The Fed’s decision to maintain its balance sheet size had a very negative effect on markets last week. I’m not sure that such a negative reaction was warranted, but first I’d like to explain exactly what the Fed is talking about.

Over the course of 2008 and 2009, the Federal Reserve purchased roughly $1.7 trillion in Treasury and mortgage securities in order to flood financial markets with fresh capital and promote increased lending and liquidity.  Central banks take this action, referred to as quantitative easing, to stimulate financial markets.  To remove the stimulus, central banks these sell securities to shrink their balance sheet and decrease money supply in the financial markets.

Today, the Fed’s balance sheet is not shrinking because they are selling these securities, but because of a refinancing wave resulting from the low interest rate environment is causing homeowners to take out new mortgages at more favorable rates to pay off their old higher-rate mortgages.  As a result, long-term risks are being transferred from the Fed to the private sector.  Because new risk in the private sector could force up risk premiums and interest rates, this is a form of monetary tightening. 

So when the Fed said last Tuesday that they wanted to keep its balance sheet size constant, they were basically saying that the economy still requires exceptionally low interest rates at this stage.  As a result, the Fed will reinvest principal payments (not interest payments) from agency debt and mortgage-backed securities (MBS) into longer-term Treasury securities.

Fed officials understand the weight of their words and, thus, changes in wording are extremely deliberate.   It would be shocking if they tightened policy without telegraphing their actions.  We will know the Fed is ready to tighten policy when they remove the phrase “extended period” from their view of the duration of “exceptionally low” rates.

To be honest, I’m a little confused why people were surprised by this decision.  Market participants weren’t expecting the Fed to come out and say they are ready to raise interest rates.  And with all of the deflation talk swirling around the financial world, I would have thought market participants would welcome low interest rates.

Once the Fed does eventually begin to tighten, it will be a welcome sign that the economy is no longer in need of emergency accommodations.  Personally, I think we no longer need rates at emergency levels.  Maybe I’m naïve, but the financial market doesn’t have the feeling of Armageddon that it did in 2008-2009.  Even a move to 1% would be nice.  After all, money supply doesn’t appear to be the problem right now.  Instead it’s the speed at which that money is moving through the system.

Businesses and consumers are unwilling to borrow, spend, or invest money.  Much of this is due to the uncertain environment.  Both the healthcare and financial legislations are open to interpretation.   Businesses and consumers won’t be able to gauge the effect of these legislations as well as other issues, such as taxes, until at least after November elections. 

Until there is less uncertainty, businesses and consumers will remain timid and the velocity of money low.

Peter Lazaroff, Investment Analyst

www.acrinv.com