Over the past year, the US government and the Federal Reserve have expanded the Federal Reserve balance sheet from $3.81 trillion (Jul 2019) to $7.009 trillion. Over $3.2 trillion have entered the U.S. economy through the Cares Act, Fed liquidity initiatives, and other stimulus programs.
For much of the Fed’s history, many did not care about the Fed’s balance sheet as every Thursday, the Fed would release the weekly balance sheet report listing all the assets and liabilities, providing a consolidated statement of the condition of all 12 regional Federal Reserve Banks. The Fed’s assets consist primarily of US government securities and the loans it extends to its regional banks. The liabilities are comprised of U.S. currency in circulation, money held in the reserve accounts of member banks, and U.S. depository institutions.
The weekly balance sheet report became a hot topic during the global financial crisis starting in 2007 as the Fed launch various quantitative programs (QE) to fight the financial crisis. Just before the start of the financial crisis during Aug 2007, the Fed had a balance sheet of $870 billion on its books. The Fed balance sheet quickly expanded to $2.23 trillion by the end of 2009.
Soon after the end of the global financial crisis of 2007-2009 interests in the weekly Fed balance sheet reports faded as the U.S. economy recovered. However, the recent unprecedented expansion of the Fed’s balance sheet from $3.808 trillion last year (Jul 2019) to $7.009 trillion (Jul 2020) has reignited wide interests.
So, how big could the Fed’s balance sheet grow? And, most importantly, what are the consequences, if any?
Theoretically, there is no limit to which the Fed can expand its balance sheet. As the COVID-19 pandemic shut-down the global economy and left millions of Americans unemployed the Fed has taken some extraordinary measures. Some came directly from the 2007-2009 global financial crisis playbook to restart the economy. Fed quickly implemented an unlimited bond-buying program, increased repo market operations, created an emergency lending program, provided funding to municipal bonds, high yield, and corporate debt markets. Experts say the Fed balance is likely to balloon even more, with some forecasts suggesting that it can reach as high as $10 trillion.
Consumers, investors, savers, and borrowers are beginning to worry about the potential for a surge in inflation in the future. So, the question then becomes – what investments can offer the best protection against rising prices. There have been numerous studies performed over the years to determine the correlation between an asset’s returns and the rate of inflation. The closer an asset’s returns track the inflation rate the better the assets can hedge against rising inflation.
The Correlation Coefficient (CC) is a statistical measure that reflects the relationship between two securities. In other words, this statistic quantifies how closely one security is related to the other over a specified period. CC tends to trade within a range of -1 and +1. +1 is considered a direct correlation and -1 is considered a perfect negative correlation between the two securities. Anything between 0 and -1 and 0 and +1 denotes the degree of negative and positive correlation, respectively.
Historically, hard assets or tangible assets such as commodities (i.e., oil and gold) tend to correlate closely with the inflation rate. These assets have proven to be an inflation hedge during periods of rising inflation. Soft assets such as stocks and bonds tend to lose value as inflation rises. It is still debatable as to whether the expansion of the Fed’s balance sheet will lead to a period of high inflation in the years ahead. Nonetheless, with more fiscal and monetary stimulus likely exposure to hard assets merits consideration as an inflation protection hedge.
For your reference, enclosed are charts of hard assets and their respective correlation coefficients benchmarked against a popular balanced fund – Vanguard Balanced Index Fund (VBINX) over the past 10-years or since the start of the unprecedented expansion of the Fed’s balance sheet. Also, included are the shorter-term correlation charts over the past 2-years.