Federal Reserve Balance Sheet Charts – Weekly Update: 26/5/11
An update of the weekly Fed balance sheet charts for 26/5/11. With QE2 coming to a close, we can start to see how the dollar will be structured post-QE2.
[The first chart shows the Federal Reserve's assets as recorded on the 'factors affecting reserve balances' statistical release. The second chart shows those assets on a proportional basis. That is, the latter chart shows the Fed's various assets as a percentage of its total assets.]
The Federal Reserve is set to complete its quantitative easing program in June, and so we can begin to see how the dollar will look post-QE2. As is evidenced by the chart above, the Fed’s proportional holdings of US government bonds and notes have increased substantially over the past six months. Concomitantly, the Fed’s proportional holdings of Federal Agency debt securities, Mortgage-backed securities & portfolio holdings of Maiden Lane (et al.) have decreased dramatically. This leads me to believe that the intention of QE2 was to clean-up the Federal Reserve’s balance sheet (rather than to debauch it further).
The Structure of the Federal Reserve’s Balance Sheet & The Structure of the Dollar:
After the Bretton Woods system collapsed in the early 1970s, the dollar became an irredeemable fiat currency. Meaning, the entire stock of liabilities of the Fed (namely Federal Reserve notes & Fed Balances) became some sort of claim upon the assets at the Fed. So, today, the Fed can tinker with the dollar by changing the quantity and quality of the assets that back it.
By the very structure of any fiat currency, expansions in the size of the central bank’s balance sheet tend to dilute the fiat currency in question. When – say – the Federal Reserve expands its balance sheet, each dollar becomes ‘good for’ fewer assets. However, the quality of the assets backing the dollar can also be changed by central bankers. The most glaring example of this occurred in 2008/2009. Essentially, the private-sector had reached a maximum capacity for leverage (i.e. for the production of ‘IOU money’). The peak manifested itself in an enormous housing bubble that affected all parts of the economy. This interconnectedness of the housing market and the wider economy was deemed to be a ‘systemic risk’. Hence, when large institutions found that they owed way too many dollars and owned decreasingly appetizing MBSs, the Fed indulgently stepped in. They made dollars ‘good for’ mortgage-backed securities, and so – rather magically – the burdens upon said large institutions fizzled away. As everyone else owed dollars and owned better assets than MBSs, they came back from insolvency as well.
The above demonstrates that the quality of the assets at the Fed makes a huge difference. That being said, it should be clear that QE2 may eventually act to tighten rather than ease the pressures upon the private-sector. The dollar has become mostly ‘good for’ traditional central banking assets once more. This may prove painful for those who are very short dollars and long things.