Will Shrinking the Fed’s Balance Sheet Crash Stocks?

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The following is a summary of our recent FS Insider podcast, “Shrinking the Fed’s Balance Sheet,” which can be accessed on our site here or on iTunes here.

Following the 2008 financial crisis, the US Federal Reserve purchased trillions in toxic debt and US treasuries in order to restore confidence in the banking system.

Academics referred to this multi-year process as quantitative easing or QE, but it was more commonly thought of as money printing, with many fearing that it would lead to hyperinflation, a collapse of the dollar, and skyrocketing gold prices.

Though these worst-case scenarios failed to materialize, fears over hyperinflation have now been replaced by hyperdeflation (or, simply, a market crash) as the Fed engages in so-called “quantitative tightening,” simultaneously raising rates while allowing their balance sheet to shrink back to normal, pre-crisis levels—something that may begin as early as this year.

With the more popular bearish view getting louder in recent months and Financial Sense listeners emailing us in response, we decided to get Matthew Kerkhoff’s take on this debate since he correctly explained to our audience many years ago why QE wouldn’t lead to hyperinflation.

Kerkhoff is a long-time contributor at Dow Theory Letters and the Chief Investment Strategist at Model Investing. Here’s what he had to say…

Getting it Wrong Again

Fears over the size of the Fed’s balance sheet are rooted in a misunderstanding of quantitative easing and the role of the Fed, Kerkhoff stated. “I think these worries over quantitative tightening having a death grip on the markets are really overblown,” Kerkhoff said.

For example, as he explained in the past, QE fundamentally altered the way monetary policy was conducted. Though it flooded the banking system with so-called excess reserves, those reserves couldn’t be lent out in such a way that would bid up the prices of real economic goods.

“(Bearish commentators) are getting it wrong again,” Kerkhoff said, and he outlined two main misconceptions currently being discussed.

Double Tightening

Some have referred to the Fed moving towards “double tightening” since they’ll be simultaneously raising rates and allowing their balance sheet to shrink.

However, when it comes to interest rates, Kerkhoff noted that “this particular rate hiking cycle — if we can even call it that — is very different.”

The Fed is more data-driven now, Kerkhoff stated. Rather than raising rates every single meeting for two years straight — as we saw from 2004 to 2006 — the Fed is much more cautious in assessing the downstream impacts of each rate increase, especially since the US economy has been growing at below-average rates.

Thus, the idea that the Fed will (or be forced to) tighten may continue to take longer than people anticipate and, as we have seen, not look anything like prior rate raising cycles.

Shrinkage Estimates

Another major misconception is on how much the Fed’s $4.5 trillion balance sheet will need to shrink. Before the crisis, it was closer to $800 billion. According to the bearish view, once it returns back to these “normal” levels, this will crush the US economy and stock market since this is what’s holding them up currently.

However, this begs the question: What is the appropriate size of the Fed’s balance sheet?

“What we’ve seen over the last 10 years or so is that the cash in circulation has gone from about $800 billion to about $1.5 trillion,” he added. “That by itself puts a floor on the size of the Fed’s balance sheet” since it is also a component of what they hold.

Additionally, when QE was introduced, it fundamentally altered how the Federal Reserve performs open market operations to influence the Federal Funds rate.

“A lot of estimates are suggesting that in order for this transmission mechanism to still operate, we’re going to need about $1 trillion, plus or minus, of excess reserves still in the system,” Kerkhoff noted.

If we add this $1 trillion to the $1.5 trillion needed to cover currency in circulation, we’re already at a $2.5 trillion Fed balance sheet, he added.

To Kerkhoff, that means we are going to see some tightening, but we’re not going back to the old ways of doing things. Furthermore, “we’re not going to see the balance sheet go back to where it was at pre-crisis levels,” he said. “That’s quite literally an impossibility.”

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