The Federal Reserve Will Need To Get Aggressive With Removing Its Balance Sheet And It Will Choke Our Economy

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by: D. H. Taylor

Summary

Aggressive central banks worldwide have increased reserves of member banks to excessive levels.

Property markets in certain areas are already pushing high year-over-year rates.

Overseas money is going to continue to flow into the country and altering the real estate markets.

There is a major fallacy with Quantitative Easing (QE) that pumping money into the system will ultimately support that system. It does not. If that were the case then Japan would be the most aggressively growing economy in the world. It is not. Instead, QE creates an imbalance. The world is about to see how that imbalance will play out. Asset prices are being pushed artificially high and inflation will be a norm. In order to prevent major damage the world's central banks, the ones that have been propagating QE, will have to reverse what they have created. This will not be a smooth, simple process. This will choke off economic growth and likely throw the economies of the world back into recession.

Pardon the oversimplification, but the idea behind QE is simple. A country's central bank buys debt and bonds from a member bank. With this process, money is materialized out of thin air by the central bank. By doing so this creates excessive reserves that those member banks can then use to lend to businesses and individuals.

The Bank of Japan (BoJ) is one of the biggest players in this. The BoJ has pumped trillions of yen into their system with QE in order to prop up price pressures which were negative as well as stimulate economic growth. The BoJ did this by purchasing massive quantities of bonds off of member banks providing the opportunity for the banks to the loan out the funds to individuals and businesses in the country. That did not happen.

If the BoJ pushes short term and long term interest rates all the way to 0.0% then which Japanese citizen or Japanese business do these banks lend these additional funds to? Australia, of course. Australia has some of the highest interest rates in the industrialized world. So, if you were a bank in Japan and you had extra funds you would send it to another country to lend out to other businesses and individuals that will pay higher interest rates. It is a no brainer.

Australia's property market has been on fire and has been increasing some 17% year-over-year in Sydney alone. That rate is finally expected to decline since there have been new rules instilled into the lending market and has already started to abate. Banks and lending institutions have been sending money to Australia for many years because in search of higher returns.

The Bank of Japan's balance sheet is incredible when you look at the chart visually:

There are a lot of people that are fearful of the Federal Reserve's balance sheet. In comparison, this chart makes that fear seem unnecessary. Two things: First, you need to consider that the Federal Reserve and the Bank of Japan are not alone in creating massive amounts of money, and second, tree was also the Bank of England and the ECB - the ECB is still in their QE phase.

There is something that needs to be pointed out. If a country's central bank buys bonds from member banks, as these banks have, that is not how money gets "printed". Instead, it is the first step in the process. With fractional reserve banking, a bank that has excess reserves may lend out those reserves. If a bank has one customer and that person has $1,000.00 in their account, the bank can lend out to another person up to a certain fraction of the amount that was deposited. Generally, 90% of excess reserves may be lent out by a bank. That means, in the case of the bank with one customer and one deposit on their books, the bank can lend out $900.00 to another customer. And just like that, the money supply grew by 90%.

But, with Japan, while the money supply is growing, considering the rate at which the bank blew up their balance sheet, the rate of growth of the money supply in Japan is moving significantly slower. All of the money that is being pushed into the system by the Bank of Japan is making its way around the world. This is one of the reasons that Australia is having a property bubble with a lot of speculative and risky loans created.

The Federal Reserve is not much different in this sense and neither are the Bank of England (BOE) and the European Central Bank (ECB). These banks have largely done the very same thing to prop up their respective economies; they have all increased their balance sheets to extraordinary levels due to the extraordinary economic times. Here are the three balance sheets for the respective central banks:

The respective programs of the Fed, BoE and ECB have had more of an effect in the respective countries than the Japanese programs. Currently the ECB is still in the process of increasing their balance sheets to positive effect; the European economic data have been improving. The ECB are slated to end their asset buying programs at the end of the year. In the meantime, the Federal Reserve is in the position to start removing the liquidity they provided.

However, this is a perfect time to point out that the real estate market in the United States may be the strongest part of the economy. Housing purchases and prices have been moving up consistently. While the U.S. economy looks to be in a soft patch, it may be temporary. However, the real estate market has been consistent.

At the same time, there are outlying aspects that have contributed to the increases in real estate prices. Chinese citizens have been sending money abroad purchasing assets such as homes driving up real estate prices in cities such as Seattle and Sydney. That trend looks to be solidly in place and the various "targets" have seen considerable year-over-year price increases.

The United States is not in a property bubble at this time. However, the trend is moving upward as prices continue to rise. Because of these elevated asset prices the Federal Reserve may be driven to remove the policy accommodation they put into place. They will effectively be taking away the fuel from the economy's engine. The funds they pushed in to the system had one purpose: Propel the economy aggressively. Now, they must remove that. That will not be a simple process. Nor do I think the Fed can really foresee the magnitude of what is about to happen simultaneously.

But, if the Federal Reserve were to start the process of shrinking their balance sheet then the money that has shifted out of Japan and into the Australia will start flowing in to the United States. Despite money being taken out of the system by the Federal Reserve there will be funds continually flowing in to the country. The Fed will have to push interest rates upward in order to reduce the money flowing in and its affect on the money supply.

However, as the Federal Reserve raises interest rates, that will attract more money from Japan. The Fed will have to continue raising interest rates. And, then more money will flow in. It becomes a feedback loop.

At the same time, remember that the member banks are sitting on reserves they have not necessarily put to work. Those reserves are going to be lent out more and more to real estate. This will further prop up the real estate market here in the United States. Also, keep in mind that the BoJ and ECB are both still buying up assets, pushing reserves onto member banks. Those reserves are going to want to find a good place to earn a high interest rate.

The central banks did what they had to do during extraordinary times. But, I always like to keep things simple in my analysis. And, I always like to apply physics to economic analysis. This phrase we all learned in 9th grade physics seems to encapsulate a lot of what our governments do to us: For every action, there is an equal, and opposite reaction.

The central banks did extraordinary things. Now we get to see what the equal and opposite reactions will be. I am thinking, from an economics point of view, it is going to be dizzying. The Federal Reserve will need to be aggressive in removing their excessive balance sheet. I think it will go hand-in-hand with increasing interest rates. The Fed is going to have to maintain a healthy level of real estate growth with moderate price increases. But, despite the fact that the Fed acts the way they will, the flows inward from outside the U.S. are the most worrying to me.

Just as the Federal Reserve, and other central banks had to get aggressive to prop up the economy, these central banks are going to have to be aggressive at removing this policy accommodation. The choking effect will be dramatic. Quantitative Easing may have made sense at the time, but now we get to see the equal and opposite effects of QE. It might be that the cure is worse than the illness.

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.