Most people focus on the Fed's interest rate cuts in the fight against inflation, but in its fight against inflation, most people ignore another factor - reducing its balance sheet (i.e. "shrinking the balance sheet"). In fact, the Fed is not doing well in shrinking its balance sheet!
The FOMC (Federal Open Market Committee) mentioned balance sheet reduction in its December statement, stating that it would continue to reduce its holdings of U.S. Treasuries, agency debt, and agency mortgage-backed securities (MBS), as described in the "Plan for Reducing the Size of the Federal Reserve's Balance Sheet" released in May.
The problem with this announcement is that it does not follow the plan outlined in May, which called for selling $30 billion in Treasuries and $17.5 billion in MBS each month in June, July and August, for a total of $45 billion per month. In September, the Fed also said it would increase the monthly balance sheet reduction to $95 billion.
According to the plan, the Fed's balance sheet should have been reduced by $560 billion by the end of December last year. However, according to the latest data, as of December 19, the balance sheet had only been reduced by $401 billion. This means that unless there is a large-scale balance sheet reduction in the last week of this year, the Fed's balance sheet reduction will be nearly $160 billion slower than planned.
This raises a question: If the Fed is truly committed to curbing inflation, why is it shrinking its balance sheet so slowly?
In fact, even if the Fed shrinks its balance sheet at a rate of $95 billion per month, it will take 7.8 years to reduce its balance sheet to pre-pandemic levels. Seeing this, can you still say that the Fed really wants to defeat inflation?
Learning from history
After the 2008 financial crisis, the Fed implemented three rounds of QE (quantitative easing) policies, pushing its balance sheet from less than $1 trillion to $4.5 trillion. The Fed then reduced its balance sheet in 2018, with the lowest level falling to just under $3.76 trillion. However, after the stock market crash and economic turmoil in the fall of that year, the Fed quickly changed direction.
The Fed resumed QE long before the COVID-19 pandemic, and in October 2019, its balance sheet re-surfaced at over $4 trillion. During the pandemic, QE was like a stimulant, so much so that by April 11, 2022, the size of the Fed's balance sheet had soared to $8.965 trillion. This means that between 2008 and 2022, the Fed injected nearly $8 trillion of created-out-of-thin money into the economy. Coupled with the low interest rate environment, this over-issuance of money has laid the groundwork for inflation this year. The problem is that interest rate cuts alone cannot eliminate inflation. To truly solve the inflation problem, all the new money created over the past decade must be withdrawn from the economy.
Yet the Fed’s balance sheet has shrunk by only a relatively modest 4.5% since it began its fight against inflation, which is clearly not enough.
In fact, the Fed’s QT policy does not reduce the money supply at all. Despite monetary tightening in recent months, M2 growth in 2022 is currently flat at zero. This is undoubtedly an improvement compared to the massive expansion of the money supply during the epidemic, but it will only slow the economy and will not curb inflation, which can also be seen from the performance of the CPI data. However, although the slowdown in money creation is not enough to push inflation to the Fed’s dream 2% target, it is enough to burst the economic bubble created by loose monetary policy. The most important thing is that although the Fed talks a good game in promising to curb inflation, its actual actions do not match its words, especially in reducing the size of its balance sheet.
This once again raises questions about the Fed's commitment to fighting inflation. If it really regards inflation as "public enemy number one" and believes that the economy is strong enough to cope with tighter monetary policy, then why doesn't it significantly reduce its balance sheet?
The Fed may be confident in its rate hikes and the economy’s resilience, but with liquidity drying up at an extremely fast pace, the Fed has put the economy at serious risk of a major event.
The Federal Reserve played an important role in the market trend in 2022. In order to fight inflation that hit a multi-decade high, the Federal Reserve implemented the most aggressive interest rate hike in decades, causing many stocks and even bonds, as well as global risk asset investors, to suffer losses, because the interest rate hike will suck liquidity from the market. In 2023, the market predicts that interest rates will remain high, and interest rate cuts may not come until 2024. But this does not mean that the Federal Reserve will still be the main driver of market trends. In 2023, corporate and company fundamentals will be the main driver of market trends. The key to making profits in the U.S. stock market in 2023 will be to "find companies that can defend profit margins. Because the prospect of earnings growth is the real risk of the stock market."