Three in Five Podcast

Episode 19: Three central bank questions for Dec

Steve sits down with Dec Mullarkey, Managing Director of Investment Strategic Research and Initiatives at SLC Management, to discuss the Fed’s balance sheet expansion and its impact on the market.

Steve Peacher: Hi everybody thanks for dialing in for to another session of “Three in Five,” this is Steve Peacher, President SLC Management and I’m with Dec Mullarkey today. Dec is a Managing Director in our strategic research area. Dec, thanks a lot for taking some time.

Dec Mullarkey: All right, good to be here Steve.

Steve Peacher: So, I want to talk today about balance sheets of the Central Bank, the Fed in particular. From the financial crisis through the Covid crisis, the Fed and the other central banks have had an extraordinary expansion on their balance sheets largely to buy bonds in the marketplace, can you provide some perspective on the scope of this in the U.S.?

Dec Mullarkey: Yeah absolutely and you hit it, it was those two crisis drove it, but just to focus in on the U.S. and then we'll reference it a little bit to the other major central banks. The Fed is up to about $7 trillion right now, to give some perspective on that, that's a third of our GDP. So, it's a big number. But how we got there, prior to the crisis we were less than a trillion. The crisis hit, this is the financial crisis in 2008, and it looked like the world was falling apart, we could get into a deep recession or deep depression and at that point the Fed cut rates to rock bottom and then they said we got to do more, and this is where they came up “let's do some massive bond buying here.” And that massive bond buying was mainly in government bonds and mortgage backed securities to the tune of about $4 trillion. Now they didn't do it right away, it took a little bit of time, but that's where that's how they actually grew their balance sheet halfway there. Then you know as they went through time and there was aftershocks, they didn't get an opportunity to unwind it to try to unwind some, but they didn't get very far there, because they then when Covid it hit they realize we're back in the same boat here, this is a major crisis, potentially a major meltdown, and they did the same thing. They acted quicker this time, did probably another $4 trillion or did do another $4 trillion. And that's where we got to, we're basically up to $8 trillion right now, and for perspective other central banks did the same thing. You look at the European Central Bank, ECB, whose view is that they have moved slowly, and they had through time, but they have $10 trillion on their balance sheet. And then you look at the Bank of Japan’s at $7, you got you got China at $6, so everyone is in that range, but it did come down to averting two major crisis which, in our lifetime have been major, major shocks and we look across economic history, these have been major shocks. So, they felt this was the only way they could freeze up, they could put money into the capital markets, prevent them from freezing up because that was big concern and it worked it worked from that standpoint.

Steve Peacher: Dec, isn't this balance sheet expansion really just another way of printing money and, if so, why hasn't all of this support and liquidity sparked massive amounts of inflation?

Dec Mullarkey: Yeah so that's really intriguing question. So, you're absolutely right it's equivalent to printing money and the case of the Fed they do it through creating reserves, but it's the same impact. So, the one thing, and it has been a conundrum for the Fed, I mean particularly after the financial crisis. The one thing that happened in the financial crisis is that was a balance sheet shock and that households were over leveraged. And when you're over leveraged, the last thing you're going to do, regardless how cheap money is, you're not going to borrow, you're really going to try to get your debt down, get it under control. And the other thing, banks were reluctant to lend after the financial crisis as well, so you didn't see any expansion in debt, therefore that money really was not making its way back into the economy.

And that was that's been I think a big driver why inflation really, really didn't show up in any in any pulse after the financial crisis, it was fairly anemic and it bothered the Central Bank that they couldn't get it up. The same thing happened after this crisis as well, or seems to be happening. I think everyone reads the headlines and say, “oh inflation is up.” Transitory inflation's up, inflation expectations are down. But here's an interesting kind of view into the consumer right now. The Bank of New York has done some great work on this, where they looked at what consumers have done with the three stimulus checks and they added that up. And guess what? The consumers only spend about 30% of those checks1, the rest to pay down debt and they split it with saving. So again, we're seeing a very, very cautious consumer coming out of Covid as well. And, and that may well carry over once we get beyond some of these temporary effects we're seeing right now. That could well end up being you know fairly tame inflation here. So that has been the struggle and it's certainly something the Central Bank keeps you know you're working on to see “how can we get inflation up?”

Steve Peacher: So, here's the money question, how does this play out? How are the central banks going to unwind these holdings and, importantly, if that starts to happen, what does that mean for markets that have been bolstered by low interest rates, which have been an offshoot of this policy?

Dec Mullarkey: Yeah, so this is the great question, and this is again, you know this is new territory for Central Banks for economic textbooks and everything. The path to if to, if you will, first of all, maybe withdrawing some of the stimulus we have, is to taper the bond buying that we're doing right now. In the case of the Fed they're expecting probably by the end of this year, just to trail off bond buying. Now that's a minor part of it, but they'll probably take a year. And what they will do after that will be to raise rates. They will try to get rates up to somewhere well off zero. And that could take you know could probably take another year, maybe to get up to one and a half percent, somewhere in that range on the short rate. And after that, and this is what they did after the 2008 crisis. At some point they're saying, all right we're going to allow, we're going to shrink our balance sheet, we're not going to reinvest flows coming off the existing stock of bonds, we're really just going to let that trail off. And based on the kind of you know estimates I’m throwing out there, that probably suggest that you basically in 2026 before you start to let the actual balance sheet roll off. Now the one question and the Fed is struggling with this and markets will need to be informed of this, is that the Fed has also made the statement. Yes, you know back the pre financial crisis, a trillion was enough in reserves and that backed currency that was out there, but they have now realized that we probably need a bigger balance sheet because the functioning of capital markets, particularly providing repo lines, their view right now is that maybe you need $2 trillion2 for that just to make the system run smoothly. And when you look at actually the expected growth in currency that's probably another $3 trillion, so you could well say that, ultimately, the size of the balance sheet could settle somewhere, you know around maybe $4 or $5 trillion. So with if you passively allow the balance sheet to run out, you're allowing markets to get their head around that to factor that in, and I think there things can work pretty smoothly because you've created a lot, you know obvious expectations, where you're going. The big issue, though, is if another crisis comes along there's other shocks, they can continue to do this bond buying but at some point, or other it’s actually it's no longer effective. So, it'll be an interesting path Steve, but you know I guess we're all hoping that it becomes a predictable, passive path, but a lot remains to play out here.

Steve Peacher: So the hope is that this happens gradually, and markets can adjust in a gradual fashion.

Dec Mullarkey: Exactly.

Steve Peacher: So, one final question having nothing to do with printing money or the Fed's balance sheet. Dec, you and I are both big tennis fans and of course we're in the middle of the U.S. open, so what I’m interested in is who's your pick to win this U.S. open, either on the men's side, the women's side or I’ll take both if you have a projection.

Dec Mullarkey: Yeah frankly Djokovic of it looks hard to beat but I absolutely love this young Canadian player, he's Auger-Aliassime I’m sure I’m mispronouncing his last name but he's playing really, really strong. I would love to see him in the final matching against Djokovic, and I haven't looked at the path there. And I will also have to say my favorite on the women's side is this young Canadian, not playing to the home crowd here. But Leylah Fernandez, she's 18 years old, she beat Kerber she beat Osaka before that. This kid looks fearless and fun and that I’m picking her right now, all the way. It would be tough, but I think those would be phenomenal outcomes if you know if she wins on that side and you see also a Canadian national on the other side.

Steve Peacher: Okay well it's gonna be fun to watch, it's always a great weekend with the finals and semi finals the U.S. open. Dec thanks a lot, and thanks everybody for listening to this episode of “Three in Five.”

Dec Mullarkey: Great catching up Steve.


Data for this podcast has been sourced from: 
https://www.bloomberg.com/graphics/2021-central-banks-binge/

¹ https://www.forbes.com/sites/zackfriedman/2020/10/19/how-americans-spent-1200-stimulus-checks/?sh=2e4fd82d680f

² https://www.bankrate.com/banking/federal-reserve/why-the-fed-pumps-billions-into-repo-market/

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