We all heard that the Fed is now starting to tighten along with "unwinding the balance sheet". It is something that is talked about on the financial media each day. However, few really knows exactly how it works.

To understand this, we need to be sure to follow the process and what the Fed is involved with. It is also imperative we comprehend the assets being used and where they are coming from.

When discussing the Fed and their buying or selling, it is vital to highlight that they do not use USD in most instances. This is where most go wrong. It is also how people mistakenly believe there is "too much money" out there when there is actually a liquidity crisis in the USD.

Therefore, let us walk through the process so everyone understands what takes place.

To do that, we have to start with Quantitative Easing since that is one way the Fed can expand their balance sheet.

Source

QE - Swap Arrangements

The Fed does its activity through what is called the Repurchase Market (Repo). This is where you heard of them buying assets. It is also the place that most people make the first fatal flaw.

To show how this works, we will use a simple illustration. For our purposes, we will reduce it to two parties. Repo transactions are more complex, usually including 3 or 4 parties. Nevertheless, we will still highlight what the Fed does.

Let us say that the Fed decides to by $25M in 10Y bonds. Many think the Fed hits the open market, plops down $25 million in cash, and that is it. This is not how it works.

To acquire this assets, the Fed goes to a depository institution such as Bank of America. The securities are on the commercial bank's balance sheet. Here is where the Fed issues a swap.

The $25 million in bonds are removed from BOA and put on the Fed's balance sheet. This increases their assets by $25M sending Twitter sphere crazy, instigating the "Printer go brr" memes.

What is correct is the Fed prints up $25 million. However, it is not USD. The Fed creates a reserve that is places on BOA's balance sheet. This makes BOA whole.

However, anyone who took any accounting knows you can't add an asset without offsetting it with a liability. This is exactly what the Fed has to do. The reserve that goes on BOA's balance is a liability to the Fed since it owes BOA $25 million.

Therefore, the Fed's balance sheet went up by $25 million on both sides. Funny how the Twitter world doesn't ever mention the Fed's liabilities.

Here is another way we know the Fed doesn't create USD. Fed liabilities are not legal tender. Since USD is legal tender in the US, what it is creating is something other than USD.

Finally, these reserves are very specific. Citigroup cannot hold them. Neither can Goldman. Only depository institutions can have these reserves on their books.

Now that we see how these securities get on the Fed's balance sheet, we can delve into the unwinding of the balance sheet.

The Fed "Selling"

Just like the buying of securities is misunderstood, the selling is also taken the wrong way.

So how does the Fed "unwind" its balance sheet?

This can happen in two ways. The first is to do the reverse of what was just posted. Using our example, the Fed goes back to BOA and puts the 10Y Treasuries back on its balance sheet. The $25 million in reserve is removed and "discarded". Of course, the liability from the Fed's balance sheet is also take off.

Go through the accounting and both balances sheets are made whole.

We also hear where the Fed is also going to let some of the Tbills and bonds expire. How does this work?

At expiration, a bond is redeemed and payout is due. In this case, the payout comes in the form of USD and is made by the Treasury. Therefore, if $1 million of the $25M is expiring, the Fed simply redeems them.

Here we start the USD process.

The Treasury sends $1 million in USD to the Fed. Since the Fed is unwinding its balance sheet, it is not looking for another asset. So it turns around and send the USD to BOA. This is offset by the removal of $1 million in reserves from BOA. The associated amount is then taken off the Fed's liabilities.

What we are left with is BOA with $24 million in reserves and $1 million in USD. Since BOA doesn't want the cash because this money is ultimately tied to deposits which they owe interest on, they either lend the money or buy more government approved securities. This is why cash, in the form of deposits, are liabilities to banks.

If another million of the, now, $24 million, expires next month, the same process happens. Obviously the real world numbers are a lot bigger but you get the point.

The Treasury Doesn't Print USD Either

Many believe the Treasury simply prints the USD it needs to make payments. This is not true either. The Treasury gets USD by selling bonds, not printing the currency.

Therefore, it has USD in its bank account to pay bills. This is where it gets the $1 million to pay the Fed, which ultimately remits it to BOA.

And where does the US Government bank? At the Fed.

Here is the USG's account.

When the government (Treasury) gets low on USD, what does it do? If you said sells more Treasuries, you are correct.

Hopefully this short tutorial will help you next time you hear the talk of the Fed looking to unwind the balance sheet.

It also helps to show how these entities are not involved with USD.

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