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Reducing the Fed’s Balance Sheet

While Wall Street is focused on geopolitical affairs, the Fed is debating something else that deserves more attention — whether or not to decrease the Fed’s balance sheet.  The Libertarian wing of the Republican Party has been highly critical of the Fed for this and insistent that the Fed “deleverage” or sell bonds off its balance sheet.

During the long, slow recovery from the Global Financial Crisis, the Fed experimented with quantitative easing or QE, which has the effect of increasing money supply.  Within reason, an increasing money supply is good for the economy.  Reducing the Fed’s balance sheet is QE-in-reverse.

The mechanics are this:  The Fed buys existing bonds, which are added to the Fed’s balance sheet as an asset — to pay for the bonds, the Fed issues new money — the new money increases the total supply of money in the economy.  The reverse is this:  The Fed sells bonds on its balance sheet and receives cash from the buyer, which removes that cash from the money supply, because it goes back into the Fed.

Ben Bernanke says the Libertarians are wrong, and that we should not reduce the Fed’s balance sheet at this time, and I agree.

The Fed has already begun the “normalization” of interest rates or increasing those rates to more a normal level, which has a chilling effect on the economy.  Increasing rates slow enough not to slow down the economy is an art, not a science.  These waters are murky enough, without implementing any QE-in-reverse program that has never been done before.