Impact of the Fed’s Balance Sheet on Investment Performance

Source: Stern School of Management, New York

The huge expansion of central bank balance sheets in 2020 has created a fresh round of hand wringing by investors. These investors are concerned that the U.S. Federal Reserve (Fed), together with other major central banks, have shifted their mandate (with the blessing and encouragement from politicians) from managing inflation to one that focuses on preventing recessions.

Most pundits point to Alan Greenspan and Ben Bernanke as the original architects of these policies, but the move to untether fiat currencies from a monetary anchor dates back to President Richard Nixon and his Federal Reserve Chief Arthur Burns. In the face of rising unemployment and inflation, Burns took America off the Gold Standard in 1971, which lead to a huge spike in the price of gold and other precious metals, before the market adapted the new regime.

Once the gold standard was eliminated, central banks were initially constrained in their efforts to expand monetary policy by “bond vigilantes”, institutional bond traders and managers who demanded to be paid higher rates of interest to take on the risk of increasing government debt levels.

However, in the nineties, the economy was beset with disinflation, largely due to technological advances and the expansion of global trade. This allowed the Fed to run increasingly easier monetary policies, without worrying about inflation. The result was an influx of new equity investors, as baby boomers abandoned GICs, creating the irrational exuberance of which Alan Greenspan complained. In the chart above, you can note the divergence that erupted between other asset classes and equity prices (the green line) during that time frame.

This situation was exacerbated in the Financial Crisis of 2008/9 when the Fed realized that the amount of debt the government would need to issue to bail out the U.S. banking system would drive interest rates much higher and choke the economic recovery. The solution was to buy the newly issued government bonds itself and build the size of the Fed balance sheet, in tandem with sovereign debt levels. With no new investors to plug the hole, the central banks became a new source of capital to financial markets.

Many investors were alarmed by this active support for increasing government debt levels. History provides many examples of periods when central banks allowed monetary policy to become too expansionary, leading to the economy spiralling into an inflationary nightmare. These financial historians point to the Weimar Republic, and more recently Venezuela, as examples of monetary officials flirting with danger and losing.

Others argued that much of the liquidity created by the last rounds of central bank intervention, did not meet the stated objective of supporting GDP and jobs growth. Instead, the stimulus money found its way into capital markets and not into the economy, leading to asset price inflation. You can note in the chart, the slight flattening of the GDP line while equity markets moved higher at a steeper slope.

The Federal Reserve is now caught in a conundrum of its own making. How can it return to a more normal monetary policy without disrupting financial markets? At this point, the reality is that the central banks probably cannot exit their role in financial markets. Therefore, we should expect this modern, active central bank to be with us for some time.

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