The Fed released news recently that it would be increasing its balance sheet by another trillion dollars. This is significant and all the capital markets reacted to it strongly. However, most investors don’t know what the Fed’s balance sheet is or how it could affect their trades and portfolio.

[VIDEO] What is the Fed’s Balance Sheet

The Fed reported that it would be buying $750 billion in mortgage backed securities, $300 billion in long term Treasury notes and $100 billion in U.S. agency notes. That purchase will increase the size of the Fed’s assets by a trillion dollars. Assets are one half of most balance sheets and are offset or balanced against liabilities and owners equity. However, the Fed’s balance sheet is a little different.

To offset assets the fed controls the money supply. This includes currency in circulation, reserves and excess reserves at banks among several other components. The total of these money supplies balances or equals the Fed’s assets. That means that the Fed increases its asset position by essentially increasing the money supply.

In the video I will explain why this is so news-worthy. Since last year the Fed has tripled its asset position on its balance sheet. That means that the money supply has also increased. The Fed has done this to fight potential deflation and to try and relieve the financial sector of it troubled assets.

If money can be made available by increasing its supply then the current theory states that the credit market will unclench and the economy will be more likely to recover. However, the offsetting risk of this strategy is that an inflation scare may occur.

Once the announcement was made, the market moved in conflicting directions. Gold jumped up and the US dollar declined, which is what we would expect if inflation was becoming an issue.  However, bond prices (Treasuries specifically) also rose in value, which is not what we would expect to see if traders are worried about inflation.

The rise in bond prices is largely attributable to the fact that the Fed will be supporting demand for them by buying $300 billion worth in the near term. However, this disturbance to the normal order of things is extremely concerning. While it is impossible to predict which direction the market may go in the near term we can say that there is a very high probability for additional volatility.

That volatility, due to increased intervention in the market and the increased risk for an inflation scare can be dealt with but it requires planning. Traders should be thinking about controlling risk through diversification and preparing a plan for investing in an inflationary but stagnant economy.