My son who is taking an Economics class in college asked me, “What is the greatest Macroeconomic risk we currently face?”  I responded that it was Monetary Policy – he needed only a general area of risk.  What I really think is that the greatest Macroeconomic risk is how the economy responds as the Federal Reserve reverses course and sheds assets over the next few years, as it has said it would do and as it has, in fact, started to do during the past few months.  I didn’t lie to my kid – this is a part of Monetary Policy.  I believe the Fed’s actions with respect to its own balance sheet is the greatest current Macroeconomic risk because it hasn’t been done before and because another economics-related branch of government, the Congressional Budget Office, doesn’t even list the Fed’s asset sales as a risk in its most recent economic forecast.  It is often the part of the iceberg that you don’t see that poses the greatest risk.

$4.4 Trillion

The Fed’s assets peaked in 2014 at about $4.4 Trillion.  The Fed’s assets on their balance sheet consist of debt instruments (Treasury securities, mortgages, and other government-backed debt).  The Fed started aggressively to purchase debt in the open market as the Great Recession hit in 2008-2009.  The Fed’s purchase of debt provided liquidity to the markets and helped the economy to recover from the Recession.  They continued to buy so much debt that their balance sheet grew from about $1 Trillion when they started to $4.4 Trillion.  I previously wrote about this in my post of March 30, 2018, titled “No Playbook“.  Football coaches operate with a strict playbook.  The Fed is currently operating without one that they have tested during practice.

Now the Fed is starting to go the other way:  Selling assets instead of buying them.  In reality, the Fed is simply not repurchasing assets as they mature and fall off of their balance sheet.  After holding steady in the $4.4-$4.3 Trillion range since 2014, the Fed’s assets have shrunk this year by about $200 Billion, and are now at about $4.2 Trillion.  The Fed is hoping that this gradual sell-off of assets will not disrupt the economy that much.  They are taking the training wheels off gradually.  Let’s hope that they are correct.  The economy is strong now by most measures.  If the economy unexpectedly begins to weaken, the Fed might be forced to curtail or even reverse its bond selling program, which would not be good for the Fed’s credibility.  

The CBO

The Congressional Budget Office (CBO) puts out a periodic Macroeconomic projection.  The most recent projection was published on August 13.  The projection mentions various issues they see that may have a negative impact on the US economy.  Trade issues, tax cuts, and interest rates are mentioned.  The mainstream media mentions these as well.  Fed policy relating to asset sales and shrinking its balance sheet is not mentioned as a risk in the CBO projection.  That makes me worry.  For the past 10+ years, our economy has been helped along by the Fed’s ballooning balance sheet.  That balloon will be having air let out of it – gradually, but still with less inflation.  I certainly see this as a Macroeconomic risk.  The CBO misses this risk.

IMO

I do not see our economy going into a recession because the Fed has started and will continue to reverse course.  However, if the Fed needs to re-reverse, there could be hell to pay.  My point is to pay attention to the Fed’s actions (I will keep you posted) and see what happens but be aware of what is happening.