The Great Unwinding

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by: Shareholders Unite

Summary

The Fed (and other central banks) has amassed a great amount of assets, bloating its balance sheet.

The Fed has started signaling to the markets that it is considering starting to unwind some of this.

How did the Fed get here and what are the risks of this unwinding of its bloated balance sheet? We'll investigate.

Many central banks have really bloated their balance sheets since the financial crisis when interest rates went to zero and the central banks argued that purchasing assets was just another way to loosen monetary conditions when the interest rate instrument had met it's natural end.

There were many observers panicking about these moves, it even inspired an open letter to the Fed in 2010 where an assortment of hard money men warned about these policies leading to accelerating inflation (later some of them would argue that they were only speaking about the risks, and that these risks still exist).

Others (like some Austrian inspired economist like Peter Schiff) went even further and predicted stuff like 'currency debasement,' the collapse of the dollar and of the bond market and the Fed would not be able to retreat without causing another economic crisis.

Of course, as economics101 would have it, nothing of this has happened, despite years of zero interest rate policies (some central banks even embarked on negative interest rate policies) and really bloated balance sheets.

A quick reminder of that economics101 is warranted. The financial crisis created great damage to household balance sheets (like a $9T on houses alone). In order to repair the damage to their balance sheets, households started to spend less, save more, and rather than engage in new borrowing they preferred to pay off existing loans.

Credit demand collapsed, hence the zero interest rates. There was a big savings glut as the private sector moved into an enormous financial surplus (savings exceeding investment).

This sucked demand out of the economy, which spiraled downwards, rescued mostly by swift changes in monetary and fiscal policy, lessons learned from the slow reaction to similar events in 1929.

For much of the post-financial crisis history, the economy ran with a lot of excess capacity, which is simply the mirror image of the balance sheet repair of the private sector (in the US, households).

In an environment where the private sector is repairing balance sheets, that is, credit demand being low despite zero interest rates, and there is lots of spare capacity in the economy, it's basically impossible to create accelerating inflation.

There is actually another view on the inflation problem in the aftermath of financial crisis. Some, like uneasymoney, argue that it would have been beneficial. The obvious benefit is of course the reduction of the real debt burden, but there is more, from uneasymoney:

I was hoping for a repeat of what I have called the short but sweat recovery of 1933, when, in the depths of the Great Depression, almost immediately following the worst financial crisis in American history capped by a one-week bank holiday announced by FDR upon being inaugurated President in March 1933, the US economy, propelled by a 14% rise in wholesale prices in the aftermath of FDR's suspension of the gold standard and 40% devaluation of the dollar, began the fastest expansion it ever had, industrial production leaping by 70% from April to July, and the Dow Jones average more than doubling.

And it didn't only work in the US:

But the undeniable fact is that inflation worked; countries that left the gold standard recovered, because once currencies were detached from gold, prices could rise sufficiently to make production profitable again, thereby stimulating multiplier effects (aka supply-side increases in resource utilization) that fueled further economic expansion. And oh yes, don't forget providing badly needed relief to debtors, relief that actually served the interests of creditors as well.

So those who were so worried about inflation that they found it necessary to write an open letter to the Fed might have been doubly wrong.

Unwinding?

However, now that the economy is running close to full employment and the deleveraging process is basically over, this could actually become a problem. Some, who want to 'stress the system,' actually argue that a modicum of above 2% inflation would be benign.

Overheating the economy for a period could reactivate the rusty resources and labor that got laid off structurally (labor force participation is still nowhere near where it was before the crisis), to reverse some of the hysteresis effects.

While there is something to be said for that, we want make a couple of other points. There are worries about the size of the Fed's balance sheet. Indeed, it's much larger than before the crisis. Basically there's $4.5T where there used to be only some $1T.

People worry about 'normalization,' both on the interest rate front as well as on the balance sheet front. For instance, some worry that the Fed won't be able to unwind all of its balance sheet. Indeed, until now they have reinvested the proceeds of maturing assets, keeping the balance sheet basically constant.

But why is this a problem? When the economy starts to overheat and inflation becomes a more serious threat, the Fed could gradually start to unwind (perhaps by starting to not reinvest the proceeds of maturing assets, which is what the Fed policy discussions seem to suggest as the most likely route).

This is simply a traditional 'leaning against the wind' monetary policy. There are plenty of world savings and the demand for safe assets is perhaps as strong as ever, given the rising pension problem in many areas of the world.

At the Fed they are not overly worried either. Vice chair Stanley Fischer pointed out that:

the recent news that the central bank might begin reducing its balance sheet later this year barely affected yields.

Of course, we know that this hasn't always been the case. Fed tightening, especially when it comes unexpectedly, can lead to violent reactions on asset markets, as we have seen with the 'taper tantrum' a couple of years ago.

But in essence, this is unavoidable. If the Fed deems it's necessary the economy needs a tightening of monetary policy, it should not hold back because asset markets might take it the wrong way. We don't think monetary policy should be used to target asset markets at all.

There are other policies for that, so-called macro-prudential policies, regulatory changes that mainly prevent stuff like excess credit, deterioration of lending standards, the creation or undercapitalized financial institutions, etc.

Conclusion

There has been considerable concern over bloated central bank balance sheets, but we have to admit we don't really see the problem. So far there is little evidence it's doing any harm, even if we readily admit that the process of accumulating these assets (in the US case, mostly government bonds and mortgage backed securities) didn't do wonders either.

This makes the policy decision rather easy. Gradually unwind when this is deemed safe and appropriate, that is, in an environment where the economy itself is normalizing and returning close to full employment.

That is, unwinding the bloated balance sheet should be considered a normal tool of policy when tightening is appropriate. Whether that tightening takes the form of higher rates or a gradual unwinding of the Fed balance sheet, or a combination of both doesn't really matter all that much in the bigger picture (even if it might matter for specific targets the Fed tries to achieve).

Another matter is when circumstances arise in which central banks deem it appropriate to actually increase their balance sheets again (the ECB and BoJ are still in this game), but we'll leave that for another article.

Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.