Ben Emons, Columnist

The Other Side of the Fed’s Balance Sheet

When the central bank sheds assets, fractional reserves will be affected, too.

May 15, 2017 at 12:50 PM UTC

Ben Emons is the founder of FedWatch Advisors, a firm specialized in analysis and investing around the Fed. Previously he was associated with NewEdge Wealth as head of fixed income and Medley Global Advisors as Managing Director of Global Macro Strategy. The opinions expressed are his own.

Full of surprises.
Photographer: Alberto ALBERTO Pizzoli/AFP/Getty Images

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In the fretting about the unwinding of the Federal Reserve’s balance sheet, what may be overlooked is its impact on the fractional reserve system.

The financial system is based on “fractional reserves,” the process under which banks make loans by holding a fraction of deposits in currency or at the Federal Reserve. But when the Fed's balance sheet will finally shrink, the current large amount of excess reserves will begin to adjust to a new reality. There are three distinct effects that could occur: monetary base contraction, the revival of the federal funds market and an increase in velocity of money.