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The Fed Balance Sheet – It’s Not Going to Shrink

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The Federal Reserve Open Market Committee will meet this week. There is virtually no expectation of a rate hike this time around, but there is widespread anticipation that the Fed will outline its strategy for shrinking its massive balance sheet.

In his most recent podcast, Peter Schiff made a pretty good case that the Fed won’t be able to shrink the balance sheet at all. I fact, he says the central bank will end up having to expand the balance sheet even more when it’s all said and done. The deteriorating economy is one factor, but an even bigger problem for the Fed is the exploding national debt.

Regardless of what the Fed has to say, they’re not going to do anything. Or, if they do anything, it’s simply going to be to create the impression that they’re doing something – that they’re going to follow through with their plan. But nothing is going to happen, because before they get even a tiny fraction of the way, they’re going to have to reverse course, because they’re not going to allow interest rates to spike. They’re not going to let the entire phony house of cards economy collapse, except to the extent that they might allow a little bit of a collapse to make Trump look bad. So, that may be the needle they’re trying to thread.”

The Fed’s balance sheet is about as large as it’s ever been – just over $4.5 trillion. The central bank is widely expected to announce plans to begin shrinking the balance sheet by selling off some of its assets. This seems to have caused a lot of excitement in the financial world. The stock market has reacted positively in the days leading up to the meeting, setting several records. But Peter said he doesn’t understand what all of the enthusiasm is about.

I don’t know why the markets are excited about the prospect of a plan to shrink the Fed’s balance sheet, because if the Fed actually shrunk the balance sheet, the markets wouldn’t like it because it would put dramatic upward pressure on interest rates which are not good for stocks.”

Peter also questioned the timing, noting GDP forecasts are down. A lot of the pessimism about growth is based on economic news that came out before the hurricanes. But the damage from Harvey and Irma now offer a convenient place to pin the blame for any economic slowdown. Regardless, Peter asks an important question: With all this bad news about the economy, why is the Fed going to try to make it worse by shrinking its balance sheet?

Janet Yellen and company face an even more fundamental conundrum. The Fed is going to have a hard time proceeding with quantitative tightening during a period when the federal government is undoubtedly going to need to borrow a lot more money. The budget deficits are already poised to explode because all the hurricane relief money has to be borrowed. Plus, the Trump plan for tax cuts will almost certainly increase the deficit. Not only will tax cuts likely decrease federal revenue, at least in the short-term, the Republicans will have to work with the Democrats to get a deal done. That will almost certainly mean more spending.

Maybe it’s going to be money for everybody because it’s all going to be Democrats and Republicans coming together to basically fill everybody’s stocking with Christmas goodies for the voters.”

So, will the Federal Reserve really press aggressively forward with tightening and add to this deficit/debt pressure? Peter explained the big problem facing the federal government and its central bank.

Remember, if the Treasury is going to borrow more money. That’s more bonds that are being offered for sale. Now, if the Federal Reserve is not only not buying any of those bonds, which it normally would do, but if its shrinking its balance sheet, then it can’t buy any of them. So now the federal government – the Treasury – is going to have to go into the private market to sell well over a trillion dollars worth of treasuries to finance next year’s budget deficit without any help from the Fed. But  not only is the Fed not going to help, they [the Treasury] are going to be in competition with the Fed. Because not only will the US Treasury be trying to unload treasuries, but the Federal Reserve will be doing the same thing.”

Keep in mind, any attempt to shrink that massive balance sheet will put dramatic upward pressure on interest rates unless the Fed changes course. That leads to another problem Peter didn’t even get into. If rates go up, so do payments on the massive $20 trillion national debt. Any significant increase in real interest rates will crush the US budget under massive debt service payments.

So, all of this talk about how they’re going to shrink the balance sheet – it’s not going to shrink. The balance sheet is going to explode to new highs.”

Peter conceded they Fed might be able to shrink the balance sheet slightly to show they tried to do it – just like it raised interest rates a little, but never really raised them to a normal level.

But I don’t even know if they’re going to get that far, because the economic backdrop is deteriorating pretty fast. I don’t know that the Fed wants to push on it by actually going forward with this.”

Gold has been falling in anticipation of the Fed meeting, but Peter said he thinks it will start upward again once we get the Fed meeting behind us.

I think regardless of what the Fed says, it’s bullish for gold. And of course, they’re never going to follow through with anything that they say if they’re talking about actually shrinking the balance sheet.”

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