How the Fed Shrinking Its Balance Sheet Impacts Investors

Since the United States' financial crisis, the Federal Reserve has massively grown their balance sheet to $4.5 trillion from quantitative easing (QE). QE is a form of monetary policy to stimulate the economy by injecting money into the hands of banks through buying their assets. This is to increase the flow of money by pushing banks to make more loans and buy new assets themselves.

The Fed announced three rounds of QE from 2008 through 2012, buying mostly long-term Treasuries and mortgage backed securities. Now, Philadelphia Federal Reserve President Patrick Harker announced on January 20 th that the Fed is likely to start reducing their bond holdings.

It has been transparent that the Fed will be reducing its balance sheet in a passive and predictable manner. This means that rather than selling securities to the market, they will be taking their foot off the gas in reinvesting maturing assets. Ben Bernanke, former Federal Reserve Chairman, stated in his blog on Brookings Institution, "By allowing the balance sheet to shrink passively over a number of years, without active selling, the FOMC (Federal Open Market Committee) aims to maximize predictability and minimize potential market disruption".

What does this mean for investors?

The Fed currently looks to be using two strategies to tighten the economy: gradual interest rate hikes and balance sheet reduction. It is naturally concerning for investors to worry that with this, economic tightening could occur too quickly. If interest rate increases get out of hand, economic activity would slow quicker than predicted.

However, no Fed spokesperson has expressed a sense of urgency in balance sheet reduction. They have used the language that tightening will hold until interest rate increases are "well under way". Mark Zandi, chief economist at Moody's Analytics Inc., stated "My guess is they (the Fed) view this as a 2018 project".

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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