I hear the term ‘balance sheet reduction’ a lot in the recent days in regards to the ending of QE. Could some please explain what balance reduction means? Is it the same as balance sheet run off (which I do not know either)?
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The Fed has been buying stuff for the past couple years, mostly corporate debt. This increased demand holds prices up and pumps money into the economy – a process called quantitative easing.
The Fed has now taken away be punchbowl, as inflation indicates that the economy was overheated because they bought too much. They are selling their stuff, and getting money back. This reduces the money available in the economy and raises interest rates.
The key point is that the Fed can create and destroy money. When the Fed expands it’s balance sheet it creates money out of thin air. When the Fed shrinks it’s balance sheet it effectively destroys dollars.
First of all, all money in the USA is borrowed into existence. Before someone borrows the money, it literally does not exist. And when you pay it back, it does not go to the bank, it goes back into “non-existence”, with the bank only keeping the interest. Well, during recessions and other sensitive times, the Federal reserve can add money to the economy by buying “assets” with money created out of thin air. These assets include Treasury Bills, Corporate bonds, mortgages, etc. But because this money is created out of thin air, the assets are accounted for as borrowed money. So right now the Fed has about $9 trillion of assets bought in this manner. A good portion of that balance sheet assets bought under QE or quantitative easing. So to lower the balance sheet, the Fed Sells those assets and the money goes back to oblivion and comes off the Feds balance sheet. So the number gets lower. Just to give you an idea of how things have changed, before the 2008-9 financial crisis, the balance sheet was at around $1 trillion. So they have added $8 trillion to the economy since then. This is what people call “printing money”, when you hear that in the media. But of course, it’s just a metaphor, it’s really just a number in a bank account.
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