Fed Story 1 - How the Fed Balance Sheet expanded over the years
If you break up the above Fed balance sheet chart, you can spot 4 distinct phases. The first phase was the global financial crisis of 2008 when the Fed holdings of securities jumped from less than $1 trillion to above $2 trillion. In the second phase that began in 2012 and lasted till 2014, the Fed expanded its balance sheet from around $2.5 trillion to over $4 trillion in the aftermath of the European crisis.
However, from 2014 till 2020, the Fed balance sheet was kept constant at around $4 trillion as the Fed refrained from fresh purchases. This third phase lasted all the way till 2020. However, when the pandemic broke out, the US had to drive growth and liquidity and that led to the Fed balance sheet expanding from below $4 trillion to $8 trillion by mid-2021.
Just for perspective; the Fed balance sheet expands because it keeps buying securities in the market so as to infuse liquidity through its repo window. This puts money in the hands of the people and this liquidity boost also gives a spending boost. But what does a Fed balance sheet of $8 trillion mean and what could be the implications?
Fed Balance Sheet at $8 trillion means a lot of liquidity
On a monthly basis, Fed buys $80 billion of treasuries and $40 billion of MBS. This $120 billion liquidity infusion means that the Fed balance sheet expands by $1 trillion every 8-9 months. While the Fed balance sheet is already more than double the peak size of the global financial crisis, this figure could cross $10 trillion by the end of 2022.
The impact is that as this continues, the private sector and households end up holding less of treasuries and mortgage backed securities. These are now being held by the Fed. In turn, the private individuals and the private businesses are holding money purely in the form of deposits with the banks.
Apart from liquidity, there risk of yield hunting
One clear implication of this expanding Fed balance sheet is that the private households and private businesses are left holding too much money in the bank. Now this has another spill-off effect. What do people do with all the money? They either go binge shopping and we are already seeing that happen in the form of revenge shopping in the US and other countries. The other possibility is the hunt for higher yielding assets.
When there is too much liquidity and limited investment opportunities in low-risk assets, investors will gravitate towards high risk assets. Now, that is not very a very good idea. For example, a retired person getting desperate for yields and overexposing to junk bonds or even equities is not a good signal. In the process, risky assets may look enticing but in reality it is just pushing more people to take on unnecessary risks.
Asset inflation is already a global reality
In the last 18 months, the global markets have corrected sharply and then bounced back with a vengeance. There is a lot of liquidity sloshing around. Investors are willing to buy stocks at ridiculous P/E ratios purely because they believe that the liquidity glut would continue. As long as the liquidity glut continues, valuations will remain buoyant. It is almost like the Greater Fool theory at work.
In a way, this asset inflation is becoming a substitute for commodity inflation. The central bank can control commodity inflation by tweaking rates, but it has little control; or little intent to control asset inflation. That is a reality as long as the Fed can continue to expand its balance sheet without hiking rates.
$10 trillion balance sheet trajectory is good news for India
India will not really worry about the size of the Fed balance sheet. However, Indian markets would be really worried should the Fed come out tomorrow and say that it was done with its asset purchase program. Back in 2013, when the Fed first hinted at a taper, Indian markets saw outflows of $15 billion as FIIs lightened up on Indian bonds. That risk still exists; just that the scope of that risk has widened substantially. But there is good news for India.
The trajectory of $10 trillion being talked about hints that the Fed is not really uncomfortable for now. Balance sheet building was conceived as a temporary measure but it has become a permanent feature over the last 12 years. That is the one thing that India would have to be really cautious about. Someday, someone may just decide to spoil the party!