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Visualizing the Federal Reserves Balance Sheet

In 2008 the Federal Reserve Bank (the Fed) began a program of Quantitative Easing in conjunction with deep cuts in the Federal Reserve Funds Rate (sometimes called the overnight rate). To do so, the Fed began buying US Treasuries and Mortgage Backed Securities in the 'open market' (the actual mechanism used by the Fed is called Open Market Operations or OMOs).

This was a new Fed 'tool' in helping to shape market interest rates. Previously, the Fed was said to have the power of setting the Fed Funds Rate, setting the Discount Rate, and using Moral Suasion (telling the market what it should do). The Fed also has a regulatory function that many felt it had historically ignored (but, that's a different post).

When the Fed was buying US Treasuries it was increasing market liquidity. If you take a $1 bill out of your pocket you will see that it says Federal Reserve Note, our money is actually a product of the Federal Reserve Bank. Therefore, when the Fed was buying Treasuries it was in effect printing US Dollars to put into circulation. This had the effect of increasing market liquidity and in some sense of lowering the value of the $US (increasing supply vs potential demand).

As the Fed shifted to balance sheet reduction in 2017 they began selling off their holdings and in so doing took US Dollars out of circulation. The balance sheet reduction was akin to a Quantitative Tightening versus its previous operations of buying US Treasuries. This also raised interest rates because it increased supply of US Treasuries, reduced market liquidity and increased the value of the $US by decreasing the supply of US dollars.

How much did the balance sheet reduction increase rates? There are various estimates, but many people accept Morgan Stanley's calculations of ~.25% for each $200 Billion of debt sold off the Fed balance sheet. The Fed has reduced their balance sheet by about $800B from its peak, which would mean an increase of .75% to 1.25% equivalent rate hikes or an actual Fed Funds rate near 3.00-3.25% currently.

At its July meeting the Fed has stopped reducing its balance sheet and has cut the Fed Funds Rate by .25% with another 1.00% in cuts expected over the next year. They still must do something with the Treasuries that mature and coupon payments that they receive on the securities they continue to hold. Rolling those dollars into short dated Treasuries will reduce short rates, maintain liquidity and keep the $US from strengthening further. This seems to be the best approach.

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