Even if you only casually follow Federal Reserve news, you’re likely going to hear one piece of hard-to-decipher jargon tossed around: “balance sheet normalization.”
That’s because it’s come back into focus amid dysfunction in a complicated, yet significant area of the financial system known as the repo market.
But even though it’s hard to find a dictionary that translates what central bankers say into everyday English, this isn’t a topic to ignore. While most consumers focus on how the Fed impacts borrowing costs, this wonky term has major implications for the U.S. economy, the stock market, monetary policy and your pocketbook.
Here’s everything you need to know about the Fed’s balance sheet, including what it is, why it’s important and even why it’s been back in the news lately.
The basics of balance-sheet normalization
More broadly, “balance sheet normalization” refers to the Fed’s efforts to sell off the huge holdings of assets it bought a decade ago to keep the economy afloat during the financial crisis.
In November 2008, then-Fed Chairman Ben Bernanke faced a financial panic. The Fed reduced interest rates to virtually zero, but that still wasn’t enough to jump start an economy suffering its worst turmoil since the Great Depression.
To inject more life into the financial system, the Fed turned to unconventional and unprecedented measures: It started buying long-term Treasurys, debt and mortgage-backed securities to “increase the availability of credit” for home purchases and prop up the economy, according to a Fed statement from 2008.
These purchases were dubbed “quantitative easing,” or QE, by financial experts. The Fed, however, prefers “large-scale asset purchases,” says Joe Pavel, senior media relations specialist at the board of governors of the Fed.
Fast-forward to October 2017: The Fed started gradually selling off those holdings because the economy had since healed from the last recession. The Fed concluded this process Aug. 1.
What does QE have to do with the balance sheet?
You probably have an idea of the different types of debts you may owe, such as student loans, credit cards or a mortgage. In accounting terms, those are considered liabilities. In contrast, the things you own — stocks, bonds or a house, for example — are considered assets.
The U.S. central bank, too, keeps track of its assets and liabilities. It publishes this data in a weekly financial statement known as “the balance sheet.”
U.S. paper currency, as well as money that commercial banks hold in accounts at the Fed, are counted as a liability. Assets, on the other hand, are things that the Fed has purchased, such as Treasurys.
Now, go back to 2008. When the Fed announced it would start buying massive amounts of bonds, including “subprime” mortgage securities and other forms of distressed debt, it listed them as “assets” on its balance sheet.
This caused the balance sheet to balloon. In Aug. 2007, before the financial crisis hit, the Fed’s balance sheet totaled about $870 billion. By Jan. 2015, after those large-scale asset purchases had occurred, its balance sheet swelled to $4.5 trillion. That’s more than a five-fold increase.
By the time the Fed finished its normalization process, the balance sheet totaled $3.78 trillion.
Before these measures, people weren’t interested in the Fed’s finances, says Kenneth Kuttner, a professor of economics at Williams College who has researched unconventional monetary policy.
“It was the most boring thing in the world — like watching paint dry,” Kuttner says. “Quantitative easing changed all that.”
Why did the Fed turn to QE?
To know why the Fed took such drastic measures to revive the economy, it’s important to remember the goal of the central bank: ensuring stable prices and maximum employment.
Traditionally, the Fed influences the pace of economic growth by adjusting its key short-term interest rate known as the federal funds rate, which determines how much it costs banks to borrow and lend to each other overnight.
When the economy needs a little bit of help, the Fed can make credit less expensive. That prompts businesses to invest more in themselves and add jobs. Cheaper borrowing costs also gives consumers an incentive to make purchases, such as cars or homes, on credit. But if the economy grows too quickly, the Fed can raise interest rates to try to prevent it from overheating, which also makes it more attractive to save.
The Fed manipulates this short-term interest rate by buying and selling U.S. government bonds, notes and bills, which are added to its balance sheet.
But as the financial crisis worsened, interest rates were slashed to virtually zero and the Fed still hadn’t seen the economy revived. Thus, it decided to do more. That’s when it started to buy Treasurys and mortgage-backed securities on the open market. The sellers of these securities (such as big banks) would use the cash from the sales to boost lending and reinvest in their businesses, according to the Fed’s reasoning.
The economy appears to be in far better shape compared to a decade ago.
When the Fed announced these unconventional measures, it said it would reduce its holdings back to the normal, pre-crisis level once the economy started to recover. That’s seemingly been fulfilled, with the expansion now in its 11th calendar year, the longest on record.
Enter the term “normalization.”
What consumers should watch for
There’s just one problem: The asset purchases were so unprecedented that Wall Street investors worried that the economy may suffer harm and grow more slowly if the Fed reduced its holdings too aggressively. That’s because it takes money out of the financial system. And just as interest rates typically fall when reserve supplies increase, the central bank risks lifting borrowing costs as it decreases reserves.
As a result, some have claimed that the balance sheet normalization process amounts to policy tightening. Thus, it’s often been dubbed “quantitative tightening.”
It’s the fear that “maybe monetary policy is a bit more contractionary than indicated by the fed funds rate,” which is still historically low, Kuttner says.
The process is also fraught with unknowns.
It’s like “going into a forest that hasn’t been mapped before,” says Mark Hamrick, Bankrate’s senior economic analyst. The Fed “wasn’t sure what they’d find on the way in, and getting out of the woods is similarly fraught with unknowns.”
Why am I hearing about the balance sheet again?
That became apparent in September — but not for the reason you might be thinking. The normalization process didn’t exactly slow down the economy as experts feared, but it played a role in an extremely technical, short-term disruption.
The Fed had previously stated that the balance sheet would end up being much larger than it was pre-crisis. That’s because banks keep much more cash in accounts at the U.S. central bank — often referred to as “reserves.” But when the Fed started selling off its balance sheet holdings, bank reserves subsequently declined. Officials thought they chose an optimum level, but then Sept. 16 came along.
That’s when a large amount of cash started pouring in and out of a complicated corner of the marketplace: the repo market. It subsequently created a funding shortage that drove up interest rates past the Fed’s target range.
A “repo” is a shorter word for “repurchase agreements,” and the repo market is a place where parties go to exchange cash for securities. Trillions of dollars in debt are financed here, including that of the U.S. Treasury.
Economists still don’t know what exactly caused the funding shortfall or why it happened. Part of it was the timing. Corporate tax payments came due, sucking cash out of the system, right as new Treasury debt was offered up to the marketplace.
“The banks had less excess reserves to lend,” says Yung-Yu Ma, chief investment strategist at BMO Wealth Management. “If we look back in hindsight, it was the case that the Fed reigned in the balance sheet too much.”
As a result, the Fed started injecting cash as soon as Sept. 17 to pull down interest rates. It’s also been conducting overnight lending operations. But on Oct. 4, it made a big announcement: It would start “organically” growing the balance sheet again, at an initial pace of $60 billion each month — mainly shorter-term Treasury bills, a “moderately aggressive” package, Ma says.
“The Fed looks like it’s erring on the side of providing extra comfort to the markets that it does have this under control,” Ma says. “I would still consider it more technical in nature and not indicative of bigger strains in the economy or the markets that the Fed is not able to address.”
But is this QE?
There’s an important distinction to make: “Organic” growth isn’t the same as quantitative easing. That’s something Fed Chairman Jerome Powell has been vocal about. It’s mostly because the move isn’t meant to push down long-term rates.
“It’s trying to keep the repo market stable by allowing there to be more excess reserves in the system,” Ma says. “It’s not about going across the yield curve and going into the mortgage market to push down rates and provide stimulus across the spectrum.”
The move, however, might add downward pressure to rates indirectly, Ma says, whether that’s through the mortgage market or to other Treasury markets out on the yield curve.
There’s also the risk that it may make it more complicated for the Fed to adjust rates again, whether that be hiking them or cutting them, according to Bankrate’s January Fed Forecast survey. Officials at the Fed initially got involved in the repo market mess because it pushed up the federal funds rate beyond its target range. That suggests the Fed may indirectly have trouble controlling interest rates.
Even so, it doesn’t look like this will happen anytime soon. The Fed in December signaled that it expected to keep short-term interest rates on hold over the next 12 months, judging that its three straight cuts in 2019 would be enough to cushion growth.
All of this underscores that the Fed’s messaging is going to be important moving forward, Ma says.
“It isn’t a big signal that the Fed is trying to go all-in to stimulate the economy,” Ma says. “It’s just trying to make sure that markets function well and that the primary tool that it plans to use for monetary policy at the present time still remains those short-term interest rates.”
Some experts are skeptical about whether these actions will fix the problem, with the most drastic call coming from Credit Suisse. Zoltan Pozsar, Credit Suissee’s managing director for investment strategy and research, suggested that the Fed wouldn’t be able to fix the repo market turmoil simply by injecting cash into the marketplace. Instead, they’d need to reinstate another round of “QE” because reserves are still insufficient, he said.
Of course, that hasn’t been confirmed, while other Fed watchers are predicting that the Fed will take a different, less-drastic step. One such alternative is the creation of an even-more wonky financing program known as a “standing repo facility.” This facility would likely be a permanent program at the Fed, allowing participants to exchange bonds for cash at a set interest rate.
Many details still need to be hammered out — such as who would be eligible — but it’s something that “many” Fed participants see as needed, according to records of the Fed’s December meeting.
What next steps should consumers take?
All of this volatility and uncertainty underscores the importance of building an emergency savings fund, Hamrick says. Investors, meanwhile, should brace for more market choppiness as the Fed figures out this process.
“Some of the volatility that we saw in financial markets toward the end of 2018 is an indication of what can go wrong if the Fed makes a policy mistake,” Hamrick says. “The worst of that may be behind. But whether anticipating an economic slowdown or market volatility, think about your long-term plans, including retirement and emergency savings.”
The bottom line: Embrace the unconventional.
“Consumers, investors, savers and borrowers should think about this (quantitative easing) as one of the two main tools in the central bank’s toolbox to help adjust the strength of the U.S. economy,” Hamrick says. “It remains to be seen how the Fed will learn how best to employ it and whether there are unintended negative consequences from having invented and deployed it.”
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