The Fed has good reasons to shrink its balance sheet. Buying securities pumped trillions of dollars of excess reserves into the banking system, making it harder to control the fed funds rate, which represents the cost of overnight loans among banks.

With the rate near zero, that hasn’t been an issue. Now that the Fed expects to raise the rate, it will have to deploy new tools to soak up the excess reserves, increasing the Fed’s role in money markets. Fed officials want to minimize their influence in those markets, while also restoring the effectiveness of the funds rate.

In the longer run, the Fed plans to “hold no more securities than necessary to implement monetary policy efficiently and effectively,” according to the September statement. It will “hold primarily Treasury securities, thereby minimizing the effect of Federal Reserve holdings on the allocation of credit across sectors of the economy.”

‘Tough Call’

When to start shrinking the balance sheet “is a tough call,” says economist Raymond Stone. That may be especially true as recent data on employment, retail sales and production indicate the economy is slowing.

“You really don’t know how the markets are going to react,” said Stone, of Stone & McCarthy Research Associates in Princeton, New Jersey. If long-term interest rates “rise more than you want, you end up constraining economic activity at a time when we are still struggling a little bit.”

When the first wave of maturities comes due in February 2016, the Fed will have three options: continue reinvesting the principal payments, stop reinvesting, or begin phasing out reinvestments slowly.

Antulio Bomfim, a senior managing director at Macroeconomic Advisers LLC in Washington, said policy makers will probably choose the third approach to soften the blow.

“Instead of going cold turkey, you stretch it out over a period of months, where you are progressively reinvesting less and less,” said Bomfim, a former Fed economist. “By mid-next year, that’s when we see them as being out of reinvestments altogether.”

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