The size of the US Fed’s balance sheet remains a concern

On Friday, Powell reiterated his message, saying the Fed’s utmost focus is on bringing inflation back to 2% because the economy works for no one without price stability. This time the stock market took Powell’s message seriously and the Dow Jones Industrial Average fell 3%, or about 1,008 points, to 32,283.

The question is why the stock market wasn’t buying Powell’s message until now. The Fed tries to influence short-term interest rates by raising or lowering the Federal Funds Rate, the interest rate at which commercial banks borrow and lend to each other overnight. The Fed is raising the federal funds rate this year.

For years, the Fed has been trying to influence longer-term rates and, in the process, has increased the size of its balance sheet. At the end of August 2008, weeks before the financial crisis began, the size of the Fed’s balance sheet was approximately $910 billion. As of August 24, it was $8.85 trillion.

Generally, the size of a central bank’s balance sheet should grow at the same pace as its overall economic growth. The US gross domestic product (GDP) in 2008 was $14.77 trillion. In 2021, GDP stood at $23 trillion, an increase of 56% since 2008.

Since 2008, while the Fed’s balance sheet has grown close to nine times, the size of the US economy has grown by just a little over half.

This increase is because the Fed is printing money and pumping it into the financial system by buying bonds. It did so between 2008 and 2014 to protect financial institutions in crisis and subsequently to lower long-term interest rates so that people and firms could borrow, spend money and help with economic growth.

To spur economic growth, the Fed reiterated the formula in late 2019, before the outbreak of the coronavirus. Once Covid started spreading, so did the printing of Fed money and buying of bonds.

Central banks can print all the money they want, but they have no control over where it ends up. As a result, a large portion of this money went into the stock markets, real estate and cryptocurrencies. Home rentals are rising rapidly due to an expensive real estate market. Home rent is a major component of how retail inflation is calculated in the US. Among other things, high home rents have driven retail inflation in the US to a decade high.

Raising long-term interest rates is crucial for the Fed to control retail inflation. In May, the Fed said it would withdraw money it printed and pumped into the financial system. This was to push long-term rates. The plan was to withdraw $47.5 billion every month from June to August and $95 billion on that. This meant that about $143 billion should have been withdrawn from June to August, and the Fed’s balance sheet should have shrunk by an equal amount. Nonetheless, from June 1 to August 24, the size of the balance sheet has decreased by approximately $64 billion. That’s why big investors didn’t take the Fed’s statement about interest rates seriously.

In addition to raising the federal funds rate, the Fed needs to shrink its balance sheet at the same pace it announced. This, along with aggressively raising the federal funds rate, would prompt the stock market to buy a message about how serious it is about controlling inflation.

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