funds. When banks have increased reserves, they can then lend out additional funds at lower rates to businesses and individuals. These additional funds being added to the financial system help boost demand, which overtime can lead to increased inflation. At times, inflation can increase at a faster rate than the FED would like, which it may then attempt to reverse by selling the securities it already owns back to the open market, thereby taking money out of the financial system, causing higher interest rates and lower demand. The FED has a long-run inflation target goal of moderately above 2%.

Due to COVID, it is expected that additional deficit spending by the Federal Government will occur to further support the economy and help drive down unemployment. This will likely result in continued support from the Federal Reserve and further expansion of its balance sheet. Investors should be mindful that the danger in deficit spending is that the significant supply of Treasuries could lead to higher interest rates over time and potentially higher than wanted inflation. For these reasons, Ancora monitors FED activity closely and examines both the size and composition of its balance sheet, among many other inputs, when making investment decisions.

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