Even if you've only casually followed news related to the Federal Reserve, you've likely encountered this piece of hard-to-decipher jargon: "balance-sheet normalization."
Fed Chairman Jerome Powell referenced it 30 times at the Fed's January news conference.
But even though it's hard to find a dictionary that translates what central bankers say into everyday English, this isn't a topic to ignore. While most consumers focus on how the Fed affects borrowing costs, this wonky term has major implications for the U.S. economy, monetary policy and your pocketbook.
More broadly, "balance-sheet normalization" refers to the Fed's recent efforts to sell the huge holdings of assets it bought a decade ago to keep the economy afloat during the financial crisis.
In November 2008, Fed Chairman Ben Bernanke faced a financial panic. The Fed reduced interest rates to virtually zero, but that still wasn't enough to jump-start an economy suffering its worst turmoil since the Great Depression.
To inject more life into the financial system, the Fed turned to unconventional and unprecedented measures: It started buying long-term Treasurys, debt and mortgage-backed securities to "increase the availability of credit" for home purchases and prop up the economy, according to a Fed statement from 2008.
Such purchases were called "quantitative easing," or QE, by financial experts. The Fed, however, prefers "large-scale asset purchases," said Joe Pavel, senior media relations specialist at the Fed Board of Governors.
Fast-forward to 2019: The Fed is gradually selling off those holdings because the economy has healed and is growing at a healthy rate. The sale of these bonds is referred to as "quantitative tightening."
What does QE have to do with the balance sheet?
You probably have an idea of how much money you owe, such as student loans, credit cards or mortgages. In accounting terms, those are considered liabilities. In contrast, the things you own _ stocks, bonds or a house, for example _ are considered assets.
The U.S. central bank, too, keeps track of its assets and liabilities. It publishes this data in a weekly financial statement known as "the balance sheet."
U.S. paper currency and money that commercial banks hold in accounts at the Fed are counted as liabilities. Assets, on the other hand, are things that the Fed has purchased, such as Treasury.
Now, go back to 2008. When the Fed announced it would start buying huge amounts of bonds, including "subprime" mortgage securities and other forms of distressed debt, it listed them as "assets" on its balance sheet.
That caused the balance sheet to balloon. In August 2007, before the financial crisis hit, the Fed's balance sheet totaled about $870 billion. By January 2015, after those large-scale asset purchases occurred, its balance sheet had swelled to $4.5 trillion.
Before those measures, most people weren't interested in the Fed's finances, said Kenneth Kuttner, a professor of economics at Williams College who has researched unconventional monetary policy.
"It was the most boring thing in the world, like watching paint dry," Kuttner said. "Quantitative easing changed all that."
Why did the Fed turn to this?
To know why the Fed took such drastic measures to revive the economy, it's important to remember the goal of the central bank: ensuring low inflation and maximum employment.
Normally, the Fed influences the pace of economic growth by adjusting its key short-term interest rate known as the federal funds rate, which determines how much it costs banks to borrow and lend to each other overnight.
When the economy needs a help, the Fed can make credit less expensive. That prompts businesses to invest more in themselves and add jobs. Cheaper borrowing costs also gives consumers an incentive to purchase cars and homes on credit. But if the economy grows too quickly, the Fed can raise interest rates to avoid it overheating, which also makes it more attractive to save.
The Fed can also manipulate the short-term interest rate by buying and selling U.S. government bonds, notes and bills, which are added to its balance sheet.
But as the financial crisis worsened, and the Fed cut interest rates to virtually zero but the economy was not revived, the Fed decided it needed to do more. That's when it started to buy Treasurys and mortgage-backed securities on the open market. The sellers of these securities, such as big banks, the Fed reasoned, would use the cash from the sales to boost lending and reinvest in their businesses.
It's been a decade since the financial crisis. What's the Fed doing now?
The economy is in far better shape compared with a decade ago.
Unemployment is near a 50-year low. Employers added more than 300,000 jobs in January, even with a government shutdown and uncertainties related to the U.S.-China trade conflict. Inflation is tame, just below the Fed's 2 percent target. And if the economy keeps growing come midyear, it will be the longest expansion on record.
When the Fed announced these unconventional measures a decade ago, it said it would reduce its holdings back to the normal, pre-crisis level once the economy started to recover. Enter the term "normalization."
The Fed began reducing its fixed-income holdings in October 2017, and now its balance sheet is just above $4.026 trillion.
What should consumers keep their eyes on?
There's just one problem: The asset purchases were so unusual, Wall Street investors are worried that the economy may suffer and grow more slowly if the Fed reduces its holdings too aggressively, which takes money out of the financial system and amounts to policy tightening.
"Where's it going to end _ $2 trillion? $1.5 trillion? There's no good sense where the ultimate destination is," Kuttner said, referring to the final size of the Fed's balance sheet when normalization is complete.
To ease investors' fears, policymakers at the Fed issued a separate statement about the normalization process at their January rate-setting meeting, essentially giving themselves room for flexibility. The Federal Open Market Committee is "prepared to adjust any of the details for completing balance sheet normalization in light of economic and financial developments," the statement read.
There are still many unknowns when it comes to the Fed's balance sheet normalization plan.
It's like "going into a forest that hasn't been mapped before," said Mark Hamrick, Bankrate's senior economic analyst. The Fed "wasn't sure what they'd find on the way in, and getting out of the woods is similarly fraught with unknowns."
The process of the Fed unwinding its asset purchases isn't risk-free. Just as interest rates typically fall when reserve supplies increase, the central bank risks raising borrowing costs as it decreases reserves.
That could be a challenge for U.S. central bankers, who voted to raise interest rates four times last year based on economic measures, Kuttner said.
"If that's the case, then maybe monetary policy is a bit more contractionary than indicated by the fed funds rate," which is still historically low, Kuttner said.
But policymakers indicated at the January FOMC meeting that they would be "patient" before lifting borrowing costs again, voting to leave the federal funds rate in a range of 2.25 percent to 2.5 percent as they judge the impact of previous rate hikes.
What should consumers' next steps be?
This uncertainty underscores the importance of building an emergency savings fund, Hamrick said. Investors, meanwhile, should brace for market choppiness as the Fed figures out this process.
"Some of the volatility that we saw in financial markets toward the end of 2018 is an indication of what can go wrong if the Fed makes a policy mistake," Hamrick said. "The worst of that may be behind. But whether anticipating an economic slowdown or market volatility, think about your long-term plans, including retirement and emergency savings."
The bottom line: Embrace the unconventional.
"Consumers, investors, savers and borrowers should think about this (quantitative easing) as one of the two main tools in the central bank's toolbox to help adjust the strength of the U.S. economy," Hamrick said. "It remains to be seen how the Fed will learn how best to employ it and whether there are unintended negative consequences from having invented and deployed it."
