Your Money & Politics

The Fed started shrinking its balance sheet in October 2017. It euphemistically named the program "balance sheet normalization." I call it "bloodletting," in honor of the medieval medical treatment for disease.

The Fed's Quantitative Easing (QE) program had caused asset markets, including stocks, bonds, housing, and commercial real estate, to become bloated and diseased as prices inflated relentlessly. They floated higher on a sea of the Fed's newly conjured money.

The Fed pumped that money directly into the accounts of the big shots who make the markets, known as "Primary Dealers." The Primary Dealers are appointed by the Fed to be its exclusive correspondents in the execution of monetary policy. They're also responsible for absorbing a significant portion of the Treasury's issuance of new bonds, notes, and bills. They mark that paper up and sell it to investors.

The Fed expanded the money supply by buying securities – U.S. Treasuries, Agencies, and Mortgage-Backed Securities (MBS) – directly from those Primary Dealers.

The dealers used the money to buy Treasury securities from the U.S. government. Since they are trading firms, they also used the cash to buy other bonds, as well as stocks, and occasionally exotic derivatives. Those cash injections helped to ignite and promote animal spirits among hedge funds and other massive leverage speculators, along with more conservative investment institutions. We saw the effect in the long-running big bull market. The policy of QE ultimately carried stock prices to extremes of valuation only seen at modern major market tops.

The Fed stopped QE in late 2014, but the stock market continued its bull run. That was partly because the Fed was still pumping a little money into dealer accounts through its MBS replacement purchase program.

More importantly, in late 2014, the European Central Bank (ECB) started buying all manner of European government and corporate bonds hand over fist in a QE program that essentially took the hand off from the Fed when the Fed left the field. The same big banks that are Fed Primary Dealers also operate in cahoots with the ECB. That's how money printed in Europe by the ECB can instantly show up on Wall Street and in U.S. markets. That helped to keep stock prices inflated and rising.

But the Fed went into reverse in October 2017, and the ECB also tapered its buying and will go to zero purchases this month. Its balance sheet will also begin to shrink. More money will leave the worldwide pool of market liquidity, which is just a fancy way of saying money available for investment.