Slow Pace Of Balance Sheet Reduction Calls Into Question Fed’s Commitment To Inflation Fight
Most people have focused on Federal Reserve interest rate cuts as it battles price inflation. But there is another element in the inflation fight most people ignore – balance sheet reduction.
It isn’t going well.
The December FOMC statement mentioned balance sheet reduction in passing.
The Committee will continue reducing its holdings of Treasury securities and agency debt and agency mortgage-backed securities, as described in the Plans for Reducing the Size of the Federal Reserve’s Balance Sheet that were issued in May.”
The problem with this statement is it isn’t following the plan described in May.
The plan called for $30 billion in US Treasuries and $17.5 billion in mortgage-backed securities to roll off the balance sheet in June, July and August. That would total $45 billion per month. In September, the Fed said it would increase the pace to $95 billion per month.
Given the plan, the Fed balance sheet should have dropped by $560 billion as of the end of December. According to the latest data, as of Dec. 19, the balance sheet had only shrunk by $401 billion.
That means unless there is a significant drop in the last week of the year, balance sheet reduction is nearly $160 billion behind the planned pace.
This raises a question: if the Fed is really committed to slaying inflation, why is it shrinking its balance sheet so slowly?
The question becomes more poignant when you realize that the quantitative tightening plan wasn’t particularly ambitious to begin with. At $95 billion per month, it would take 7.8 years for the Fed to shrink its balance sheet back to pre-pandemic levels.
And that’s how you slay inflation.
Historical Perspective
In the wake of the 2008 financial crisis, the Federal Reserve ran three rounds of quantitative easing, pushing the balance sheet from $8.98 billion to just over $4.5 trillion. The central bank tried to reduce the balance sheet in 2018, but quickly reversed course after the stock market crashed and the economy got wobbly in the fall of that year. At its low point, the balance sheet dipped just below $3.76 trillion.
The Fed had already returned to quantitative easing before the coronavirus, and the balance sheet was back above $4 trillion in October 2019. QE went on steroids during the pandemic, with the balance sheet peaking at $8.965 trillion on April 11, 2022.
In effect, between 2008 and 2022, the Fed injected nearly $8 trillion in money created out of thin air into the economy.
Coupled with artificially low interest rates, all of this money creation predictably drove the price inflation we’re seeing today. The problem is that rate cuts alone won’t unwind inflation. All of the new money created over the last decade-plus needs to be pulled out of the economy.
Since the Fed waded into its inflation fight, the balance sheet has only shrunk by a relatively tepid 4.5%.
This isn’t adequate.
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About the Author: Patriotman
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