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The Fed Runs Up Another White Flag. Balance Sheet Reduction Is Done.

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Since the end of QE and the “taper” in October 2014, the Fed has been trying to “normalize” their balance sheet and interest rates. The balance sheet needed to be reduced from $4.5 trillion to about $2.5 trillion through “quantitative tightening” or QT, which is tantamount to burning money. Interest rates needed to be raised to around 4% in stages of 0.25%.

The purpose of QT and rate hikes was so that the Fed would have the capacity to lower rates and increase the balance sheet (“QE4”) again to fight a new recession. The rate hikes started in December 2015 (the “liftoff”) and the balance sheet reductions started in October 2017.

Both started slowly but have gained momentum. Rates are now up to 2.5% and the balance sheet is just below $4 trillion. The Fed’s problem was that actual rate hikes were about 1% per year and the balance sheet reduction at $600 billion per year had the effect of another 1% of rate hikes.

Would the Fed be able to achieve it’s goals of 4% rates and a $2.5 trillion balance sheet without causing the recession they were preparing to fight? It turns out the answer is no.

In late December, Fed chair Powell announced the Fed would be “patient” on rate hikes. That means no more rate hikes until further notice. Now, according to this article the Fed has also thrown in the towel on balance sheet normalization.

When QT began, Janet Yellen said it would “run on background” and would not be an instrument of policy. Ooops. Now the Fed is ending it, so it clearly is an instrument of policy.

The Fed may have avoided a recession for now, but they have left themselves far short of what they’ll need to fight the next recession when it comes. That could lead to another lost decade. The U.S. looks more like Japan with each passing day.

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