Fed hold interest rates steady, balance sheet concerns remain

The Federal Reserve decided to hold interest rates steady at its June 11-12 meeting. This is good news, but the bigger story isn’t about interest rates. It is about the Fed’s curious balance sheet decision. By continuing a slower pace of reducing its excessive bond holdings, the Fed is signaling an openness to stimulus later this year, which would make inflation worse.

At the very least, it subtly signals to markets that they should expect inflation to linger for a while longer. The Fed should instead be more aggressive.

This all ties back to the COVID-19 pandemic. We’ll be past its aftermath at some point, but not just yet.

The Fed added $5 trillion to its balance sheet from 2020 to 2022. This more than doubled its holdings. This grew the money supply by 40 percent over two years, which is about quadruple the normal rate. This was the main cause of the pandemic inflation, which in turn rose to about quadruple its normal 2 percent-ish pace.

The Fed did this both to stimulate the pandemic economy, and to help finance a bipartisan spending spree from Congress and Presidents Trump and Biden.

The Fed has been slowly pulling its balance back to Earth since 2022, by about $75 billion per month. After growing from $4 trillion to $9 trillion during the pandemic, the balance sheet is currently back down to around $7 trillion.

This is a major reason why CPI inflation is down to 3.3 percent instead of 9.2 percent. At its last meeting six weeks ago, the Fed decided to slow this $75 billion monthly decline down to $25 billion per month, which could be stimulus in disguise. At the very least, it contradicts the Fed’s interest rate policy.

Why is the balance sheet so important? The Fed can use it to directly adjust the money supply, which is by far the most important driver of inflation. Interest rates only affect the money supply at several steps removed, and are far less potent.

The Fed’s balance sheet consists mostly of government bonds. When the Fed buys up bonds, it buys them with money. Unlike other buyers, the Fed can use money that it creates out of thin air. This is how it can directly grow the money supply by almost any amount it wants.

If the Fed instead wants to shrink the money supply, then it sells bonds, and then retires from circulation the money it receives. Again, it can do this in almost any amount it wants, at any time.

What the Fed has been doing is gradually letting that balance sheet go back down. For the last two years it has been letting its bonds mature, and then retiring the dollars it gets from the principal repayments. If that total exceeds $75 billion, then it buys bonds until the net effect is a $75 billion per month decline—now $25 billion.

Money supply adjustments don’t get more direct than that. Interest rates, by contrast, do not affect the money supply directly. They affect it indirectly by changing how fast money circulates. Higher interest rates, like we have now, slow things down. People see higher mortgage rates and decide to hold off on buying a home. Higher rates for loans mean people will hold off on a new car, home improvement, or growing their small business.

Lower interest rates speed up monetary circulation by encouraging people to take on more mortgages and loans. The effect is small because the Fed only has a band of a few percentage points to work with, whereas its balance sheet adjustments can run into the trillions of dollars. In theory, they could go to infinity, but let’s not give them any ideas. That’s what got Argentina, Zimbabwe, and other countries into hyperinflation.

So that’s the monetary econ 101 lesson. While it is good news that the Fed is still rolling back its balance sheet, slowing down that decline contradicts Fed Chair Jerome Powell’s stated commitment to fighting inflation.

Interest rates get all the headlines, while few people pay attention to the Fed’s balance sheet. However, markets are clever enough to catch on to this sleight of hand. Inflation expectations likely will not go down until the Fed’s actions match its rhetoric, and until Congress proves that it can resist further deficit spending sprees.

A strong economy gives the Fed plenty of maneuvering room to undo the rest of its pandemic overreaction. It should take advantage of the opportunity.