Another Weekly Decline in the Size of the Federal Reserve’s Balance Sheet!
The total size of the Federal Reserve’s balance sheet declined by $7,795 million during the week ending July 27th 2011. In the post-2008 world of perennial central bank balance sheet expansions, this is rare (and probably temporary). Presumably, we’ll be seeing such contractions over the coming weeks; so we should savour them and position ourselves accordingly!
[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.]
As was the case last week, the Federal Reserve’s balance sheet contracted via reductions in the holdings of Federal Agency Debt securities, Mortgage-backed securities and the other junk that was taken on during the 2008/2009 crisis. Despite this contraction, the Fed continued to accumulate US government bonds and notes – thus the cosy relationship between the US Treasury and the Fed continued.
We have reiterated the following for several weeks now, but it still stands and it is still incredibly important. Despite the widely held view that ‘QE2′ was uber-loose monetary policy, the officials at the Federal Reserve seem to have been intent on ‘improving‘ the Fed’s balance sheet. They think that consistency matters (and it does to an extent). So, since they view long-term US government bonds as ‘risk-less’, they think that they are undoing the damage that was inflicted upon the dollar during the 2008/2009 crisis. However, as we frequently discuss here on greshams-law.com, monetary policies for irredeemable currency systems are about quantity and quality.
So, as can be seen from the second chart above, the composition of assets backing the dollar (as in, Federal Reserve notes & reserve balances) has shifted towards the more ‘traditional’ central banking asset of US government bonds. This, by itself, would tend to increase the burden upon issuers of ‘IOU money‘ (and therefore the credit creation process). However, QE2 also came to pass with dilutive balance sheet expansions (which gave rise to the tearing commodity prices of late 2010/early 2011). Now, in contrast, the Federal Reserve’s assets are shifting towards US government bonds and notes via balance sheet contractions. Especially with the heavy ‘discount to par’ seen on Federal Reserve notes (see chart below), the burden upon issuers of IOU money (i.e. deposits) could increase significantly.
[Incidentally, the chart below shows that the market is discounting heavy monetary debasement by the Federal Reserve. Should this not come to pass (or, indeed, if anything else should come to pass), then there could be a drastic reversal in the prospects for the dollar.]
Recommended: Charting the Federal Reserve's Assets - 1915 to 2012