The Federal Reserve’s balance sheet swelled to over $7 trillion this year. That’s up from around $4 trillion at the end of 2019.
That the central bank’s balance sheet increased throughout 2020 is hardly surprising. We know why: COVID-19.
Since February, Fed Chair Jerome Powell and his Fed buddies have engaged in more asset purchasing than the Fed has at any other time in history. That includes the Great Depression and the 2008-2009 global financial crisis.
Along with direct asset purchases, the Fed has made trillions of dollars of low- or zero-interest-rate loans to member banks and key industries. At the same time, it has dropped the federal funds rate to 0%.
But the Fed’s unprecedented asset purchases aren’t new for central banks. In fact, the Bank of Japan (BoJ), the central bank of the world’s third-largest economy, has done the same thing for nearly 20 years. It’s accelerated in the years following the Great Recession.
The BoJ currently has a balance sheet of just over 6 trillion USD. That’s over 130% of Japan’s GDP. During 2019, the BoJ was the single largest buyer of stocks on the Tokyo Stock Exchange, and it’s the biggest landlord in Japan, carrying nearly 2 trillion USD in mortgage-backed securities.
If the Fed matched the BoJ balance sheet relative to GDP, its balance sheet would be over $25 trillion. That’s over three times higher than it is today. Furthermore, while the U.S. Fed buys ETFs that may contain small allocations of U.S. stocks, it doesn’t yet dabble in the stock market directly.
Jerome Powell is on record saying he’s in favor of the U.S. government launching another round of economic stimulus. And he’s in favor of the Fed paying for it by buying U.S. Treasury bonds. That alone could grow the balance sheet to just a hair under $10 trillion.
The reason investors should care about the size and scope of the Fed’s balance sheet can also be informed by the Japanese experience so far this century: Its GDP growth has lagged global economic growth by a wide margin. For example, since 2000, U.S. GDP has averaged nearly 3% per year, but Japan’s has lagged at under 1% annually over the same period. That’s a classic case of “stagflation.”
Economists at the Fed have long warned about the Japanese approach and the headwinds an ever growing balance sheet creates. However, given the COVID-19 realities, it’s unlikely the U.S. Fed will be able to slow balance sheet growth much… at least over the next year. And likely for longer.
If the balance sheet keeps growing, and Congress passes more stimulus, it suggests interest rates will stay low for the foreseeable future… and stock prices look set for further gains.
Of course, we know a big run like this can’t last forever. But while it does, investors have to play along. The trick is to keep looking out for signs that show the easy money (low interest rates and stimulus) is coming to an end. It won’t be easy. But that shouldn’t stop you or us from keeping a close eye on the markets.