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What does the Fed mean when it talks about reducing its balance sheet?

Question of the Week - April 10, 2017

Guest Post - Monday, April 10, 2017

What does the Fed mean when it talks about reducing its balance sheet?

In the course of its regular operations, the Federal Reserve maintains a balance sheet of assets and liabilities, which is meaningful for government accounting purposes, and, more tangibly, to serve as a vehicle for holding U.S. treasury bonds that are bought and sold during the Fed’s routine open market operations (which serve the key function of interest rate targeting). Since the financial crisis when quantitative easing was put into place through the massive purchase of treasuries, this asset bucket has also held agency mortgage debt, in an effort to help stabilize home finance markets in the wake of the widespread breakdown of housing prices and well-publicized issues with mortgage underwriting quality.

Since 2008, this balance sheet has grown to $4.5 trillion, or nearly a quarter of U.S. GDP, in contrast to just over 5% prior to the financial crisis, around where it had been for a few decades. The bulk of assets held are treasury debt, but also, since 2008, agency mortgages, which were purchased for similar reasons and to help with liquidity in the Fed role of lender of ‘last resort’, to push interest rates downward and ease financial conditions generally, during and since the financial crisis. Now, the difficult question is how to unload these bonds and shrink the balance sheet back down to a normal size. A likely, and less intrusive approach, would be to either gradually or abruptly stop reinvesting proceeds from maturing bonds into new debt, which would to allow it to shrink naturally. A less likely, and arguably more dramatic and destabilizing approach, would be to actually sell some of these bond holdings. Due to the Fed’s role as largest holder of these bonds, it’s quite possible sales would saturate the market with supply—pushing down prices and pulling up interest rates—more sharply and quickly than policymakers intend.

There is a careful balance here, in gracefully shrinking a very large portfolio of bond holdings, but not doing so in a manner that generates a variety of negative side effects. Regardless, there is a higher likelihood now that this process may begin later this year (this is one of those things that has been swept under the rug for so long, some investors perhaps hoped it would never be dealt with). But paring back the size of holdings is a healthy and necessary move in the long run—it gives the Fed more ammunition to deal with future crises and potential needs for more quantitative easing, and helps treasury and agency markets gradually return to some semblance of ‘normal’ with more natural market dynamics and ‘float’, although this could still take some time. In fact, due to the large amounts involved, some economists estimate that this balance sheet unwinding could take up to 10-20 years.

Another component in the implementation is how this is all communicated, which was also discussed in the minutes to some extent. Markets have been increasingly focused on tone and key words used when Fed officials have written or spoken about these issues in recent years—as much so or more than the actions themselves. Expect much more media discussion of the topic in coming months.

Read our Weekly Review for April 10, 2017.

Read the previous Question of the Week for March 13, 2017.

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