June 20, 2021

Finance 101: What is the Fed’s balance sheet and why it matters?

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We have heard a lot about the US Federal Reserve System (Fed) or US’s central bank (equivalent to our Singapore’s MAS), and how it affects the market with their monetary policy. 

One of the major components of the Fed’s quantitative easing program so far has been its huge bond purchase program which has resulted in a surge in its balance sheet to US$8 Trillion.  

The quantitative easing program by the US Fed has been a major contributor to the stellar performance of the stock market over the last few years but has also led to increased turbulence and worries among market participants recently with the rise in inflation.

What does this all mean? and how does it affect the economy?

What is the Fed’s Balance Sheet?

Like a company, the Fed’s balance sheet simply contains the number of assets and liabilities that the Fed holds. One of the major components of the Fed’s liabilities is the amount of currency in circulation.

Ballooning assets- The Fed’s assets contain mainly the government securities and mortgaged-backed securities that it purchased/hold. Since the start of the COVID-19 pandemic, the Fed has unleashed an unprecedented amount of stimulus to support the economy. This includes the purchasing of $80b/month in Treasury bonds and $40b in mortgage-backed securities since June 2020. 

When the Fed buys these bonds, it increases the money supply in the market by swapping the bonds in exchange for cash to the public, increasing the amount of money circulation in the market. Theoretically, there is no upper limit to how much the Fed can expand its balance sheet.

Dollars in circulation over the last 10 years.

How does the bond purchase program by the Fed help the economy?

  1. Lower interest rate for debts. By purchasing the bonds and mortgage-backed securities, the Fed increases the price of bonds and pushes down the yields on these assets. The interest rates of several debt instruments including mortgages are typically benchmarked to the yield of government debts, hence when the yield on these instruments drops as well.
  2. Lower interest rates encourage consumption and stimulate the economy. Lower interest rates result in cheaper financing and encourage more borrowing and consumption, which hopefully will drive demand for goods and services and stimulate production and employment. 
  3. Liquidity in the financial system prevents credit crunch. With more amount of money in the financial system, it helps prevent a credit crunch where there is a lack of funds available or banks increasing the criteria for borrowing, preventing companies from having access to capital. (Which was a real concern at the start of the crisis, as businesses and banks were worried to spend or lend, due to the huge uncertainty and fear of financial loss brought about by  COVID-19)

Too much of anything is bad

While the Fed’s stimulus program has helped to stabilize financial markets, there are now increasing concerns of a surge in inflation. (Too much money in the system causes inflation; i.e. if there is too much money, and the number of goods produced remains the same => inflation)

Inflation is an increase in the prices of goods and services. 

Some inflation is good for the economy as it helps boost consumer demand and consumption,  (it is a sign of a healthy economy, as demand for products/services increases, pushing up prices) and drives economic growth.

However, too much inflation may be bad if it results in

  1. Overspending in the near term==>overheated economy and subsequently a recession. Consumers may worry about price increases and shift a lot of their consumption to the near term, and stop spending in the subsequent years.
  2. Lower competitiveness for companies products resulting in lower exports and GDP growth

As the US economy recovers from the pandemic, inflation has surged 

So far, the Fed has believed and assured markets that the price increase is temporary, and is a result of the US economy’s reopening and recovery- as the pandemic has left consumers with excess savings that they want to spend. 

Jump in US personal savings rate since COVID-19

Whether inflation is here to stay remains to be seen, but with the Fed’s latest signal of tapering as early as 2023, clearly, some of its confidence has been shaken as perceived by some market participants, as stock markets take a beating over the last week.

Do let us know what you think in the comments section below

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