How will the Fed reduce its balance sheet?

As the federal reserve begins to gradually tighten monetary policy, its next task is to tackle the $ 4.5 trillion elephant in the room: its bloated balance sheet.

Beginning in late 2008, the Fed began purchasing assets on a large scale, such as US Treasuries and government-backed mortgage-backed securities (MBS), to prevent a complete collapse of the financial system. For six years, the feds embarked on this asset-buying program, known as quantitative easing, which kept interest rates at unprecedented levels in the hope that rising bank lending would fuel growth.

The effectiveness of the program will never be known (you cannot prove a counterfactual scenario in which there was no qe), but the financial system in the United States survived a scare of historic proportions. Some argue that it continued for a long time, which led to over-inflated asset prices, but we put that discussion on for another day.

On October 29, 2014, when Fed Chair Janet Yellen announced the end of the bond purchase program, the Fed’s balance sheet had reached $ 4.48 trillion. By reinvesting principal payments and securities maturities, the balance sheet has remained at or around $ 4.5 trillion. According to weekly data released by the Fed, its balance sheet consists of $ 2.5 trillion in Treasuries and $ 1.8 trillion in mortgage-backed securities.

As economic conditions continue to improve, evident in the labor market and rising inflation, albeit gradual, the Fed faces mounting pressure to address its balance sheet. In December, the Fed declared that it would not begin the process of reducing its balance sheet until “the normalization of the level of the federal funds rate is underway.” when that will be or at what level federal officials believe normalization will occur remains unknown. This subjective notion aside, when eating begins to reduce your balance, it will do so in one of two ways. You can sell securities on your balance sheet, or you can choose not to roll over maturing securities.

Key findings

  • The US federal reserve balance has been at $ 4.5 trillion since 2014.
  • The Fed can reduce its balance sheet by selling its balance sheet securities or by ceasing to reinvest maturing securities.
  • During federal meetings, committee members proposed leaving $ 30 billion in maturing Treasuries and $ 20 billion in mortgage-backed securities (mbs) runoff per month.
  • The $ 50 million per month phase-down plan started in October 2017, and the balance sheet is expected to be less than $ 3 trillion with this plan by 2020.

Sale of securities

Until the election of Donald Trump, the chances of the Fed actively selling securities to reduce its balance sheet was unlikely. In this scenario, a more aggressive path to balance sheet reduction, the sale of securities would put pressure on the bond market, which could cause interest rates to rise rapidly, causing unwanted volatility in financial markets. However, Trump has been highly critical of Yellen and the Fed’s low interest rate policy; If it decides to shake up the feds, it could change the central bank’s strategy.

“This could be important for balance sheet policy because many leaning Republican economists criticized quantitative easing and expressed a preference for a quick balance sheet balance, perhaps even through asset sales,” said Dan Struyven, an economist at Goldman, according to cnbc.

In a January blog post titled “Lower the Federal Reserve Balance Sheet,” former Federal Reserve Chairman Ben Bernanke warned against the Federal Reserve actively trading its balance sheet. “However, I am concerned that, in practice, attempts to actively manage the unwinding process may lead to unexpectedly large responses in financial markets,” said bernanke.

In May 2013, the Fed announced that it would reduce its $ 70 billion a month bond purchase program. The announcement triggered a panic selling in the US treasury markets, and interest rates rose further. the day became known as the conical tantrum.

Maturation: the mature approach

Simply letting the balance slowly decline by not reinvesting maturing assets is an easy path to balance reduction. While Republicans argue that the pace of reduction should be rapid, it’s worth noting that $ 1.4 trillion of the $ 2.5 trillion in treasury has maturities of less than five years. Also, if the federal reserve is to maintain its balance sheet permanently, something Bernanke has argued for, the short duration of these securities is the argument for allowing assets to mature over time – the most mature and stable approach.

Bernanke argues that the feds must maintain a great balance sheet to improve the feds’ ability to provide assets in a crisis.

Take off

Minutes of the March 2017 federal reserve meeting showed federal officials endorsed a plan that would begin to reduce the balance of $ 4.5 trillion by the end of 2017. ” Most participants anticipated that gradual increases in the federal funds rate would continue and felt that a change to the committee’s reinvestment policy would likely be appropriate later this year, ”the minutes noted.

Three months later, these plans became clearer. At the June federal reserve meeting, committee members stated that once the phasing out begins, they will leave $ 6 billion a month in mature treasury runoff, slowly increasing to $ 30 billion in the coming months. .

With respect to its agency debt and mortgage-backed securities (MBS), the Fed put forward a similar plan in which it will begin cutting $ 4 billion a month down to $ 20 billion. In addition, the Fed said that the long-term plan is to keep the balance “considerably below what has been seen in recent years but larger than before the financial crisis.”

On September 20, 2017, the Fed officially announced takeoff. The outcome of the balance sheet was underway. the gradual reduction of $ 50 billion per month would begin in October, and at this rate, the balance sheet would fall below $ 3 trillion in 2020, at which point the next discussion will be how large the Fed’s balance sheet should remain once the reduction is complete.

The bottom line

Almost a decade has passed since the Fed launched what was, at the time, one of the boldest monetary policy moves in recent history. In just a few years, the Fed quadrupled its balance sheet in an attempt to combat a full-blown bank collapse.

Years later, most participants agree that the feds avoided a full-blown disaster. however, just as they agree with the qe program, they are so unanimous that undoing the trillion-dollar balance will be a delicate task in itself. And like the asset purchase program, only time will tell.


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