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April 2014 FOMC minutes: Why focus on normalization?

Part 5
April 2014 FOMC minutes: Why focus on normalization? (Part 5 of 7)

Must-know: “Normalization” meets a non-normal Fed balance sheet

After tapering, the new fear is “normalization”

One of the things the Fed mentioned is that at some point, rates need to return to more normal historical levels. This will be in the context of a massive Fed balance sheet, and the Fed notes that we’re more or less in uncharted territory. While the Fed doesn’t anticipate increasing rates any time soon, it’s beginning the process of figuring out which monetary levers will be most effective. The Fed staff was ordered to continue to research the question.

Fed AssetsEnlarge Graph

The Fed’s balance sheet has gotten huge

Quantitative easing has grown the size of the Fed’s balance sheet almost eightfold since the turn of the century. From holding just over $500 billion in assets in 2000, it has recently hit $4 trillion. Some of the participants worried that additional purchases would result in capital losses. This isn’t an insignificant fear—the Fed currently supports over $4 trillion in assets with about $55 billion in equity. Under any other entity, that would be considered an unthinkable leverage ratio.

It was pointed out, however, that these assets would provide income to the Treasury over the life of the program—especially when the effects of the program on the overall economy are taken into account—and that any potential reputation risks to the Fed from capital losses could be mitigated.

That said, a balance sheet of this size could make extricating itself from the economy a more difficult challenge. While the Fed continues to taper (reduce asset purchases), it’s important to remember that the Fed’s balance sheet continues to grow—just at a slightly slower pace.

If the Fed’s exit from extraordinary measures causes turbulence in the bond markets, mortgage REITs like Annaly (NLY), American Capital Agency (AGNC), Capstead (CMO), Hatteras (HTS), and CYS Investments (CYS) will be affected.

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