Is Fed’s balance sheet reduction helping to kill inflation? (Daily 2-Min S&P 500 Commentary by Sidney Shauy)
In its relentless mission to reduce inflation, the Fed raised the benchmark short-term rate to 4.25%-4.50%, the highest since 2007. But remember the Fed has another monetary tool in its toolbox besides rising rates. That is the Fed Balance Sheet’s Quantitative Tightening. Don’t be scared by the name because its principle is very simple. Since the 2008 Subprime Financial Crisis and especially after the 2020 Coronavirus Crash, the Fed engaged in “quantitative easing”, aka “money printing. But how was it done? The Fed simply bought fixed-income securities (e.g. treasury bonds, MBS, etc,) from the market. To pay for these massive purchases, the Fed “printed money”. This inflated the Fed’s balance sheet to a record $9 trillion (actually $8.962 trillion to be exact) in securities. This excessive cash or liquidity in the economy inflated the stock market, bond market, housing market, etc. which in turn fueled inflation. Now the Fed is reversing the entire process by doing the opposite.
Since April, the Fed let maturing securities in its balance sheet expire without replacement. The plan was to reduce it by $95 billion per month (1% of its holdings). But the last reading was $8.583 trillion, or it was reduced by $48 billion per month. Apparently it’s half of what’s been planned but the calculation is more complicated. It’s believed that every $500 billion of reductions is equivalent to the effect of a 25 bp rate hike. The exact size is debatable as there are several studies with different conclusions. But it seems to me and many observers that this tool should be used more aggressively than raising interest rates for faster and better results because the main culprit for inflation was exactly the excessive liquidity in the economy.
Disclaimer: Views are author’s only and do not constitute financial or investment advice. Past performance does not guarantee future performance.
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