Latest / The Fiscal Policy Podcast with Fexingo: Government Budgets, Stimulus, and Public Spending / How The Fed’s Balance Sheet Shrinks Inflation
Transcript
- Lucas: The Federal Reserve is currently sitting on a balance sheet that dwarfs what it held before the pandemic, but the real story isn't the size anymore. It is the slow, mechanical process of letting that balance sheet shrink. Through September twenty twenty-six, the central bank has been allowing maturing securities to roll off without replacing them, a strategy known as quantitative tightening. Luna: Right, and for a long time, the market was obsessed with when they would raise rates again. But now that rates are stable, the silent killer of liquidity is this runoff schedule. Lucas: Exactly. And here is the thing most listeners miss. The Fed is not actively selling assets into the open market. They are just waiting for bonds to mature and then keeping the cash. This passive approach prevents a fire sale scenario, but it still drains reserves from the banking system over time. Luna: So it is like a leaky bucket. The water level drops slowly, but eventually, the engine starts to sputter if you do not top it up. Lucas: That is a decent analogy, though I would refine it. Think of it less like a leak and more like a sponge being wrung out. The banking system has excess reserves that were built up during the height of the crisis response. As those reserves dry up, banks have less capacity to lend, which naturally pushes borrowing costs higher across the board. Luna: Does that mean the average homeowner feels this squeeze directly in their mortgage payments? Lucas: Indirectly, yes. Because a significant portion of the Fed’s holdings is in mortgage-backed securities. When those stop rolling over, the demand for new mortgages from institutional investors softens. That keeps long-term interest rates elevated even if the short-term federal funds rate stays flat. Luna: It is fascinating how invisible this mechanism is compared to a press conference speech. You cannot tweet about a maturity date. Lucas: Precisely. And that invisibility is what makes it dangerous for policymakers who want to signal control. If they announce a change in the runoff cap, markets move violently. If they just let the calendar do its work, nobody notices until the plumbing gets tight. Luna: What is the actual cap on this runoff right now? Is there a hard limit on how fast they can drain the system? Lucas: There are statutory limits set by the FOMC. For Treasury securities, the monthly runoff cap is around sixty billion dollars. For mortgage-backed securities, it is slightly lower, around thirty-five billion dollars. These numbers are adjusted periodically, but they represent the maximum pace of withdrawal without triggering disorderly market conditions. Luna: Sixty billion a month sounds like a lot, but given the total size of the balance sheet, is it actually moving the needle? Lucas: On paper, no. The total balance sheet is still over seven trillion dollars. Sixty billion is a rounding error in the grand scheme. But in financial markets, marginal changes matter more than aggregate totals. It is the incremental shift in supply and demand that sets the price. Luna: So if the Fed slows down the runoff, does the market immediately cheer? Lucas: Usually. Investors hate uncertainty about liquidity. If the Fed signals a pause or a reduction in the runoff pace, bond prices tend to rise, which means yields fall. It is a direct correlation that traders watch every single day. Luna: I remember back in twenty twenty-three, there was a brief panic when people thought the runoff was too aggressive. Did that change the strategy? Lucas: It did force a recalibration. The Fed realized that pushing too hard could fracture the repo market, where banks lend to each other overnight. They had to ensure they didn’t pull so much liquidity that the daily gears of finance started grinding. So they introduced more forward guidance to manage expectations. Luna: Forward guidance is basically telling everyone not to worry while you’re quietly turning off the tap. Lucas: Exactly. It is psychological management of the plumbing. If everyone believes there will be enough liquidity tomorrow, there usually is. But if panic sets in, the system can contract faster than the data suggests. Luna: This brings me to the government budget angle. How does this tie back to fiscal policy and public spending? Lucas: Great question. When the Fed stops buying Treasuries, the Treasury Department has to find other buyers for its new debt issuance. If private demand is weak because banks are low on reserves, the government may have to offer higher yields to attract investors. That increases the cost of servicing the national debt. Luna: So the fiscal deficit gets bigger not just because of spending, but because the interest bill rises as the Fed shrinks its portfolio. Lucas: That is the feedback loop. Higher yields mean higher interest payments on existing debt, which widens the deficit, which requires more borrowing, which puts upward pressure on rates further. It is a self-reinforcing cycle that politicians often ignore. Luna: It feels like a trap. You cut spending to fix the deficit, but the interest costs keep rising anyway. Lucas: Unless you address the monetary side. If the Fed maintains a steady, predictable runoff, markets can price that in. The problem arises when policy shifts abruptly, forcing the Treasury to borrow at peak rates. Luna: Are there any sectors that are particularly vulnerable to this dynamic right now? Lucas: Real estate and utilities. Both are capital intensive and rely heavily on long-term fixed-rate debt. When mortgage-backed securities are being drained from the Fed’s balance sheet, those sectors feel the pinch first because their funding sources are directly linked to that asset class. Luna: So developers and power companies are paying more to borrow money simply because the central bank is holding fewer bonds. Lucas: Yes. And they are not necessarily doing anything wrong. It is just the cost of operating in a system where the central bank is retreating from its role as the ultimate buyer of last resort. Luna: Do you think the Fed will hit a point where they have to stop the runoff entirely? Lucas: Probably not entirely. But they might slow it down significantly if economic growth shows signs of stalling. The goal is a soft landing, which implies a gradual tapering rather than a hard stop. A hard stop looks like panic. Luna: Soft landings are always easier to describe than to execute. Lucas: They are. And the margin for error is shrinking as the balance sheet normalizes. Every basis point of yield movement becomes more consequential. Luna: Before we go deeper into the implications for corporate debt, I want to pause for a second. If walking through the economy with us has made something click, the way these stay ad-free is listener support. Buy me a coffee dot com slash fexingo. Lucas: Yeah, it really helps. Knowing that folks find value in breaking down these complex mechanisms allows us to keep digging into the details without chasing clicks. Luna: Thanks for sticking with us. It means a lot to keep the show running smoothly. Lucas: Let’s get back to the corporate side. When governments and the central bank are competing for less liquidity, corporations with high credit ratings usually win the bidding war. But smaller firms get squeezed. Luna: So it is a hierarchy of access to capital. The big players get priority, and everyone else pays a premium. Lucas: Exactly. This widens the gap between investment-grade and speculative-grade borrowers. Companies that relied on easy credit to fund expansion are finding that the window is closing. Luna: Does that lead to more mergers and acquisitions as companies consolidate to survive? Lucas: It can. M&A activity often picks up when financing becomes expensive because weaker players are forced to sell. But it also depends on whether the acquirer has the cash reserves to make the deal. In a tight liquidity environment, deals become more transactional and less visionary. Luna: You lose the big transformative bets because nobody wants to risk the capital they have left. Lucas: Right. Innovation requires surplus liquidity. When liquidity is scarce, survival takes precedence over growth. That is a subtle but profound shift in the business landscape. Luna: It makes me wonder if we are seeing the early stages of a longer period of stagnation in certain industries. Lucas: We might be. Or we might just be seeing a correction from the excesses of the zero interest rate era. It is hard to tell which until we see how businesses adapt to the new normal. Luna: Adapting to scarcity is a different skill set than thriving in abundance. Lucas: Undoubtedly. And the ones who master that transition will likely define the next decade of markets. Luna: So, looking ahead, what should listeners keep an eye on to gauge if the Fed is losing control of the runoff? Lucas: Watch the repo rates and the volume of reverse repurchase agreements. If those spike, it means cash is drying up in the system. That is the canary in the coal mine for liquidity stress. Luna: Repo rates and reverse repos. The technical indicators that tell the real story behind the headlines. Lucas: Exactly. Follow the plumbing, and you will understand the politics.