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Balance sheet reduction and Labour conference

29 September 2017

 Why is the Federal Reserve reducing their balance sheet?

After the global financial crisis in 2007, the US Federal Reserve ("Fed") launched its debut quantitative easing programme. It bought US Treasuries and asset-backed securities to provide liquidity and insurance to investors. Ten years on and various iterations later, the Fed's balance sheet has risen from $1 trillion to $4.5 trillion.

At the end of 2015, the Fed started to hike interest rates and has since raised them four times. This is the result of a strengthening US economy with robust growth indicators, stable inflation and unemployment hovering near its lows. Ever since, rates have started to normalise, commentators have toyed with idea of how the Fed will shrink its balance sheet, which currently stands at 23% of GDP (compared to 6% pre-crisis).

The Fed revealed how it could proceed with a balance sheet reduction earlier this year and announced at last week's meeting that it would start the implementation of it next month.

This comes off the back of stable economic conditions which now warrant removal of this emergency measure. The wind-down is a multi-step process intended to gradually reduce the balance sheet to a more normalised level. A good way to think of it is taking the training wheels off of a bike.

Going forward, the removal of an indiscriminate buyer from the market may worry some investors due to its impact on demand-supply dynamics. Whilst these concerns are understandable, the Fed has the flexibility to adapt the process if economic conditions deteriorate. We have seen the Fed exercise this flexibility when it came to previous interest rate increases.

At the recent Labour conference, Jeremy Corbyn said that they are the mainstream now, but how mainstream are his economic policies?

The UK snap general election in June was largely expected to be a non-contest. However, Labour managed to win 262 seats against the 318 won by the Conservatives, which was far more than forecasted by pre-election opinion polls and confirmed Labour's return to favour in the UK. With the youth vote principally driving this shock result, Jeremy Corbyn stated this week that the Labour party are a "government-in-waiting" and are "now the political mainstream".

His speech described his new economic vision for the UK, centred on vast public spending. The Shadow Chancellor, John McDonnell, outlined plans for widespread nationalisation of utilities and the scrapping of Private Finance Initiatives ("PFI"). Other proposed policies include higher pay for public workers and higher pension contributions.

On nationalisation, it appears that Labour intends to bring water, rail and energy industries back under public control. The listed utilities in the UK alone amount to around £100bn in terms of market capitalisation. Add in the proposal on increasing public pay and UK government debt rising sharply under Labour is almost unavoidable. National debt as a percentage of GDP currently sits at roughly 90% in the UK and over a 5-year term, a rise to levels like the 130% seen by troubled Italy are possible.

The big question following the conference is how Labour can fund this kind of spending when UK debt is already so lofty. Implementing these policies would likely lead to significant increases in borrowing costs and a sharp decline in sterling.

Certainly, Corbyn has recovered since the no-confidence vote he faced in June last year, but question marks remain about the long-term practicality of a number of his proposed policies. The younger electorate may favour these hard left policies but older generations will vividly remember the "winter of discontent", the last time a more socialist labour party was in power. These policies may seem mainstream when looking at Twitter however this is unlikely to represent the wider views of the electorate.

 

 

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