News of the Federal Reserve’s recent meeting continues to be a hot topic in the business community, with headlines highlighting a quarter-point hike in interest rates. A critical component worth discussing is the Fed’s strategy of reducing total assets, thereby reducing liquidity in the economy.

Interest rates are important, but pay attention to balance and cash flows. Efforts to shrink the Fed’s $9 billion balance sheet are not only contributing to rising interest rates, but are also directly impacting the level of lending and investable savings in the market.

A recent article in Barron’s addressed the issue, noting that “central bankers have signaled that they may start reducing balance sheets earlier and more aggressively than markets anticipated.” This is what people need to watch out for – what plan does the Fed have to reduce liquidity in the system? This is what drives inflation, asset value, low long-term interest rates, and turmoil in the economy. It will be crucial for business owners in particular to monitor and pay close attention to how this may affect their business and finances in the near future.

understand liquidity

The liquidity in the marketplace on the Fed’s balance sheet speaks to the money supply currently chasing commodities. While more money in the system looks good, it ultimately inflates the value of our currency.

In 2008 there was a huge liquidity crisis and the Fed had to triple its balance sheet – the pandemic hit just as it was beginning to subside. So for the past 14 years we’ve been in an economy where liquidity continues to rise, and perhaps we’re about to see a reversal for the first time. What we do know at this point is that there will be winners and losers, and if you’re heavily indebted, it’s going to be a tough road.

As liquidity contracts, our money supply begins to taper off, ultimately reducing inflationary pressures.

A switch to normalization

Today we are in a unique environment that we have never seen before. For comparison: 2017 was the Fed balance sheet half the size it is today. And while a move to a less liquid, higher interest rate may seem risky, it will move us to a more normal, more balanced environment.

In the real estate sector in particular, we have seen investors flood the housing market to take advantage of the highly liquid low interest rate environment. While there are near-term benefits, local economies ultimately miss out on the multiplier effect that results from new home buyers who would otherwise buy homes and then spend to make them homes.