The Federal Reserve’s Growing Balance Sheet and You

The Graph featured here shows the break out of the various debt holdings on the Fed’s balance sheet, over a specific time interval of 2004 to the present. It clearly shows a growing trend of the accumulation of assets. How did it grow so quickly during this time period? The Fed buys up the assets from the banks, as the banks receive cash from the Fed. Note: The third party dealers broker the transaction.

This has been the primary tactic for the various Quantitative Easing(QE) programs since the market correction of 2008. The balance sheet gives some indication of how much money was been introduced into the money supply, and just imagine how the fractional reserve factor has impacted the actual balance of loanable funds for the banks.


Inflation…inflation and inflation. $4.5 trillion and rising.

Inflation, The Coronavirus, and the Exponentially Growing Federal Reserve Balance Sheet

Since the outbreak of this “virus”, emergency measures, by The Federal Reserve(The Fed), have been implemented. One of those measures has been The Federal Reserve dropping interest rates to 0%.(Read more of this on my other blog articles) Other measures have been on going prior to this “pandemic”—these measures are accelerating thanks to the “virus”.

Let’s look at the graph of the growth trend Federal Reserve’s balance sheet. Assets, on the Fed’s balance sheet, have skyrocketed for the year 2020, overtaking the Repo activity done by the Fed from September 2019 to December 2019(On the graph it is indicated as QE-4). Although they did not officially call this “Quantitative Easing”, the net result was the same: Liquidity was restored for banks, while the Fed purchased the illiquid bank’s assets—this was done printing money from nothing. Looking at this chart, it is quite evident that the current Fed balance sheet is well over $4.67 trillion dollars and rising. This has surpassed the prior peak of circa 4.5 trillion during the zenith of QE-3.

Critics will claim: “Well there isn’t any inflation. See the Consumer Price Index.” This claim is non sense. By definition, inflation is a monetary phenomenon, as it is the expansion of the monetary base. It’s quite clear the monetary base as been expanded exponentially. The “price” inflation impacts the capital markets first, as seen by the equities market and other capital markets. (Note: The term “Price” inflation is simply used to recognize rising prices, as its separate from actual inflation) The recent market crash is evident of this, based upon the constant build up of the prior QE measures. Also, if there were no “price” inflation, why the need for the bailout of the banks with sub prime auto debt on the books?

With regards to sub prime auto loans, Car prices have risen—not necessarily due to the increase of the economic cost to make a car(I would argue it’s declined), but the value of the currency to actually purchase the vehicle has declined. This makes it difficult for the average citizen to purchase the vehicle, as the price seems out of reach. This is due to his wages not keeping pace with the rising prices(declining currency value). Sub prime lending bridges the gap, and many individuals can acquire a new vehicle. However, due to the nature of the sub prime market, the default rate is high—leading to bank illiquidity. Due to the increase of sub prime auto loan defaults, this creates a ripple effect on the secondary market—where institutional investors purchase large packages of these loans—causing the aforementioned QE action by the Fed. Yes, there is inflation.

A growing Fed balance sheet is a harbinger for inflation. The Fed simply doesn’t print cash, it buys assets with cash, that action expands the money supply. The transaction—that buys the assets—is done with a third party dealer, and that dealer deposits the check in their bank. The deposit expands the money supply thanks to fractional reserve banking deposit factor, Also, where does the Fed obtain the cash to buy the assets? Answer: It creates it out of thin air.

Oh and speaking of the dealers, here is a listing, per the New York Fed:

These entities handle the monies for the asset purchases between the Fed and the Fed chartered banks. Once the monies are deposited, the money supply is expanded.

The intrepid zeal to “fix” the issue is in play with the Fed especially during a time of crisis. Will these “fixes” “help” boost the economy?

Read more regarding this topic here:

Federal Reserve Engages in $500 billion in Repurchase Agreements—Pledges $10 Billion to Act as a back stop for Commercial Paper Market

The Federal Reserve, due to the current crisis caused by the cornavirus, has decided to engage in some aggressive monetary policy to boost the economy. First, they are seeking to acquire repurchase agreements(repos). These agreements have been discussed on this blog in detail. See here: http://robertwilliamsjr.com/repurchase-agreements-are-on-the-rise-who-cares-you-should

Secondly, the Fed placing forward $10 Billion to act as a backstop to the Commercial Paper market. Both measures are supposed to help in the liquidity of the banks that have commercial paper stagnated on their books.

With a Repo, the Fed actually purchases the debt from the banks, then exchanges that for cash. The banks will agree to buy back the debt at a later date. In the meantime, the banks’ balance sheet is strengthened thanks to the injection of cash.

My assessment: More cash in the system, more inflation. A higher back Commercial drop: A moral hazard.

Read more here

https://www.thestreet.com/investing/federal-reserve-sets-commercial-paper-backstop-dollar-gains

Fed Rates at 0%

In an effort to “boost” the economy, the Fed has dropped interest rates to 0%. What does this mean? With regards to the fundamentals of interest rate theory, the overall aggregate time preference of marginal utility is based upon purchasing items in the present versus the future. In short, the rationale behind this interest rate drop is to encourage spending and boost consumption. There are some glaring flaws with this tactic.


First of all, the notion of the interest rate is subjective to each individual in the economy: How does the Fed actually know what the utility ranking for each individual in the marketplace? They may aggregate numbers, and run various statistical models to attempt to determine the true interest rate, however, this process still will come up short. Unless the members at the Fed are demigods, there is no way of accurately determining the rate. This causes mis allocation of resources starting in the capital markets.

Secondly, it debases the monetary base. Since the rate is at 0%, the goal is to push for consumption in the present. The need to spend money now due to the “cheap” money will deliver more lending into the marketplace. Since the interest is technically a “price”, the Fed price fixing it at 0% makes for a false expansion of the money supply. The asset prices will rise(like a balloon), at the cost of those who can not afford to acquire those goods(assets) at the inflated prices. Note: The prices rise, not due to Price inflation per se, but due to the devalued monetary base. It takes more monetary units to buy that particular item, as that is reflected in higher prices for that item.

If many are concerned about the growing inequality between “classes”, the analysis should start here with monetary policy. As the Fed continues to expand the money supply and grow its balance sheet, look for a growing trend of more sub prime lending to help the lower income classes to acquire goods. This class will not be able to catch up with the rising prices, since their income is fixed.

The Fed Doesn’t Have the Control Over Interest Rates Everyone Thinks It Does

Strictly speaking, the Fed does set the interest rates, but, from an economic perspective, it does not know what the true interest rate is. It’s impossible to know, yet many assume that the Fed does know this rate. Attempting to set the interest rate is a form of price control, as spawning from this attempt provides a chain of economic events…these events are costly. For example, keeping interest rates too low, allegedly is supposed spawn economic growth, but the trade off cost for this price fixing measure is more inflation. Inflation devalues the monetary base—requiring the consumers to use more monetary units to buy the same goods.

Excerpt from the article:

“Last week, the Federal Reserve did what was expected by leaving their targetfor the fed funds rate unchanged. To the point that a misplaced adverb can cause a mini market selloff, investors meticulously dissect Federal Open Market Committee minutes and hang on Fed Chair Jerome Powell’s every word for language that provides insight into where the Fed may take interest rates. It’s a near universal axiom that the Fed sets interest rates, and we’re all just along for the ride.

How much control does it really have, though?”

https://www.thestreet.com/markets/fed-doesnt-completely-control-interest-rates?puc=yahoo&cm_ven=YAHOO&yptr=yahoo

Repurchase Agreements Are On The Rise: Who Cares? You Should

Since September 2019, The Federal Reserve has cranked up its repurchase agreement operations(Repo), after a period of dormant activity. In the recent past, since 2009, The Fed was engaging in more Quantitative Easing(QE). As a result, the Fed has been buying back the cash from the banks as a means to offset the QE.
While you are reading this, you maybe asking yourself: “What is this jobberwocky regarding repurchase agreements? Why should I care?” Both are excellent questions, and they deserve an answer. For starters, let’s discuss the concept of a repurchase agreement.

The Pawn Shop Transaction
Imagine you are short on cash, and you have some urgent expenses that require your immediate attention. Let’s assume, for this example, the amount needed is $1,000, and your next payday is in 7 days. You are feeling anxious. However, you begin to rise out of your lugubrious mental state, and you recall that you own a fine musical instrument. Bubbling over with excitement, you scurry over to the local pawn shop, hoping to get some cash to help you in your current plight. You enter the pawn shop, and you are shocked to the fact they can give you the $1,000 for the instrument. But, you suddenly realize: There is no free lunch. The pawn shop operator reviews the condition of the instrument, as he checks to see if its value is worth the exchange. The pawn shop operator agrees to the deal, but you must pay him back $1,300 in a week. The pawn shop gives you the cash, which helps your cash position for the short period until the next payday. In the exchange, the Pawn Shop takes control over the Musical Instrument.
You are okay with these terms despite the interest rate charged because you really need to cover these urgent expenses. In a week, you pick up the instrument and pay back the pawn shop $1,300. The $1,300 represents the original amount plus interest. If you never payback the Pawn Shop, then the shop keeps the Musical Instrument. Most likely, in this hypothetical scenario, the musical instrument is worth well more than the $1,000. The pawn shop’s risk is mitigated by following: (1) their proper valuation of the instrument, and (2) the interest charged to you for your repayment.

A Repo: The Pawn Shop Transaction…with a twist
A repurchase agreement works in a similar fashion, but there is a slight twist: The ownership of the collateral does change hands, but there is an agreement for the receiver of the money to purchase back the asset in a short period of time. The assets sold, in the repo, can be US Treasuries, Mortgage Backed Securities, or the like. The Federal Reserve will provide the bank the cash for the asset. The bank agrees to purchase back those securities at a later date, for a higher price. That buy back price is driven by the Federal Funds lending rate, which is established by the Federal Reserve. Side note: That rate is the amount used to factor how much interest to charge when banks borrow from each other. Once this occurs, the bank has more cash on the balance sheet. A reverse repo is simply the opposite transaction, from the bank’s perspective. The Fed will simply sell to the bank those assets/securities, in exchange for cash.

Why would a bank engage in a Repo transaction with the Fed? For starters, this helps maintain the proper cash reserves for the bank. Next, since the Federal Reserve sets the Federal Funds lending rate, perhaps the bank can take advantage of some arbitrage opportunities. A conceptual example to consider: If the funds rate is 1.75%, perhaps the bank feels it can earn 2.00% on another investment. Another reason: A bank could have liquidity issues from a group of loans that have defaulted, and they lack the cash to move forward. The reasons to enter a repo with the Fed are not limited to simply a few. With any economic transaction, there are costs, and the repo transaction is not immune to this.

Concern One: Moral Hazard
The concerns regarding these transactions can be many, I will simply cover two. First, since the Federal Reserve acts as “The Lender of Last Resort”, this repo transaction acts as a moral hazard. The banks can engage in all sorts of risky business knowing that The Fed is going to bail them out. If the banks decide to invest into a bundle of a certain type of investments, and that tranche goes sour, their liquidity is compromised. The Fed can come in, engage in a repo agreement, and liquidity is restored. If banks had no “safety net” for their investing behavior, they would be forced to moderate their investment risks accordingly.

Concern Two: Inflation
Once the funds are injected into the banking system, this expands the money supply instantly. With inflation, the economic value of the currency drops as each piece of the monetary unit is added to the money supply. Since banks operate with a fractional reserve model, once the funds are given to the banks, they show higher cash reserves on their financial statements. For example, a deposit of $1.00 can be expanded to show $10 on the bank’s books. Imagine that with billions of dollars. That becomes massive.
As with all inflationary measures, the first recipients of the cash are the main benefactors. In this case, it is the banks. The interesting thing about inflation: It acts as another tax on everyone else, mainly savers and individuals on a fixed income. A few benefit from the expansion of the money supply, and the economic cost of this monetary expansion is spread all throughout the rest in society.

Why Should You Care?
If you are on the quest of building wealth, knowledge about the financial world around you is important. With regards to monetary policy, and even fiscal policy, it impacts your ability to build and accumulate wealth. The insidious combination of loose monetary policy, and the federal government spending at egregious levels, makes it increasingly difficult to save and build wealth.
With the expansion of the money supply, it can develop asset bubbles. In the last 2O years, we have seen two different bubbles burst, due to loose monetary policy. With both bubbles, the warning signs were there, many continued with their investments and lost. If the investors who were wiped out could see the signs, perhaps things could have been different.

Conclusion
With the expansion of repo operations, the Fed’s balance sheet continues to grow. Some traditional economists may see this as necessary due to the fact the Fed must be able to maintain and smooth out the economy when needed. This activity comes with a tremendous cost, as individuals are feeling the squeeze of inflationary risk. Something to consider: Inflation is not really about prices rising, but it’s more about the monetary base being devalued. Since it takes more monetary units to by more goods, it gives the illusion that goods prices are rising, when it’s really the fact that the currency is loosing value over time. This is the surreptitious nature of inflation as it relates to these sort of central bank policies.

Excursus
Here is an article ink that covers this matter in more detail. It also provides graphs of the Federal Reserve’s balance sheet mix comprising Treasury Bills and Mortgage Backed Securities. The ratio blend of these assets fluctuate daily, as repos can activated and unwind overnight or in weeks. The point is the growing balance sheet, as it relates to the Fed’s increased activity with repo operations. The link: https://wolfstreet.com/2019/12/05/fed-goes-hog-wild-with-t-bills-but-repos-drop-from-a-month-ago-and-mbs-shrink-by-22-bn/

The Federal Reserve website providing an explanation of asset balances: https://www.federalreserve.gov/releases/h41/current/default.htm

An article describing the renewal of the repo operations: https://mises.org/wire/ghosts-failed-banks-have-returned

How the Fed has Boxed themselves into a corner, as they did before the Housing Market crash: https://mises.org/power-market/3-charts-showing-just-how-boxed-fed