Is the Fed's Growing Balance Sheet a 'Free Lunch'?

One of the hallmarks of the "Great Recession" has been the Fed's easy money policy, which has manifested

itself in low interest rates (ZIRP) and, the now famous, QE (Quantitative Easing or money printing).

As we entered the Great Recession in 2008, the Fed seemingly had few options to assist the economy and stave off what could have been a more severe depression. In an effort to stoke growth in the economy, the Fed cut interest rates to near zero and ultimately implemented QE, that expanded the money supply and has since led to the rise in value of risk assets, like equities, among others (at the time of this article most US stock indices sit at record levels). The concept behind raising the value of assets, like equities, was to create a "wealth effect" that would start a virtuous cycle of more consumer spending and more capital investment. As a result of the Fed's policy, its balance sheet has expanded at an unprecedented pace.

Are there ramifications to the Fed's growing balance sheet? Is the Fed inflating another bubble like we saw in 2000 and 2007? Or, is there such a thing as a 'free lunch'?

Growing Balance Sheets

As seen in the image above, the Fed's balance sheet grew steadily from 2001 until 2008, showing a balance just shy of $900 billion. Then, over night, its balance sheet experienced a dramatic increase

only to be followed by an endless run of quantitative easing. However, the US Fed is not alone in its endeavor to kick start the economy through asset purchases. The second image reflects a global policy of asset purchases resulting in increasing balance sheets. What impacts might be felt as a result of this global policy, specifically, to the U.S.? Is there comfort in the knowledge that the U.S. is not alone in its policy of QE? Or is there concern that we are now the leader in this effort? The U.S. Fed's balance sheet shows the most dramatic change of all of those represented in the attached image.

Another Bubble Inflating?

Through its efforts, is the Fed simply creating another bubble from which we will suffer yet another dramatic decline and an additional assault on the fragile psyche of most investors? "This time is different" is a popular, and to many investor's ears, chilling refrain, often used to explain away concerns regarding the latest dramatic rise in some asset class's value. So, can the Fed orchestrate a slowly recovering economy and rising asset prices without a costly glitch? The short answer is "maybe". If the economy progresses to a more healthy level of growth and the fundamentals better match the performance of stock indices, record stock levels could be sustainable. However, another recession, and or, runaway inflation could knock markets from their highs. The unanticipated contraction in first quarter GDP and the rise in inflation has some analysts and money managers on yellow alert. They're not quite at red alert, yet. The popular and tiresome weather excuse has provided cover for bulls so far, but that excuse is losing some luster as data collected for the winter months is replaced by spring and summer data. If these concerns manifest themselves and markets take a hit, what implications does this have for a Fed with an inflated balance sheet?

Foreign Creditor Confidence?

With the Fed claiming that it can and will hold the securities it purchases until maturity, it only signifies that the market will not have to absorb the supply at some point in the future, but that does not relieve the Fed from the effects of rising interest rates. The cost of holding securities in the face of rising interest rates is material and significant. The impact of inflation on the value of the U.S. dollar and on interest rates is a two-pronged financial sucker punch. Because commodities are priced in U.S. dollars, a falling dollar means higher costs for U.S. corporations. Rising interest rates make the debt the Fed is holding less valuable as an asset and rolling over the debt becomes more expensive. One implication is that foreign governments might be less inclined to hold U.S. debt in the face of a falling dollar. Until now, the Fed gets the benefit of the doubt from its creditors. If foreign investors were to lose confidence in U.S. fiscal and monetary policies, an already bloated Fed balance sheet would be challenged to absorb more debt from the secondary market. As the balance sheets of other nations grow, combined with falling dollar-denominated assets, foreign governments will be less inclined to add more U.S. debt on to their balance sheets, choking off an avenue of funding for the Fed. Additionally, if a large holder of U.S. debt were to liquidate suddenly, this would serve to drive up interest rates and drive down the value of the U.S. debt.

Market's Love-Hate Relationship with Inflation

On the one hand, markets rely on some level of inflation. Without inflation, capitalistic economies do not function properly. Some level of inflation allows the successful use of debt financing. Inflation, in this case, represents growth. It allows the prices of products that companies sell to go up and it degrades the value of debt used to finance that production. At a minimum, it keeps the price of products from falling below the cost of production. As the cost of debt is fixed, inflation provides margin for profit. However, inflation also reduces the value of cash flows, which in turn reduces the value of the underlying company or asset. Too much inflation will creep in to income statements in the form of higher production costs at the same time as reducing the value of dollar-denominated assets. The Fed's large balance sheet could be the cause of a spike in inflation for the reasons noted above, and if that inflation were to get out of control, markets would react negatively and a large sell-off in both the equity and fixed income markets could follow.

Summary: Is There a Free Lunch?

So far, it's hard to say that investors have not enjoyed something akin to a 'free lunch' as the Fed has successfully orchestrated lower costs of capital and rising asset prices. What's unknown, however, is how long the current environment of low volatility and rising asset prices can last. The current bull market is five years old and counting. As values get extended and the market does not experience a traditional correction, the prospects of a more severe correction grow. In the absence of some catalyst that would alter current trend, this condition can last for years. However, the degree of Fed intervention and market manipulation has most professionals uneasy. This unease from the street can have its own effects. Unfortunately, most folks on Wall Street, do not subscribe to the notion of a 'free lunch' and are skeptical that current conditions controlled by the Fed, and its money printing (QE), will go on ad infinitum. In the absence of higher growth and a healthier consumer, that very fact could be the spark that causes the flame.