Shrinking refers to the behavior of the middle of the bank to reduce the size of the balance sheet. The Fed can achieve direct recovery of base money by selling its bonds outright or by stopping reinvestment in maturing bonds, which is a stricter tightening policy than raising interest rates. In this article, I will introduce a new knowledge of foreign exchange terms: What does it mean for the Fed to shrink its balance sheet. I hope that through the introduction of this article, foreign exchange investors can better understand the relevant knowledge of the Federal Reserve in foreign exchange.
Shrinking the balance sheet can be said to be another form, specifically a small interest rate increase. Compared with raising interest rates to increase the cost of funds and curb lending activities, “shrinking the balance sheet” is equivalent to directly withdrawing the base currency from the market, and has a greater impact on liquidity.
Fed assets remain at about $4.5 trillion, which the central bank accumulated through its asset purchase program after the 2008 financial crisis. The aggressive asset purchases are at the heart of the Fed’s “quantitative easing” program, which aims to lower long-term interest rates, increase investor appetite for risky assets, boost investment and boost the economy. Although the Fed has stopped buying bonds since 2014, the size of its balance sheet has remained the same due to the reinvestment of maturing bonds. This is what it means for the Fed to shrink its balance sheet. The specific background and reasons at that time are as follows:
1. Shrink table background
After the outbreak of the global financial crisis in 2008, the Federal Reserve cut interest rates and introduced three rounds of easing measures, which led to the rapid expansion of the Fed’s balance sheet, from $0.9 trillion before the crisis to the current $4.5 trillion. With the basic completion of the US economic recovery, continued loose policy will push up asset bubbles. At this time, gradually reducing the reserve table can reserve space for future monetary policy operations, stimulate bank credit, and transfer funds from excess reserves to the real economy.
2. The process of shrinking the balance sheet
The Federal Reserve will officially start reducing its size at the end of the third quarter of 2017, and the reduction will last for 3-5 years. The reduction in scale depends on the choice of monetary policy operation mode. If the Fed returns to the original open market operation control mode, it does not need to hold too many deposit reserves, and it is expected to shrink its balance sheet by 2.5-2.7 trillion US dollars. If the current operating mechanism of the interest rate corridor is maintained, the scale of interest rate cuts is limited and may only last for about three years.
3. Reasons for shrinking the balance sheet
- The U.S. economic recovery is basically complete, and continued easing will push up asset bubbles.
- Monetary policy should leave room for preventing the next recession. Monetary policy formulation needs to match the economic cycle. When the economy and inflation rise, monetary policy needs to be adjusted to reserve room for economic downturn and recession. The current state of monetary policy is not conducive to dealing with new recessions.
- Hope to stimulate the growth of bank credit Under the QE policy, banks have sufficient liquidity, but credit has not increased significantly. Since the beginning of 2008, it has only increased by 1.4 times, and the growth rate has slowed down sharply recently.
- Avoid the flattening of the yield curve. If the Fed keeps raising rates, it could lead to a flatter yield curve. Considering that balance sheet reduction is more effective in raising long-term interest rates, it can steepen the yield curve while raising interest rates, and ease the profit pressure of financial institutions while normalizing monetary policy.
- Reduce the Fed’s asset risk So far, the bond assets held by the Federal Reserve have brought huge profits to the central bank and the federal government.
The United States Federal Reserve Board of the Federal Reserve was established on November 16, 1914, to carry out the duties of the Central Bank of the United States. The U.S. Federal Reserve Board consists of the Federal Reserve Board in Washington, D.C., and the Banking Federal Reserve Boards in 12 districts in the country’s major cities. It derives its power from the US Congress to exercise the responsibility of formulating monetary policy and supervising US financial institutions.
The Fed’s balance sheet reduction refers to the timely reduction of the balance sheet, that is, to reduce the size of the balance sheet, that is, the Fed sells its own treasury bonds, MBS and other assets, and recovers the currency printed during November 25, 2008 to June 19, 2013 ( base currency), leading to a decline in the market dollar and a shortage of funds in the market.
Under normal circumstances, the Fed’s balance sheet reduction not only reduces the dollar in the market, but also makes the dollar more and more expensive at a fixed price level, so the impact of the balance sheet reduction is even greater! Usually, after one year of contraction, some countries show a sharp rise in prices, some show a sharp economic decline after one or two years, and some show a sharp increase in capital outflow after three years.
