More investors are starting to realize that macroeconomics plays a significant role in investment returns.
And investment returns determine if and how much our retirement accounts grow over time.
In essence, our lives are very directly affected by Federal Reserve actions since those actions have a huge impact on the economy, and hence, our investment returns.
This leads smart investors to pay more attention to what the Federal Reserve is up to. A term we often hear is that the Fed has expanded their balance sheet.
Expanding a balance sheet sounds like a good thing; we naturally think of having more assets when we think of balance sheet expansion.
But what does it really mean when the Fed expands its balance sheet?
How does it stimulate the economy when the Federal Reserve expands its balance sheet?
And how is the Fed expanding its balance sheet when there is already an enormous amount of government debt?
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The Federal Reserve balance sheet
Understanding how the Fed expands their balance sheet begins with understanding what is on the Federal Reserve balance sheet so let’s go there first.
What assets are on the Fed’s balance sheet?
The Feds’ assets are made up of different securities including:
- Government bonds
- Corporate bonds
- Mortgage-backed securities
- Way more complicated assets
Note that the “way more complicated assets” include REPOs, Discount Window Lending, and Foreign currency holdings associated with reciprocal currency arrangements with other central banks (AKA foreign central bank liquidity swaps) (1.)
Yep, like I said, the Federal Reserve’s assets are complicated.
But we just want to understand what it means when the Federal Reserve expands their balance sheet so we can:
- Invest in the right assets in a timely manner
- Retire more certain that we have enough investment savings to outlive us
So, don’t get caught up in feeling like you really need to understand all of the assets that are on the Federal Reserve’s balance sheet but do stay with the big picture here because this ultimately affects your net worth.
What liabilities are on the Fed’s balance sheet?
Understanding Federal Reserve liabilities is key to understanding how the Fed expands their balance sheet.
The liabilities on the Federal Reserve’s balance sheet include:
- U.S. Currency that’s in circulation
- Bank reserve requirements from over 5000 banks
- Access bank reserves
As you can see, the liabilities are more straightforward than the assets. They are made up of the money in circulation which seems odd but sensible as a liability.
Also, banks are required to have reserves in order to operate, and sometimes the reserves exceed the minimum requirement; those reserves are a liability for the Fed, which makes total sense.
It’s worth noting here that the amount of required bank reserves increased after the GFC.
How the Fed Expands Their Balance Sheet
The term “printing money” is often associated with the Fed expanding their balance sheet. When they “print money”:
- The money supply increases
- The Federal Reserve’s liabilities increase
As a result of “printing money”, however, the Federal Reserve has the funds to purchase more securities from banks in the open market. This increases the Federal Reserve’s assets so that total assets continue to equal total liabilities, a requirement for balance sheets.
The Federal Reserve has expanded its balance sheet through this process which began with printing money.
Does the Federal Reserve really print money?
The Federal Reserve doesn’t really print money as such. This is the term associated with adding funds to the money supply, or expanding their balance sheet.
Why does the Federal Reserve expand its balance sheet?
The Federal Reserve contracts and expands its balance sheet to accomplish either economic contraction or economic expansion, depending on what is needed at any given time.
The economy needs to grow but if it grows too fast, inflation becomes too high so there is a delicate balance.
The graph below shows the relationship between changes in the Fed’s assets and the S&P 500 index! If you’re a stock investor, you can see that Federal Reserve actions probably have a strong influence on your investment returns. Of course, some sectors will be affected more than others.
How an expanding Fed balance sheet affects the economy
Expanding the Federal Reserve balance sheet infuses fresh capital that can be used to purchase loans from banks.
When the Federal Reserve purchases loans from banks, the banks receive money, which causes the reserves on their bank balance sheet to increase.
This increases:
- The ratio of reserves to loans
- The ratio of reserves to deposits
As a result, the bank is able to sustain losses on any bad loans while still meeting the demands of depositors.
Given these improvements, the bank is able to make new loans to both individuals and businesses. This stimulates the economy.
(1.) The Fed’s Assets: https://www.federalreserve.gov/monetarypolicy/bst_fedsbalancesheet.htm#:~:text=These%20assets%20include%3A%20holdings%20of,holdings%20associated%20with%20reciprocal%20currency
https://www.csus.edu/indiv/v/vangaasbeckk/courses/135/sup/bankbal.pdf
