By C. Jay Engel
Now that the Fed has slightly upped its Fed Funds rate target twice, there is talk of a much more ominous issue: shrinking the balance sheet. Late last year, St. Louis Fed president James Bullard affirmed that 2017 "possibly might be a good time to play that card."
What that would entail, of course, is reversing the years of a ballooning balance sheet by selling the securities that it previously attained. In selling assets, the Fed sops up bank reserves and they can no longer be used in the economy.
The entire economy - as well as the so-called recovery - since the Fed began its unprecedented asset purchase has been a giant mirage. It rests on the band-aid of financial moves from the Fed that papers over the reality of the situation. The problem with band-aids (monetary expansion) in our context is that no one notices the rot underneath (the destruction of real capital).
If the band-aid is ripped off, the underlying reality is exposed. There is some worry that "the market" will respond poorly. Indeed! Why? Because the whole reason that "the market" has achieved new heights over the years is because it knew the Fed was there to backstop losses and buy assets! Reversing this trend doesn't create a new crisis, it allows - finally - the healthy correction to complete itself.
It is for this reason that the Fed and the official economists want to delay this as long as possible. Hence, in his most recent post, Ben Bernanke urges extreme "patience" [sic for "I hope we never have to do this"] in addressing the size of the balance sheet.
Bernanke had "indicated in testimony in 2013 that the FOMC was considering slowing asset purchases," and this resulted in the so-called "taper tantrum" in which the financial markets roared in disapproval. As Bernanke recalls, "FOMC members pushed back" against the idea that all this talk meant rates were going to rise. In other words, the market threw a fit at the possibility of lessening cheap money, and the FOMC rushed in to promise open spigots.
With all the talk in Fed circles of "avoiding [market] disruptions" in the fake quest to shrink the balance sheet, it appears to be a brewing financial theme without much substance. Just as the Fed undertook a 7-year narrative of raising the Fed Funds rate, it may take the entire Trump era to "talk about" shrinking the balance sheet.
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