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Fed’s capital markets role to grow: expert

Fed’s capital markets role to grow: expert

As foreign capital becomes more expensive, the US Federal Reserve’s balance sheet will likely end up as an even bigger percent of GDP than it is today, a Lombard Street Research has revealed.

In a study, chief US economist Steven Blitz noted that while the Fed can reduce its balance sheet on a shorter-run basis, it can’t return structurally anywhere close to where it was before it began snapping up $4.5 trillion of US treasuries and mortgage-backed securities during the 2008 financial crisis.

He said that with the deteriorating US savings position and smaller pool of savings globally, the longer run bias is for US interest rates to rise, but the Fed has to keep them in check to support growth. With a sustained need for real domestic growth to be powered by investment spending, the Fed can’t let real interest rates climb too high for too long.

Moderate rates will curb interest from foreign investors and as a result, the Fed will have to continue to play a part in the savings equation to ensure that there is economic growth.

According to the economist, the domestic savings position of the US looks set to deteriorate with a forecast increase in the federal budget deficit and the reduced ability of households to lend, so the Fed will have to step in.

The Fed announced the gradual unwinding of its balance sheet in September, which will take place over four to five years. The Fed’s balance sheet currently stands at 23% of GDP and is expected to fall to 14%, or $3 trillion.

Foreign capital

Between 1992 and 2007, the entry of China and Russia in the global market economy generated a large trade surplus allowing the rest of the world to be the net purchaser of 95% of net Treasury issuance. Today, China is the biggest foreign holder of treasury securities, holding $1.2 trillion, followed by Japan at $1.1 trillion.

Many of these major foreign holders are now opening up to international markets and instead asking others to participate in their domestic growth story. Many of them also face ageing populations. As a result, the global savings pool is set to shrink, so getting foreign capital will be more difficult for the US.

‘As a consequence, the Fed will likely turn to its balance sheet once again to insert itself into the S=I equation,’ Blitz said. ‘For that reason, we would not be surprised if the next cycle sees an even bigger Fed balance sheet relative to GDP.’

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