At this point of time, given that the Fed will wind down its balance sheet gradually, there will not be any impact on markets and your investments fundamentally but only through sentiments. Over a longer term, as US banks use the money parked with the Fed, there could be sharp rise in economic growth, which would pull up markets and create asset price bubbles. At this point of time, you would need to start exiting risky assets, but this time is still a long way, at least three years.
The March 2017 Fed minutes suggest that the Fed is contemplating downsizing its USD 4.5 trillion balance sheet. What does this mean, how will the Fed downsize and what will be the effect on markets and your investments?
The Fed resorted to QE (see last presentation below on why it resorted to QE) post 2008 financial crisis to prevent deep recession in the US economy. The result of the QE was Fed’s balance sheet (imagine government borrowing money and spending, it will increase fiscal deficit) size bloating by 4x. Fed does not borrow money like the government, it prints its own money.
Fed bought US treasuries and mortgaged backed securities by printing money, which as a result ended up with banks who supplied these securities being flushed with money from the Fed. US banks had turned risk averse post 2008, instead of lending the money, parked the money with the Fed. Similar to Indian banks parking excess liquidity with the RBI. To understand Fed’s balance sheet see presentation one below.
The result was that over 50% of Fed’s balance sheet on the liability size is US banks deposits. On the asset side, most of the assets are in securities (See presentation two below).
The Fed can reduce balance sheet by running down its assets, not necessarily be selling but by not replacing them when they come up for maturity. Average maturity of assets is over 8 years and it will take a long while for the Fed to wind down its balance sheet.
Banks too will then start utilizing the money parked with the Fed to lend to the economy, helping push economic growth. This could lead to inflation and rise in interest rates if the economy starts overheating.
