The Federal Reserve is expected to begin shrinking its balance sheet soon. A policy statement released on Wednesday confirmed the news. Traders also noted there was zero chance the Federal Reserve would raise interest rates.
The Fed is currently dealing with a balance sheet of $4.5 trillion that arose after the purchase of treasury bills and other financial assets after the financial crisis. The aim at the time was to keep interest rates low. In a meeting held in June by the Federal Reserve, there were conflicting views as to when the normalization of balance sheets should happen. While there are those who are calling for a more rapid response, others feel that moving fast would signal a more aggressive approach, which would also remove the support systems that helped stop the financial crisis.
Investment strategist Seema Shah at Principal Global Investors, a fund that manages about $240 billion worth of assets, said that while it was not clear the balance sheet’s uncertainty will affect the capital markets, it’s still important to move with caution. The Fed also announced after the Wednesday meeting in Washington D.C. that inflation had significantly dropped below the 2% mark set by the Central Bank.
The Fed had been watching inflation closely. In an address to Congress, Janet Yellen, a board member of the Federal Reserve, had previously indicated that the current slow down on inflation had been driven by a number of short term factors including cheaper prescription drugs and relatively cheaper cell phone plans. Although interest rates remain unchanged, it was only last month that the Federal Reserve raised its benchmark interest rate.
This was the third time in just a year that the benchmark rate went up and analysts say that this is simply an indicator of confidence, that indeed the Fed believes the economy is strong and resilient enough to withstand increased borrowing costs. Dealing with the balance sheet is however not as easy as most people think. Although it’s long after the financial crisis, a $4.5 trillion balance sheet is not a small amount and it will take some time to finally deal with it. In addition to this, the manner in which the Fed addresses the situation must be progressive so that there won’t be any negative ripple effect in the market.
The Federal Reserve has made significant steps in creating the required support systems that are needed to avert and quickly address any potential financial crisis. The genesis of these support systems can be traced back to the balance sheet and there are many who believe that reducing the $4.5 trillion balance sheet would equally be reducing the Fed’s capacity to offer effective support in case of any financial crisis. Although it’s far-fetched, it still calls for caution and no doubt that the Federal Reserve’s experience will steer in this direction. Nonetheless, there’s a commitment to deal with the balance sheet and that’s a good sign.
