The Rate of Expansion of the Federal Reserve’s Balance Sheet Slows…
An update of the weekly Federal Reserve balance sheet charts for 17/7/11. There wasn’t a great deal of change since last week given that the torrential balance sheet expansions involved with the quantitative easing program have been halted for now. ‘Other Federal Reserve Assets’ reached a record this week, indicating that there’s no shortage of funny business at the Fed…
[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.]
Balance sheet expansions have a specific significance in our modern-day irredeemable fiat currency system. Unlike in the former redeemable currency system (i.e. when a certain amount of gold could be redeemed for a certain quantity of dollars), balance sheet expansions have an immediate bearing upon the structure of our money. Formerly, it was the task of the central bank to keep its promise to redeem at a specific, stated ratio. So, whenever they expanded the balance sheet in favour of government securities, they did creep ever-closer to the status of being unable to keep their promise — however, the immediate effects were frequently limited (insofar as the redemption promise was honoured).
Now, in contrast, we have irredeemable fiat currencies. This means that the entire stock of federal reserve notes (& balances at depository institutions) are ‘backed’ by the assets at the Fed. So, whenever the Federal Reserve expands its balance sheet, each federal reserve note and reserve balance becomes an irredeemable claim upon a tiny slice of a different set of assets. There is no ‘promise’ involved.
Why does this matter?
Federal Reserve notes are typically referred to as ‘money’, but so are deposits at commercial banks often referred to as ‘money’. This terminology shouldn’t be trusted, as they are decidedly different things. The former are irredeemable claims upon a tiny slices of the assets at the Fed, whereas the latter are IOU claims upon the former. So, when the former changes (for better or for worse), the degree to which IOU issuers can honor their IOUs, change.
Since the stock of IOUs on Federal Reserve notes vastly outweighs the stock of Federal Reserve notes themselves, changes in the structure of the Federal Reserve’s balance sheet can have far-reaching consequences (not only domestically, but abroad also).
The Current Situation:
As can be seen from the charts above, the QE2 program had the effect of increasing the degree to which the stock of Federal Reserve notes are backed by US government securities and decreasing the degree to which the stock of Federal Reserve notes are backed by Mortgage-backed securities. As mentioned in a previous update:
… the Fed drastically changed the structure of its balance sheet during 2008/2009. In essence, they made dollars ‘good for’ MBSs as well as conventional central banking assets (gold, government bonds, etc.). QE2 seems to be reversing that change; the dollar is - once again – becoming ‘good for’ (mostly) conventional central banking assets again.
I say that this is bearish for asset prices. Pre-2009, supposedly important institutions owned too many MBSs and owed too many dollars. To alleviate this, the Fed changed the quality of the dollar – they made dollars ‘good for’ MBSs. Thus, institutions that were previously close to insolvency found that the burden of their dollar liabilities had lightened considerably. Similarly, everyone else – who owned stuff better than MBSs – found that they were safe again. Now, it would seem, the dollar is changing back to something similar to its former self. If imbalances still remain in the system, then can we really expect those institutions to thrive or – even – survive?
Recommended: Charting the Federal Reserve's Assets - 1915 to 2012