Let’s Talk About Shrinkage -

Let’s Talk About Shrinkage

Apr 19, 2017Jeremy ParkinsonFinance0

There’s a lot of concern these days about shrinkage. No, not Seinfeld shrinkage. We’re talking about Federal Reserve Balance Sheet shrinkage and how the Fed might go about reducing the size of its balance sheet.

When the Fed started expanding their balance sheet in 2008 during the financial crisis there was a great deal of outcry and misinformation floating around. I wrote about 10 billion posts on this trying to clear up the misunderstandings. Let’s review the basics in case you missed it:

During the financial crisis the Fed expanded its balance sheet to help stabilize the economy. They do this in the same manner that all banks expand their balance sheet – from thin air. This process involves the creation of reserve deposits that are then utilized to purchase assets from their partnering banks (many of whom had purchased these assets from other market participants).

By expanding its balance sheet the Fed created super high quality short-term instruments and traded them in exchange for high quality long-term instruments like Mortgage Backed Securities and T-Bonds. As you might recall, some of these instruments were under price pressure in 2008-9 so this process helped to shore up the banking system significantly by improving the short-term liquidity and quality of the instruments held in the private sector. This, in my opinion, was undoubtedly beneficial as it helped stabilize a financial system in deep need of it.

Importantly, what this process was not akin to was “money printing”. This is due to the fact that operations like QE do not actually expand the quantity of net financial assets in the private sector. In other words, the Fed created reserves and traded them to the private sector, but the Fed also removed a T-bond or MBS at the same time. So you could say that they printed a super short-term instrument into the private sector and unprinted a long-term instrument from the private sector. It can be helpful to think of the Fed’s balance sheet as being “off balance sheet” because it is not an impact that directly impacts the real economy. In other words, the Fed doesn’t go shopping at Walmart so any assets accounted for on its balance sheet might as well be buried in a hole somewhere.¹

As I predicted back in 2008 and 2009 QE did not cause high inflation, surging interest rates, high growth, and was not really all that impactful given all the fuss about it. Yes, I have argued that QE1 was probably very effective because it shored up balance sheets at a very unusual time, however, the future iterations of QE and the aggregate impact has been fairly small given how expansive the policy was. This makes sense since the Fed was essentially changing the composition of the private sector’s balance sheet rather than directly expanding it (as real bank loans do). Swapping a savings accounts (T-Bonds) for a checking account (reserve deposits) doesn’t make anyone go out and spend more since it is little more than an asset swap of like assets.²