Understanding the Federal Reserve's balance sheet

The Federal Reserve balance sheet is often referred to in the economic news media but few understand what it is.When one hears the words "balance sheet," it tends to conjure up a vision of long rows of numbers on an accounting ledger.Although it's likely most of us imagine a hefty balance sheet reflecting superior financial strength, in the case of the Federal Reserve's balance sheet, the opposite may actually be true.Although many would think a balance sheet details how much money one has, the legal term is it's actually a statement of the assets, liabilities, and capital of a business or other organization at a particular point in time. In simplistic terms, it's what you own and owe and then correlates the two.In the case of the Fed's balance sheet, it's actually a list of what it owns and it's not just piles of green cash. Some might argue it's not a good pile at all but another kind of pile.The pile was commonly kept at about a trillion dollars prior to 2008 but now it sits at over 4 trillion. There is a reason for the massive increase.Four trillion sounds like a big pile of cash but actually there is little cash there. What is there is about 1 trillion of what it had historically held prior to '08, which is mostly U.S. government debt. Now there is about another 3 trillion of what it bought to pull us out of the global monetary implosion that was the crisis of 2008.So what did the Feds buy and from whom did they buy it? The balance sheet contains what is called U.S. debt (treasuries which our IOUs from the Uncle Sam), agency debt (U.S. debt that might be from other government institutions or offshoots) and mortgage backed securities (MBS) to name a few. It buys the U.S. debt instruments from the government (no the Federal Reserve is technically not a government entity) and buys the MBS from, among other places, the banking system. These purchases are known as "asset purchases" and are a part of the Federal Reserve's open market operations (OMO). OMO can be thought of as a gas pedal to throttle the economy. The Feds can buy stuff from the banks, which puts more money into the system, pushing down on the economic pedal to stimulate, or the Feds can sell back this stuff to the banks, easing up on the pedal to cool an economy off. These buys and sells either put money into the economic system (when it buys and gives money to the banks) or takes money out of the system (when it sells back to the banks and the banks gives money to the Feds). During 2008 the banks were saturated in mortgages that were going bad. The Feds then boosted their balance sheet by printing up about $3.5 trillion U.S. and buying (MBS) mortgages and "other assets" from the banking system. They also bought MBS from other public and private enterprises as well. This mechanism is thought to have stabilized the banking system which was under severe strain at the time due to trillions in mortgages that were defaulting due to the housing blow up. There are opponents of this mechanism and its use but that's a story for another day.The Feds, having increased their balance sheet (holdings) from 1 trillion to 4.5 trillion during the crisis is now attempting to decrease (sell off) some of its holdings. You won't hear much about this on the evening news as it's not something they want to advertise. The reason being anytime large amounts of money are withdrawn from an economy, the economy tends to want to stall out or slow. As the Feds attempts to unwind (reduce by selling assets it previously bought) money is taken out of the system as the buyers (banking system among others) give their money back to the Feds for these assets.If you recall, when the Feds sell, like they are doing now, the "pedal" is lifted and the economy slows. Hence their trepidation to widely advertise their recent buying. They also don't want to crash the economy by buying too much too fast. Since the crisis, the Feds have tried to unwind before, only to back off when economic conditions slowed. Only time will tell if they will be more successful this time around. Marc Cuniberti is an investment advisor representative through Cambridge Investment Research Advisors, Inc., a registered investment advisor. Contact him at SMC Wealth Management, 164 Maple St #1, Auburn or 530-559-1214.