Today's Headlines: Could The Fed Trigger A Recession?

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Today's Headlines: Could The Fed Trigger A Recession?
August 8, 2017

A Balancing Act

In the wake of the housing crisis and subsequent Great Recession, the Federal Reserve took extraordinary actions to stave off financial disaster. The Fed introduced three rounds of "Quantitative Easing" (QE), consisting of a double-barreled approach to increase borrowing and spending activity – dropping interest rates to near zero and injecting money into the economy by buying debt and mortgage-backed securities.

The economy has slowly recovered since then, but the Fed is now left holding a massive asset balance (approximately $4.5 trillion) as a result of QE. To put this in perspective, the Fed balance was approximately $0.9 trillion prior to QE.

During the recovery period, the Fed has been keeping the size of the balance sheet fairly constant by reinvesting the proceeds. Later this year, according to reports, the Fed plans to reduce this balance sheet gradually by not replacing new bonds when they mature.

The Fed's goal is to reduce reserves to around $2 - $2.5 trillion, a process that should take at least four to five years. Accelerating the process by selling bonds instead of letting them expire – not out of the question in a Trump administration – would create huge volatility in the bond market, and the Fed wishes to avoid such a rapid adjustment.

Restoring the Fed's balance sheet to a more reasonable level without triggering recession requires an impressive balancing act (pun intended). Michael Darda, chief economist/market strategist with MKM Partners, notes that the Fed has tried similar balance sheet reduction efforts six times, with recession occurring in five of those six attempts.

How likely is Fed action – or a Trump-propelled acceleration of the process – to trigger recession, and what should you do about it if recession does strike?

Getting Economic Lift

Why would the Fed's actions trigger a recession? Using the reverse of QE, drawing down the Fed balance sheet removes liquidity from the economy. At the same time, interest rates are being slowly raised to return to more normal historical levels. Move too fast on either count, and money/credit becomes too tight, placing a drag on economic growth.

Using an airplane as a crude analogy, QE applied the necessary force to give the economy sufficient lift and get it off the ground. Once the economy has lifted, the extra stimulus is no longer needed – just as a plane needs less power to sustain flight – but cut the stimulus too quickly and the economy can stall, just as a plane can.

Some economists reject the airplane premise, suggesting that it's better to rapidly reduce the balance and let the market sort things out (the best analogy to this approach might be ripping off a Band-Aid quickly.) Both Fed Chairwoman Janet Yellen and Vice Chair Stanley Fischer may not be reappointed by the Trump administration, and based on Trump's previous criticism of Fed policy – and infamous lack of patience – new Fed appointees may prefer the "Band-Aid" approach.

The slow and steady approach of the Fed is designed to prevent recession during this balance reduction. While this approach is not guaranteed to work, it does suggest the Fed has learned from past efforts.

Be Ready

We aren't suggesting that a recession is imminent, or even likely. Even if President Trump wanted to accelerate the Fed’s bond portfolio liquidation, he could not simply order it — as the Fed is independent. While he could appoint new Fed decision makers (including the Chair and Vice-Chair, whose posts expire in 2018), the currently feisty Senate is unlikely to approve nominees who would endanger our still-fragile economy by accelerating the sale of Fed bond holdings

That said, it's still wise to think about what you would do if a recession did occur. A mild recession may have little effect on you at all, perhaps causing you to adjust your budget due to rising prices at the grocery store – but what would a sharp or prolonged recession do in your case?

Consider how recession-proof your job is – if you are in a layoff-prone position, you may need to cut back your expenses even further or look for alternate income sources in case of emergency. Credit will be tight, making it more difficult to extend your credit limit or open new accounts. You can check your credit score and read your credit report for free within minutes using Credit Manager by MoneyTips.

If you are preparing to buy a home, it will be harder to get a mortgage with favorable rates. Before being tempted with an adjustable-rate mortgage to get a lower rate, think about how long you plan to stay in the home and whether you can handle the likely interest rate at adjustment. MoneyTips is happy to help you get free mortgage quotes from top lenders.

You can't control the Fed's actions, but you can control your reaction to them. Keep an eye on the news, and stay ready in case you need to adjust.

The Takeaway

To prepare properly for any future recession, think about what happened to you during the last one. Were you overextended on your mortgage debts, or on overall debt (such as high-interest credit card debt)? Did you lack an emergency fund to cover a potential job loss? Were your investments weighted too heavily toward aggressive growth? Did you keep track of your expenses using a budget, so that you could shift and reprioritize expenses in tough times?

By now, you see where this is going. By keeping your credit card balances and spending under control, and sticking to a reasonable budget, your finances can better withstand the effects of a recession. If recessionary signs are on the table as you enter a large financial commitment, such as buying a home, make sure that you are not purchasing above your means and letting your debt rise to levels that give you little margin to make your payments.

In short, the best preparation for a recession is to take the same precautions you should be taking in good times – just shifting them toward a more conservative position.

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