Recently, there has been a lot of discussion about the U.S. Federal Reserve balance sheet as markets were driven to confusion over the anticipated reduction of the Fed’s economic stimulus measures. I asked two of Cambridge’s newest team members, Analysts Danesh Rohinton (global securities in the financials sector) and Grant Connor (fixed-income), to offer their perspective on the situation and highlight the risks as we see them. Here is a summary of their insights.
Central banks are required by law to maintain a minimum level of liquid assets (e.g. cash or deposits). This is known as required reserves. Historically, banks would maintain no more than the minimum level of required reserves and lend out the rest. With the onset of the financial crisis, the U.S. Federal Reserve began pumping money into the banking system at an unprecedented pace. Initially, this was done to stabilize the industry by providing liquidity. Later, the intent was to stimulate the economy by lowering interest rates.
However, the U.S. banking system has parked most of the funds at the Federal Reserve rather than deploying it into the real economy. Three rounds of quantitative easing have resulted in adding nearly $2.4 trillion to the Fed balance sheet. The vast majority of it represents excess reserves which earn a negligible interest rate of 0.25% per year (see chart below). Over the last 12 months, the Fed balance sheet grew by $966 billion but only $83 billion entered the real economy, while the remaining $883 billion was deposited by the banking system as excess reserves.
Based on conversations with management teams at U.S. banks, we believe the funds have not been deployed into the economy due to a lack of demand for loans from qualified borrowers and the unwillingness by the banking industry to loosen lending standards. However, if an economic recovery increases the demand for credit among qualified consumers and businesses or fosters greater credit risk appetites among lenders, then banks may begin to loan out their idle funds. If these idle funds enter too quickly into the economy, there is a risk of rapid inflation because of “too much money chasing too few goods” (to borrow from Milton Friedman).
Thus, the Fed faces a delicate balancing act. It must normalize its balance sheet by reducing the excess reserves of banks in order to lower the risk of rapid inflation. But it must do so at a pace that does not push up interest rates so quickly that it would smother a recovery. To strike this balance the Fed has two primary tools at its disposal. The first tool would be for the Fed to influence interest rates by adjusting the pace of treasury and mortgage-backed securities sales to absorb inflationary excess funds in the economy. The second tool is for the Fed to increase the 0.25% interest rate it pays on excess reserves of banks. This would incent banks to keep funds idle by lowering the opportunity cost of not lending it out, which should slow the potential inflationary flow of money into the economy.
Over the last five years, we have seen an unprecedented expansion in the Fed’s balance sheet. Initially, we do believe it was the right thing to do in order to avoid an economic collapse. However, the longer monetization goes on and the larger the balance sheet gets, the more risky the exit becomes. As you all know, we are bottom-up investors at heart but in these extraordinary times it’s important to have a macro framework to invest within. While a macro framework can’t determine the companies we should own in the Cambridge funds, it does help us to understand the risks facing the market.