Having bought unprecedented quantities of bonds in an attempt to keep the economy going after the global financial crisis, the US Federal Reserve (Fed) is considering reducing its mammoth balance sheet. Over the past decade, this has grown from $900 billion to $4.2 trillion, essentially because of the central bank’s quantitative easing (QE) programme.
Such a reduction is no small task and raises several important questions.
Why is the Fed talking about reducing the size of its balance sheet now? This is really about trying to ensure the Fed is able to respond to future crises. A smaller balance sheet would give the Fed more scope to expand it again to fight any future downturn.
Furthermore, the sheer amount of bonds held by the Fed is restricting supply in the wider market, which is keeping prices high and suppressing long-term yields. This could lead to bubbles forming in certain asset classes as investors look for yield from other, more risky sources.
When might the Fed begin reducing its balance sheet? The Fed has suggested that they might start this year if the economy keeps performing as it has been. On this basis, we think that they will begin reducing the size of its balance sheet in December.
There is a risk that the balance sheet reduction could cause the economy to turn, as the increase in supply of bonds causes yields to spike. But the Fed should be able to raise its funds rate twice between now and the start of the process. This would give the Fed some breathing space to cut rates if the balance sheet reduction does cause an abrupt tightening in financial conditions.
Chair Janet Yellen’s term is up in February 2018 and it’s unclear whether she will stay on. It will be a delicate time for financial markets, so starting the balance sheet process at the end of the year also avoids overlap with any potential Fed leadership transition.
How will the Fed reduce the size of its balance sheet? The Fed’s most recent formal guidance on balance sheet reduction – a September 2014 statement on ‘Policy Normalization Principles and Plans’ – outlines an intention “to reduce the Federal Reserve's securities holdings … primarily by ceasing to reinvest repayments of principal”, rather than by outright asset sales. In other words, the Fed wouldn’t actually sell current holdings, but would simply stop buying any more once its current bonds mature.
Fed officials appear to believe, and we agree, that allowing maturing assets to roll off the balance sheet passively is likely to minimise potential market disruption.
At what pace might the Fed allow maturing assets to run off? The Fed has not made its thinking clear yet. Our assessment of the Fed’s balance sheet indicates that $550 billion of assets will mature in 2018, $450 billion in 2019, and $350 billion in 2020. Letting those assets run off amounts to a fairly substantial pace: $550 billion is 13% of the total balance sheet.
The Fed will be only too aware that such pace could disrupt the market, so they might opt for a slower pace. Either way, the Fed is going to have to make its intentions clear soon.
What is the eventual size of the balance sheet likely to be? The Fed’s aim is to hold no more securities than necessary to implement monetary policy efficiently and effectively.
The size of a central bank’s asset holdings is largely determined by the volume of currency in circulation, or its liabilities. By our calculations, if the Fed ended reinvestments of maturing assets from 2018 onwards, it could reduce its balance sheet from the current $4.2 trillion to $2.5 trillion by 2022.
Does balance sheet reduction alter the likely path of the Fed funds rate? Yes. The Fed itself has suggested that it could “take a little pause” from hiking rates as it begins balance sheet reduction. They will probably hike the funds rate in June and September, but then leave rates unchanged in December when it begins allowing maturing assets to roll off the balance sheet.
The balance sheet reduction process should continue passively in the background once it has started, while the funds rate is used as the main tool of monetary policy.
How are markets likely to respond? A smaller Fed balance sheet may raise long-term bond yields. Estimates by Fed economists suggest that its QE programmes have depressed 10-year Treasury yields by about 110 basis points. So some of this fall in yields could be reversed as the size of the balance sheet is reduced. However, this should be easy enough for financial markets to digest if the process is as gradual and passive as currently predicted.
The Fed is going to have to make sure that they clearly communicate their intentions though. The last thing Janet Yellen and her colleagues will want is to spook investors and create a spike in volatility. They face a tense few months.