Saturday, January 12, 2013

Random Ramblings on the Increasing Fed Reserve Balance Sheet

Since the onset of the Financial Crisis, the Federal Reserve has opened up all the weapons in its cache to fight off the perils of this crisis. For example, they have lowered interest rates and increased purchases of Government securities just to name a few. Here is a key excerpt from the Federal Reserve's website named, "The Federal Reserve's response to the financial crisis and actions to foster maximum employment and price stability"

"The Federal Reserve responded aggressively to the financial crisis that emerged in the summer of 2007. The reduction in the target federal funds rate from 5-1/4 percent to effectively zero was an extraordinarily rapid easing in the stance of monetary policy. In addition, the Federal Reserve implemented a number of programs designed to support the liquidity of financial institutions and foster improved conditions in financial markets. These programs led to significant changes to the Federal Reserve's balance sheet.

While many of the crisis-related programs have expired or been closed, the Federal Reserve continues to take actions to fulfill its statutory objectives for monetary policy: maximum employment and price stability. Over recent years, many of these actions have involved substantial purchases of longer-term securities aimed at putting downward pressure on longer-term interest rates and easing overall financial conditions."

The Fed will attempt to lower interest rates to stimulate aggregate demand or consumer spending. The lowering of the interest rates is an example of this monetary action. Dropping interest rates from 5% to .25% is a fine example of this. Another key excerpt:

"As a third set of instruments, the Federal Reserve expanded its traditional tool of open market operations to support the functioning of credit markets, put downward pressure on longer-term interest rates, and help to make broader financial conditions more accommodative through the purchase of longer-term securities for the Federal Reserve's portfolio. For example, in November 2010, the FOMC decided to expand its holdings of longer-term securities and announced that it intended to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011. This expansion was completed as scheduled, on June 20, 2011.

On September 21, 2011, the FOMC announced that it would extend the average maturity of its holdings of securities--by purchasing $400 billion par of Treasury securities with remaining maturities of 6 years to 30 years and selling an equal par amount of Treasury securities with remaining maturities of 3 years or less--by the end of June 2012. The FOMC also announced that it will reinvest principal payments from its holdings of agency debt and agency MBS in agency MBS. On June 20, 2012, the FOMC announced that it would continue its maturity extension program through the end of the 2012, resulting in the purchase, as well as the sale and redemption, of about $267 billion in Treasury securities."

The Federal Reserve through its FOMC(Federal Open Market Committee) operations, will purchase Government Securities and MBS(Mortgage Backed Securities) This action expands the money supply, attempting to increase aggregate demand.

All of this sounds great and technical, but are some concerns?

One of the major concerns is inflation. Richmond Federal Reserve President expresses these concerns in this article named, "Fed's Lacker Sees Increased Risk of Inflation as Fed Balance Sheet Grows" Here is an excerpt from this article:

"I see an increased risk, given the course the committee has set, that inflation pressures emerge and are not thwarted in a timely way," Mr. Lacker said in remarks prepared for a Maryland Bankers Association forum. "I intend to remain alert for signs that our monetary policy stance needs adjustment."

"I see material upside risks to inflation in 2014 and beyond, given the current trajectory for monetary policy," 

Mr. Lacker's concern is a fair concern. As the Federal Reserve is attempting to fulfill its unemployment mandate, by reducing interest rates and pumping more money into the banking system, it runs the increased risk of inflation. Currently, the CPI does not indicate this concern, but please be mindful that CPI does not include all goods and services, and the economy still is in a market correction. However, the prices of commodities maybe a solid indicator of concerns of currency devaluation, or impending hyperinflation.

Unemployment Decline

If unemployment continues to decline, will the Fed stop building up the balance sheet with Government Securities purchases?

Another concern: What happens when the Federal Reserve attempts to unload these Government Securities and MBS from their balance sheet? What sort of market signals will be projected based on this action?

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