What May Be in Store as the Fed Cuts Back on the Easy Money

The amounts involved in the Fed’s quantitative easing have been staggering. Back in 2008, the Fed’s balance sheet had assets of $820 billion. They reached $4.5 trillion — yes, trillion — in 2015 and dropped only as low as $3.76 trillion in the summer of 2019. With the coronavirus financial crisis, they have ballooned again, to $8.9 trillion, and may swell a bit more before the spigot shuts. Assets held by the Fed are already more than 10 times their size in 2008, and bigger, as a proportion of gross domestic product, than at any time since World War II.

The Fed’s monetary stimulus accompanied a total of roughly $5 trillion in pandemic fiscal relief by the federal government. Governments and central banks around the world engaged in emergency relief spending, too. The global fiscal and monetary stimulus total amounts to $25 trillion, according to Chris Dillon, a global investment specialist with T. Rowe Price, the asset management company based in Baltimore. This year, that flow is being reduced to a comparative trickle.

The risks of moving at the wrong pace.

Calibrating the combined effects of quantitative tightening and interest rate increases in real time is exceedingly difficult. Cut off stimulus too rapidly and the Fed could further unnerve financial markets. It could conceivably cause a spike in unemployment and a sharp slowdown in growth, plunging the United States into a recession.

Move too gingerly, on the other hand, and the Fed could allow elevated inflation expectations to become embedded, making high inflation even more damaging. The last time that happened, when Paul A. Volcker was Fed chairman from 1979 until 1987, it took brutally high interest rates, soaring unemployment and two recessions to wring high inflation out of the national psyche.

No wonder Mr. Powell said the Fed would need to proceed with “humility.”

The Fed’s task is fraught with risk, said Kathy Jones, chief fixed-income strategist with the Schwab Center for Financial Research. The bottlenecks in the economy could clear up if the coronavirus ebbs, which could solve part of the inflation problem.

Through control of the Fed funds rate and its ability to adjust the pace and type of securities it sells when it reduces its balance sheet, the Fed can affect a broad spectrum of interest rates.

Even if the Fed manages to avoid a recession that throws a lot of people out of work, the path ahead is unlikely to be smooth.