Fed balance sheet to reach $5 trillion by the end of 2014

BROOKINGS, Ore. - Oct. 28, 2013 - PRLog -- The Federal Reserve is currently purchasing $45 billion in Treasuries and $40 billion in agency mortgage-backed securities (MBS) every month. August 2013 the Fed balance sheet reached $3.6 trillion. It is on schedule to reach $4.6 trillion August, 2014.

At some point the Fed has stated they will gradually reduce or “taper” their bond purchases. The market anticipated they would begin tapering in September. Michael Feroli, an economist at JP Morgan, believes tapering in 2013 now looks to be off the table, absent some miraculous improvement in the data. Feroli suggests recent job growth of 143,000 a month is not enough to be considered a “substantial improvement” in the economy.

Some Fed watchers believe the first three FOMC meetings are off the table because of coming Congressional debt negotiations in 2014, and a transition as Janet Yellen replaces Ben Bernanke as the Fed Chair. Janet Yellen’s first meeting in charge, if she is confirmed by the Senate, will be mid-March, and she may be in no rush to change policy. Many observers see a continuation of Quantitative Easing (QE) until June 2014, and no increase in Fed Funds rates until 2015. Even with a tapering of asset purchases, the Fed balance sheet should reach $5 trillion by the end of 2014.

If the Fed were to start bringing its holdings back to their pre-crisis level it would take several years of selling to exit its inflated balance sheet. If MBS were allowed to mature on their own it would take until 2020 for the Fed balance sheet to normalize.

Since the Fed is buying bonds when long-term rates are low, and will be selling as rates rise, one can conclude they will experience a capital loss as they exit their bond holdings. The average bond duration will hit 10 years on the Fed’s $5 trillion in holdings by December, 2014. It is projected the Fed’s net “capital” of $55 billion will be wiped out if interest rates increase 32 basis points. The Fed balance sheet is projected to suffer a $500 billion loss if interest rates rise 1%.

As the Fed attempts to taper bond purchases they are expected to be almost the exclusive source of demand for Treasuries, as bond yields rise and bond prices fall. Since the Federal government does not appear capable, in the near future, of running a budget surplus, some analysts question whether the Fed will ever by able to exit its bloated balance sheet. According to Richmond Fed President Jeffrey Lacker, “The bigger the balance sheet, the riskier the exit becomes”.

Since excess banking reserves can result in a massive increase in banking credit, the Fed will need to walk a fine line between excessive inflation, and the bursting of a bubble. A future Israel strike of Iran’s nuclear facilities could make it challenging for the Fed. When central banks assume the attributes of deity, and attempt to control an economy with fiat money, they are bound to increase instability. Only God knows the future.

“The fear of the Lord is the beginning of knowledge, but fools despise wisdom and instruction.” Proverbs 1:7

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