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Puzzle of Fed balance sheet progression will persist

Wednesday, May 17, 2017

Subject

Managing the Fed’s Balance Sheet

Significance

Before the 2008 financial crisis, the Federal Reserve (Fed)'s balance sheet stood at less than 1 trillion dollars, around half in treasury securities. The balance sheet is now nearly 4.5 trillion dollars, more than half in treasury securities and 40% in mortgage-backed securities, gathered to stabilise the financial system and promote recovery. There is pressure to reduce these holdings while growth is robust and the financial system relatively stable. Three questions are outstanding -- when the Fed starts the process, how and what the eventual size of the balance sheet should be. Complicating matters, the term of Fed Chair Janet Yellen ends in February 2018.

Impacts

  • The instruments the Fed chooses to sell off to reduce its holdings will change the yield curve, impacting corporate and public borrowers.
  • Student loan debt has grown by 170% in the last decade to 1.4 trillion dollars; 18% is in default, and 44 million people have student debts.
  • The share of automobile loans securitisations labelled deep subprime has risen from 5.1% in 2010 to more than 32.5% and may rise further.
  • Relations between the Fed and the Trump administration could deteriorate dangerously if the two criticise each other’s policies.
  • Policy divergence, with Japan and the ECB still expanding QE, will firm up the dollar -- placing dollar-indebted emerging markets at risk.
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