Happy $3 Trillion, Federal Reserve - You 'Earned' It!

by: Evan Schnidman

As the Fed's balance sheet recently reached the $3 trillion benchmark, I found myself reflecting on the Fed's actions by reading old FOMC transcripts. Looking back to the 2007 transcripts is a reminder of a simpler world and a much different Federal Reserve. At that time, the Fed's balance sheet was less than one-third its current size, interest rates could be easily lowered to stimulate economic activity, and the biggest debate among Fed policymakers was about the necessity of orchestrating currency swaps to maintain consistent levels of dollar liquidity in the international markets. Today, Fed discussions are undoubtedly about ways to further stimulate employment growth and increase the velocity of money without losing control of inflationary pressures.

In some sense, current debates bring the Fed's policy discussions much closer to their statutory dual mandate to maintain price stability and full employment, but only because current economic conditions fail to meet the goals of that mandate. Some commentators have even noted that this focus on the Fed's mandate has caused the Fed to stop worrying about continued use of unconventional methods and embrace policymaking at the zero-bound. In my view, prolonged pressure to pursue these untested policies creates a dangerous precedent that encourages policymakers to continually engage in higher-risk, higher-reward policies, not unlike their counterparts in the private sector banking community.

Perhaps most discouraging, the thing that defines the last 5 years of monetary policy is not the existence of these extraordinary measures and the massive growth of the Fed's balance sheet that resulted, but the fact that these policies were not sufficient to create conditions for a "normal" economic recovery. Investors, traders, and other market actors can disagree on whether or not these measures were necessary, but the fact is that they have not sufficiently buoyed the U.S. economy in the face of myriad headwinds.

So, what does the Fed's $3 Trillion balance sheet mean for investors? Not much while it is growing, but it does come into play if/when the Fed opts to unwind the balance sheet. As equity markets have rallied in recent weeks, this unwinding should be on the mind of investors. While it is almost certain that the Fed will maintain QE3 for several more months and ZIRP for a year or more until the employment situation improves toward the 6.5% unemployment goal, investors should look at interim market highs as opportunities to begin reallocating out of assets (like mortgage backed securities) that the Fed is holding. When the Fed does opt to sell these assets, investors with comparable assets will find their value rapidly diluted. Essentially, while the Fed's $3 Trillion balance sheet may seem like a trivial benchmark, it should serve as a reminder to investors that the Fed has the power to make the market on any asset they choose, and they always turn a profit, leaving increased odds that other investors will take a loss. So, with markets rallying and the Fed reaching such a monumental milestone, it may be time for many investors to think about their asset allocation strategy.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.