The Federal Reserve System (FRS), often called simply the Fed, is the central bank of the United

States. As a central bank, the Fed is given privileged control over the production and distribution

of money and credit in the United States. The critical feature of a central bank as opposed to

commercial banks is its legal monopoly status, which gives it the privilege to issue banknotes

and cash. Legal monopoly allows the Fed to operate as a monopoly (illegal for commercial

banks) under a government mandate. The Fed was officially established as the central bank of

the United States when President Woodrow Wilson signed the Federal Reserve Act in 1913. This

was enacted in response to the financial panic of 1907. The purpose of the Fed is to provide the

country with a safe, flexible, and stable monetary and financial system.

The Fed can increase or decrease the amount and scope of assets or liabilities on its balance

sheet, which in turn, increases or decreases the money supply within the economy. In June 2017,

The Fed announced that it would begin unwinding their balance sheet. Just prior to the “Great

Recession”, the financial crisis that spurred the adoption of somewhat unorthodox monetary

policies, multiple central banks began participating in an unconventional policy known as

Quantitative Easing (QE). Under QE, central banks purchase longer term securities from the

open market in order to increase money supply and encourage lending and investment. Fast

forward more than ten years later, central banks now find themselves in an entirely different

global economic climate. As a result, monetary policies are shifting around the world with

central banks considering shrinking their balance sheets, rather than growing them. Unwinding

the Fed balance sheet means the Fed is allowing bonds to “roll off,” instead of reinvesting the

proceeds of bonds as they mature. The Fed reduced its balance sheet starting in late 2017 by a

pace that grew to as much as $50 billion per month. Normally, a bigger balance sheet is viewed

as better for the stock market. As the Fed unwinds its asset holdings, some potential demand for

equities could be diverted to Treasuries and government-backed mortgage securities. The greater

supply for bonds might also contribute to higher interest rates and inflation.

There may be longer and more profound changes in the economy. According to Bloomberg, the

reducing the Fed’s balance sheet will usher in higher volatility and higher bond yields,

effectively making it harder to employ leverage.

Bloomberg also reports that the Great Unwinding may also impact corporate bonds. Though the

Fed didn’t buy corporate debt, QE pushed yields lower on debt, making it cheaper for companies

to borrow. This opened the floodgates for high-grade corporate debt, pushing the U.S. stock

market to all-time highs. As more retail exchange traded products track the corporate bond

market, investors may bail when yields rise and prices fall.

The unwinding of the Fed’s balance sheet will most likely have far-reaching consequences.

Quantitative easing’s injection of cheap money into the global financial system had a lot of

effects that contributed to record high-grade debt issuance and a never-ending bull market in

stocks. Now, as the central banks around the world attempt to shrink themselves, it’s not entirely

clear what the future holds. The only thing that seems certain is that interest rates and volatility

will rise, which is not usually a formula for a strong and stable economy.

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