The Federal Reserve (the Fed) controls two main things – the balance sheet and the interest paid by banks on overnight loans.

The balance sheet is the base money supply.  It essentially represents the number of dollars the Fed has created because it creates money out of thin air to purchase the assets.

There are many other factors that impact price inflation.  There is the supply side of money, and there is the demand side of money.  Even with regard to the supply of money, bank loans impact the overall dollars in circulation, as fractional-reserve lending essentially creates new money available.

The interest rate banks charge each other on overnight loans is called the federal funds rate.  The Fed used to control this rate directly by increasing or decreasing the base money supply.

Since the financial crisis of 2008, the Fed has mostly controlled the federal funds rate by paying interest to commercial banks on reserves.

When the financial media talk about the Fed raising (or lowering) rates, they are referring to the federal funds rate.  Before 2008, if the Fed wanted to raise rates, it would mean they would likely have to sell off assets on its balance sheet, or at least stop rolling over some maturing debt which accomplishes the same thing.

Now the Fed can just “raise rates” without even touching the money supply, at least on a short-term basis.

The financial media and investors seem to be more obsessed with “rates”.  The Fed controls this one rate, which certainly does have an impact on overall short-term rates.  The impacts on longer-term rates are less direct.

And while interest rates are a major component of monetary policy, it seems that the financial media and investors should be even more concerned about the money supply.  This is especially true now when high price inflation is a big concern.

For some reason, the Fed’s balance sheet gets far less attention than it should.

An Easy Doubling, Not So Easy to Unwind

The Fed’s balance sheet more than doubled in a two-year span.  It fell below the $4 trillion mark in 2019, but was just above that mark in early 2020.  It had already eased policy because of the overnight repo rate having spiked in September 2019.  There was also an inverted yield curve in 2019, which indicated a recession ahead.  The Fed was already shifting away from its mild tightening mode before COVID hysteria hit in March 2020.

But after February 2020, the Fed went into full gear running the digital printing presses.  The balance sheet more than doubled and fell just short of hitting the $9 trillion mark.

In the last couple of months, it has gone down slightly (relatively speaking).  As of right now, it stands just above the $8.9 trillion mark.  Remember it was just below $4 trillion during a part of 2019.

The curious thing is why the Fed waited so long not just to reduce its balance sheet, but just to stop growing it.  If we are to take the words seriously of the FOMC, the Fed should start reducing its asset holdings in a few days.  The Implementation Note in the last FOMC statement says it will stop rolling over $30 billion in Treasury securities and $17.5 billion in mortgage-backed securities starting in June.

The Fed is doing a balancing act.  The Fed officials want to get the roaring price inflation down, but they don’t want to completely crash the financial markets and the whole economy.

When price inflation was first becoming noticeable, the Fed chairman insisted that it was “transitory”.  It was very clear by late 2021 that it was not transitory.

Why did the Fed wait so long to change its policies?  The Fed continued to add to its balance sheet (i.e., create monetary inflation) even into the beginning of 2022.  It could have at least just stopped that sometime in 2021.

I’m not sure if there is something that everyone is missing or if the Fed officials are just that stupid.  Maybe they thought the economy was so fragile still that they couldn’t just abruptly stop all monetary inflation at once.

But if the economy is that fragile, then how will it handle a reduction in the balance sheet now?  What has changed from, say, 6 months ago, other than price inflation being even higher than it was then?

I don’t have good answers to these questions, but I think it is important to ask the questions.  Maybe the Fed officials really did believe their own words and thought price inflation would just be temporary and that they wouldn’t have to do much to address the problem.

The Fed got away with massive monetary inflation from 2008 to 2014.  It caused a lot of misallocations in the economy, but we never saw high consumer price inflation from it.

The Fed in 2022 is in a more difficult position.  High consumer price inflation is a major problem.  But in order to address it, it means reducing its balance sheet and possibly popping the Everything Bubble.  To tame consumer prices, we may get major asset price deflation in the things that have blown up for a decade or more.

We should start to see the Fed’s balance sheet decline.  It may or may not tame consumer price inflation, but it is a near certainty that it will expose some of the malinvestments in the economy.  There is good reason to fear a hard recession in the somewhat near future.

The good news about a recession is that it may actually get price inflation under control, which will be good for American consumers who are struggling right now.