Fed Balance Sheet Dilemma

The main objective of central banks is to achieve economic growth by maintaining price stability and low unemployment rates, so central banks were intervening to protect the economy from the repercussions of the COVID-19 pandemic and starting asset purchase programs and injecting more cash to encourage spending and protect the economy from a recession.

The U.S. Federal Reserve pumped nearly $4.5 trillion from March 2020 into the U.S. economy through an asset purchase program that reached $120 billion per month to reach the Fed's current budget of nearly $9 trillion, the highest in the history of the United States to stimulate the economy and protect it from recession. Indeed, we can say that the Fed has already succeeded in this task in which we can observe that unemployment rates reached 3.9%, the lowest since February 2020, and GDP in the fourth quarter of 2021 reached 6.9%. But these easing policies, unquestionably, have had more damage than some may see, namely, high inflation rates with the consumer price index (CPI) reaching 7.1%, the highest rise since 1982.

The Fed is now forced to start reducing its budget to control current inflation, but the Fed has not yet announced the mechanism or timing of its budget cut, leaving markets in a state of high volatility.

Bank of America has predicted that the Fed will begin reducing its budget in July by selling 20 billion Treasury bonds and 15 billion mortgages. Barclays expects the Fed to start in July as well, but with a slower rate of 10 billion treasury bonds and 5 billion mortgages. Deutsche Bank expects the Fed to start in August by selling 20 billion treasury bonds and 15 billion mortgages, and finally, Morgan Stanley also forecasts that the Fed will start in August by selling 25 billion treasury bonds and 15 billion mortgages.

The Fed has already decreased its balance sheet before in 2017, but after raising interest rates at the end of 2015, nearly two years after the start of the interest rate hike. It is expected that the Fed will start raising interest rates in March 2022; moreover, investors are afraid that the Fed will tighten its current policy more than the economy can tolerate which could push it into a recession.

Most economists now believe that the Fed is in a very difficult position and must choose between price stability or economic growth. But the real problem is to choose the perfect timing for the Fed’s intervention because rushing to tighten as the pandemic’s crisis continues and the supply chain crisis may inevitably push the economy into recession, but if the Fed delays balance sheet decreasing, inflation rates may get out of hand and require a further tightening that will inevitably plunge the economy into a recession, as Fed chairman Paul Volcker did in the early 1980s when he was forced to raise the interest rate to around 20% to conquer the inflation.

Markets will be waiting for the next Fed meeting in March to learn about Jerome Powell's plan to reduce his balance sheet, and how can it affect the American economy in 2022?

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