Trump Talked, the Fed Listened: Let’s Shrink the Balance Sheet, Bullard Says

The Dow is titillating the entire world by verging for days within a hair of 20,000 without actually getting there. Hitting the Big One would be another reflection of what Trump had called during the campaign an “artificial stock market” in a “very false economy,” created by the Fed that had kept rates low “for political reasons.” The crowds ate it up.

He pointed out that “the only thing that’s strong is the artificial stock market,” which was “only strong because it’s free money because the rates are so low.” But there’d be a hitch: “At some point the rates are going to have to change,” he said.

“They’re keeping the rates down so that everything else doesn’t go down,” he told reporters when they asked him about a rate hike in September.

And the Fed listened. Now the Fed has raised the fed funds rate, after flip-flopping vociferously an entire year, and is playing with the idea of three more rate hikes next year. Even Fed doves are suddenly getting antsy, after luxuriating in eight years of ZIRP and six years of QE.

On Friday, it was St. Louis Fed President James Bullard’s turn. In an interview, he told the Wall Street Journal that the Fed should consider shrinking its $4.5 trillion balance sheet in 2017; it “possibly might be a good time to play that card,” he said.

During its five years of QE, the Fed has acquired $2.46 trillion in Treasury notes and bonds and $1.75 trillion in mortgage backed securities (MBS). As these securities mature, the Fed buys similar securities as a replacement to keep the balance sheet from shrinking. Thus, the Fed continues to be a powerful buyer in the markets.

This certainty that the Fed is buying assets infuses confidence into the markets and inflates prices. It lures investors into chasing yield in ever riskier assets with ever lower returns, resulting in low cost of capital for Corporate America. It has created what Trump called the “false economy” and the “artificial stock market” where financial engineering has taken precedence over investment in productive activities that would actually move the real economy forward.

[link to wolfstreet.com]