The Impossible Math of the Federal Reserve

The Impossible Math of the Federal Reserve




by Stephen Vanelli, CFA, Knowledge Leaders Capital

Yesterday the Federal Reserve officially signaled the beginning of its balance sheet run-off. At this point, that’s old news. But, today the Fed released the Z.1 Flow of Funds, which adds to the intrigue of the balance sheet run-off. Why?

Instead of getting wrapped up in fancy terms like quantitative easing and large-scale asset purchases, I find it easier to think about extraordinary monetary policy from a savings standpoint. Distilled to its roots, the Fed has been manufacturing “savings” from thin air for the better part of a decade. When the financial crisis hit in 2008, American savings were depleted, so the Fed had to step in to produce savings (to finance huge government deficits). Now the Fed is attempting to remove that “savings” at a time when:

  1. The private sector is experiencing falling savings.
  2. The government is likely on the precipice of expanding its dis-saving in the form of greater deficits.

Some data and charts will help explain the concept. In the Flow of Funds, released quarterly by the Fed, the relevant section to this discussion (out the 198 page report) is F.4 – Savings and Investment by Sector. Below is a clip from that table, highlighting aggregate net savings by sector.

A couple quick notes about the above data:

  1. Net savings of domestic business is basically undistributed earnings.
  2. Net household savings is a residual of income minus consumption.
  3. Net government saving (or dis-saving as is the case) is the aggregate deficits of federal, state and local governments.

These net savings are the aggregation of what is left after businesses replace worn out capital and pay dividends, what households have after paying their bills and what the government has after paying its bills. It is the country’s seed corn. If there is no net savings, there can be no net investment.

The financial crisis of 2008 decimated the stock of savings, and it actually dipped negative for the first time ever. Current aggregate net savings in the US are $355 billion. That’s it!

Decomposing net savings into its sectoral components, we’ll start with the household sector. After the financial crisis, American households ramped up their savings, but since peaking at the end of 2012, household savings are plummeting.

Next, we can turn to the corporate sector. After the financial crisis, corporate profits surged, and undistributed corporate profits peaked in the third quarter of 2010 at just over $800 billion. But since then, corporate net savings have been fading.

Last, we have the government. After the tech wreck of 2000, government dis-saving picked up pace, but after the financial crisis the rate of dis-saving exploded.

So, when we combine the net savings of all the sectors and compare it to GDP, we get the following chart highlighting the long-term structural decline in American net savings.

If the Fed starts shedding assets at $10 billion/month, ramping to $50 billion/month by 2019, can the private sector absorb these securities at the same the government budget deficit is set to widen by perhaps $100-$150 billion in the next couple years?

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